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Double leverage cycle, interest rate, and financial crisis

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  • Wang, F. Albert

Abstract

We view mortgage as a risky derivative of its underlying house collateral and combine no-arbitrage valuation with equilibrium valuation approaches to develop a dynamic model of leverage cycle and interest rate. This model provides a unified explanation to pro-cyclical optimism, asset prices, and leverage, and counter-cyclical volatility and interest rate. In addition, the model shows that tightening funding margin in the mortgage securities market dampens optimism, asset prices, and leverage, whereas it raises volatility and interest rate in the housing market. A double leverage cycle leads to more volatile markets and a severe leverage cycle, thus resulting in worse financial crises.

Suggested Citation

  • Wang, F. Albert, 2022. "Double leverage cycle, interest rate, and financial crisis," Journal of Financial Stability, Elsevier, vol. 58(C).
    • Handle: RePEc:eee:finsta:v:58:y:2022:i:c:s1572308921001182
    DOI: 10.1016/j.jfs.2021.100959
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    More about this item

    Keywords

    Leverage cycle; Interest rate; Financial crisis; Systemic risk; Collateral;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • R31 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Housing Supply and Markets

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