House Prices, Economic Cycles, and Leverage with Market-Based Intermediation in the Housing Market

The housing and credit markets are closely linked. This paper presents VAR evidence that house prices can generate financial and business cycle dynamics. An increase in house prices leads to a boom in mortgage and real estate construction lending. Leverage decreases in the short run before rising at longer-run horizons across households and most financial intermediaries, irrespective of their primary funding source. To understand the results I construct a New-Keynesian model with financial frictions, the housing market and financial sector. Collateralized mortgage debt, endogenous default risk in construction lending and collateralized borrowing limits on the supply-side of credit are necessary to support the VAR evidence. The model can generate expectations-driven boom-bust cycles in the housing market, real economy and financial sector, consistent with popular accounts of the most recent crises and historical housing booms.