Research
When borrowers have access to two types of debt, and the cost of one type of debt declines relative to the other, borrowers should substitute towards the type of debt that has become relatively cheaper. When household borrowers can choose between uncollateralized debt and mortgage debt any shock that drives up the spread of the interest rate on uncollateralized debt over the interest rate on mortgage debt will incentivize households to substitute towards mortgage debt. In turn households will demand more housing to collateralize this mortgage debt, pushing house prices up. I build a model that captures this novel debt substitution channel linking debt substitution to house prices. I study this channel in the context of negative nominal interest rate policy (NIRP) in Denmark. I show empirically that NIRP is associated with an increase in the spread between the interest rate on uncollateralized debt and the interest rate on mortgage debt. Using the model I show that the debt substitution channel amplifies the impact of monetary policy rate cuts on house prices and reduces the ability of monetary policy to stimulate the aggregate consumption of borrowers. Lastly I show that monetary policy rate hikes from negative levels have a smaller impact on inflation due to the debt substitution channel.
(R&R, Review of Economic Dynamics)
From 2000-2006 US house prices and mortgage credit grew substantially. Simultaneously, the relative cost of mortgage credit fell – particularly for privately securitized mortgages – suggesting the importance of credit supply factors. This paper explores two candidate (credit supply) shocks: an increase in the inflow of global savings into the US, and innovations in the securitization of mortgage credit. I model a two-layered mortgage market. This generates a novel balance sheet effect: changes in aggregate mortgage credit quantity are linked to changes in mortgage spreads via the interaction of financially constrained commercial banks and mortgage securitizers. Innovation in securitization matches mortgage credit market dynamics by directly relaxing the securitizers’ financial constraint. Conversely, the inflow of global savings leads to a counter-factual increase of mortgage spreads through the balance sheet effect.
The Portfolio Balance Channel of Quantitative Easing in a DSGE Model with Financial Frictions [link]
Investors who arbitrage between long term government debt and corporate debt expand the Portfolio Balance Channel in that the effects of QE spill over to the overall cost of corporate borrowing. I find that overall the Federal Reserve’s second round of Large Scale Asset Purchases (LSAPII) boosts output between 0.51% - 1.69%, the equivalent of a 83 - 279 basis point cut in the Federal Funds rate. The long term maturity preference of investors increases output growth by between 0.4 and 1.34% points, and inflation between 20 and 68 annualized basis points more than the model without this expanded channel.
Overborrowing & Shadow Banking
In this paper I show that the existence of unregulated financial institutions (“shadow banks”) generates overborrowing (relative to the socially optimal level) in competitive equilibrium. This is because borrowers fail to internalize that an additional unit of borrowing, when the financial sector is well functioning, has adverse effects on the credit conditions they will face if a crisis arises. The social planner therefore has a motive to intervene to reduce borrowing in good times so as to limit the severity of a crisis. The discretionary planner’s optimal allocation can be decentralized either using borrower based instruments or via regulation of financial intermediaries. The optimal regulation of commercial banks is pro-cyclical.