Modeling a housing and mortgage crisis
The current crisis has centered on borrower defaults on mortgages and the associated effects on banks’ own credit standing (and in several cases their own default), which in turn led to tightened conditions for lending to new (mortgage) borrowers. Any model that does not incorporate all or most of these key elements cannot possibly hope to capture the defining features of the current crisis. This is particularly true of standard dynamic stochastic general equilibrium (DSGE) models, which (mostly) assume away the possibility of default altogether! This paper builds on our previous model of a system in which default plays a central role for both borrowers and banks and in which financial intermediation and money thus have a necessary real function. Specifically, we include both an additional good, housing, in the prior composite basket of goods and services and an additional agent, a new entrant to the housing market. Our previous papers on this include Goodhart, Sunirand, and Tsomocos (2004, 2005, 2006).