CORRELATED LEVERAGE * Anand M. Goel Fenghua Song Anjan V. Thakor July 30, 2010 Abstract This paper develops a theory of “correlated leverage” in financial markets in which the lender’s payoff depends heavily on the value of the collateral backing the loan. There are two main results. First, leverage is a “correlated” phenomenon in that high leverage among borrowers is positively correlated with high leverage among lenders. Both borrower and lender leverage are higher when house prices are higher. Second, a bank’s exposure to credit risk depends not only on its own leverage choice but also on the leverage decisions of other banks. The model has an overlapping-generations setting in which banks make one-period mortgage loans in the first period that are secured by houses as collateral and house prices are endogenously determined. The second-period prices of houses, and hence the values of collateral, depend on the supply of loans to the second-period homebuyers. Higher bank leverage increases the volatility of house prices in response to shocks to fundamental house values, and also leads to lower equilibrium house prices. Numerous additional results are derived, including the result that the dynamics of bank capital structure can generate house price cycles. Although the model is developed in the context of the housing market, it is applicable in any borrower-lender setting in which collateral values depend on the aggregate availability of credit, and credit risk in turn depends significantly on collateral values. Empirical and policy implications of the analysis are drawn out. ∗ Goel is from LECG, Song is from Smeal College of Business, Pennsylvania State University, and Thakor is from Olin Business School, Washington University in St. Louis. We thank Sudipto Bhattacharya, Darius Palia, Matt Pritsker, Peter Raupach, and participants at the Banco de Portugal Conference on Financial Intermediation (June 2009), the NBER Summer Institute (July 2009), the Deutsche Bundesbank-Imperial College Conference on the Future of Banking Regulation (September 2009), the Financial Intermediation Research Society (FIRS) conference (June 2010), and seminars at Washington University in St. Louis, the Federal Reserve Bank of New York, the Federal Reserve Bank of San Francisco, Imperial College London, Georgia Institute of Technology, and the Federal Reserve Bank of Chicago for helpful comments. Please send correspondence to Fenghua Song, Smeal College of Business, Pennsylvania State University, University Park, PA 16802. Email: song@psu.edu.