Summary
This issue is important to policy makers, economists, financial institutions, and finally to the US economy and the world economies.During the economic boom, financial institutions expanded their balance sheet and found due to the increasing housing prices that their leverage is small. This in turn encouraged them to give more and more housing loans to customers who were not even good credit worthy borrowers.When house prices start collpsing , this worked in the o[pposite direction that they found that the leverage is high and therefore started reducing the balance sheet sizes , and declining the housing loans.And paradoxically when the supply started reducing, the demand also fell considerably for housing loans. This of course is against the common economic principle that when prices start declining both demand and supply also declining. This has implications not only at the micro level balance sheet adjustment but also for the macroeconomy.
Analysis
Financial Institutions who were providing mortgage backed loans are first afftected both during the boom time and during the recession time when their balance sheet sizes and equity values and leverage are affected.During the reccession ,as it is now in US,Financial Institutions start liquidating their assets , and this in turn creates a ripple negative effect on other financial and non- financial companies. The jobs are lost and the consumer confdence falls.This is where the Federal Banks have to play their macroecomic management role , where the supervisory and monetary policy roles can not be totally separated .The Federal Banks will have to buy such assets which are liquidated widely in the recessionaly economy , where the liquidity trap pervades to a whole spectrum of assets, and where equity prices are falling but bonds are not substituted in that place , and may be ,for a while, commodities and gold are substituted in the place of equities and bomds , but finally they will also be liquidated and the economy can plunge into deep depression. Here Bern Bernanke's strayegies to step inthe mortgage backed assets and securities , directly by the Federal Banks can provide some defence mechanism . The moral hazard issue should not be too much focused , when the liquidity trap can even pervades into commodity asset markets also.
