Housing and Credit Markets

Prompted by the recent US experience, in this chapter, we study the interaction between cycles in credit markets and cycles in housing markets. There is a large growing literature exploring two different approaches: on the one hand, a boom–bust in house prices can generate a boom–bust in credit market and, on the other hand, a boom–bust in credit markets can generate a boom–bust in house prices. We start by presenting a stark mechanical model to formalize the interaction between housing prices and credit markets and explore these two channels in a mechanical way. Next, we present two simple models that highlight the two approaches. First, we propose a catastrophe model, where an increase in credit availability can generate first a boom and then a bust in mortgage markets because of multiple equilibria due to adverse selection: as lending expands, the composition of borrowers worsens and at some point this can generate a crash in credit market. Second, we propose a sentiment model, where house prices increase above fundamentals because investors buy assets under the irrational belief that there is always going to be an ever more foolish buyer, willing to buy at a higher price. In the course of the chapter, we relate our simple models to the large existing literature on these topics. At the end, we also point to some empirical papers that propose related facts.