Finance and Economics Discussion Series (FEDS)
September 2024
Nonlinear Effects of Loan-to-Value Constraints
C. Bora Durdu and Sergio Villalvazo
Abstract:
This paper investigates the impact of loan-to-value (LtV) borrowing constraints in models with occasionally binding credit constraints. These constraints give rise to a Fisherian debt-deflation mechanism, where exogenous shocks can trigger cascading effects resulting in significant declines in consumption, asset prices, and borrowing reversals—characteristic of financial crises. However, recent literature challenges traditional view by suggesting that collateral constraints may not always exacerbate financial disturbances but could instead foster dynamics leading to multiple equilibria. Building on this discussion, the paper explores equilibrium asset pricing models with LtV collateral constraints, identifying critical thresholds that govern asset price dynamics, consumption patterns, and current account behaviors. Our analysis uncovers that when the LtV limit is close to zero, tighter constraints induce smaller drops in consumption during crises. Conversely, when the LtV limit is close to one, we observe that tighter constraints induce larger drops in consumption during crises. The nonlinear relationship between the LtV ratio and adverse effects on macroeconomic outcomes aligns with cross-country evidence regarding the relationship between the level of financial development and the severity of consumption declines during crises.
DOI: https://doi.org/10.17016/FEDS.2024.081
PDF: Full Paper
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