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A Quantitative Model of "Too Big to Fail,"' House Prices, and the Financial Crisis

Acikgoz, Omer and Kahn, James (2016): A Quantitative Model of "Too Big to Fail,"' House Prices, and the Financial Crisis.

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Abstract

This paper develops a quantitative model that can rationally explain a sizeable part of the dramatic rise and fall of house prices in the 2000-2009 period. The model is driven by the assumption that the government cannot resist bailing out large financial institutions, but can mitigate the consequences by limiting financial institutions' risk-taking. An episode of regulatory forbearance, modeled as a relaxation of loan-to-value limits for conforming mortgages, is welfare-reducing, results in opportunistic behavior and, for plausible parameters inflates house prices and price/rent ratios by roughly twenty percent. This "boom" is followed by a collapse with high default rates.

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