1. Collateral Crisis and Labour Market Eric Tong

2. Global Rise in Unemployment Rate

3. House Price and Employment

4. Has Happened before… Claessens, Kose, and Terrones (2009, AEJ: Economic Policy) – 21 OECD countries between 1960 – 2008 – Of 122 recessions, the 34 with house price bust more severe than recessions without – Median unemployment rate 1.3 percent point higher Moreover, – Unemployment rate higher in episodes with house price busts than in episodes with equity price busts.

5. Similar Loss in Wealth for US Households between 2000 Dot- com Bubble Burst and GFC Yet employment loss is 4.5 times larger in GFC, and time to recovery is at least twice longer – Employment took 10 quarters to recover to peak level in 2000 – 20 quarters after 2008, employment is still 2% below peak level.

6. This paper proposes Households are also small business entrepreneurs. Households pledge their house as collateral to banks for loans to start business. Jobs are created along the way. 20% of small business owners pledge homes as collateral for businesses (2009 National Federation of Independent Businesses survey of small business owners; 2007 Barlow Research). Small businesses account for 60% of jobs in US and most OECD countries (OECD, 1997; Bernanke, 2010) 12% of jobs affected through the collateral channel.

7. Objective Show effect of house value change on labour market via the collateral channel.

8. Modelling Strategy Wasmer and Weil (2004, AER) – Financiers and entrepreneurs search for each other in credit market. – Entrepreneurs and labours match in labour market. – Credit and labour markets interact through the presence of entrepreneurs in both markets. Gorton and Ordonez (2012) – Banks’ incentive to check on collateral quality is not perfectly correlated with collateral quality. – Collateral quality can be either Good or Bad, and banks can either Check or Not Check. – Collateral is still useful if (Bad, Not Checked) – Sudden amplification comes in when banks switch from (Bad, Not Checked) to (Bad, Checked).

9. Literature Structural VS Cyclical Unemployment. Structural largely rejected by different empirical studies – Valletta (2012) on house-lock hypothesis – Schmitt and Warner (2011) on skill mismatch Within Cyclical, – Aggregate Demand Hypothesis: Houses as ATMs (Mian and Sufi, 2012) – Bank Financing Hypothesis: CFO survey (Campello, Graham, and Harvey, 2010, JFE) Collateral and capital investment – Bernanke and Gertler (1989), Kiyotaki and Moore (1997) Collateral and employment – Empirical: Adelino, Schoar, and Severino (2013) – Theoretical: Hristov (2009), Chugh (2009), and Garin (2011).

10. Model Setup Continuous time. Entrepreneurs, bankers, workers. Mass 1. Risk neutral. Discount rate r > 0. Entrepreneur has idea, banker has capital, worker has labour. Entrepreneur borrows from banker to start business and post vacancies, hires the worker, and produces, until business destroyed exogenously.

11. Matching (1) Credit and labour markets imperfect: agents exert time and effort to match. Match between banker and entrepreneur follows CRS function Let be credit market tightness from view of entrepreneur. Instant probability of match between entrepreneur and banker is Inverse is matching duration

12. Matching (2) Let be labour market tightness from view of entrepreneur. Probability of match between entrepreneur and labour is

13. Production Begins after worker hired. With probability q, output is y. With probability (1-q), output is 0. But unverifiable, so need collateral.

14. Collateral Each entrepreneur endowed with one house. 0 < p < 1 of all entrepreneurs hold good houses that will bring flow C units of goods during production stage. (1-p) hold bad houses that yield nothing. No agent knows true value until production stage.

15. Loan Repayment and Collateral Pledged After matched, but before true collateral value realised, banker and entrepreneur discuss loan repayment (R ) and fraction of collateral (house) to put down (x). If R > xC, all entrepreneurs will default and all bankers take over collateral pledged, getting pxC in expectation. Banks will not accept R < xC, for then they get less than pxC. If R = xC, then banks also get (and entrepreneurs pay) pxC in expectation. p and C exogenous, so negotiation on R = negotiation on x.

17. Unconditional Lending: Value of Bank Cost of bank Expected payoff of bank Bank fund raising cost Capital gain Probability of finding an entrepreneur Business start-up costProbability of finding a worker Bank expected revenue Probability of business destruction

18. Value of Firm Sweat costProbability of finding a banker Probability of finding a worker Probability of business destruction Expected output Expected repayment

19. Conditional Lending Bank screens and lends only to the p entrepreneurs with good collateral. The (1-p) firms with bad collateral bear own business start-up cost, k, and financing cost, δb. δ > 1 : more costly for firm to raise fund than for bank.

20. Equilibrium Conditions 1. Perfect competition; free entry and exit for bank and firm 2. Bank and firm share cost and payoff according to the Nash Bargaining rule – 0 < β < 1 is the bargaining power of bank – Firm shares the cost borne and capital gain shared by bank. 3. When business destroyed, firm and bank values return to stage 0.

21. Equilibrium Credit Market Tightness Number of entrepreneurs per banker Bank financing cost Firm sweat cost Relative firm-bank bargaining power

22. Equilibrium Job Vacancy Rate (1) Substitute stage 2 values backward to get the forward looking values, Substitute in the Nash Bargaining rule,

23. Equilibrium Job Vacancy Rate (2) Substitute in the backward looking capitalised cost,

24. Conditional Lending Equilibrium

25. Loan Repayment / Collateral Pledged Substitute the forward looking discounted values of bank and firm into Nash Bargaining, Collateral Demand: Repayment required to compensate the bank for its contribution during hiring stage Collateral Supply

26. Collateral Crisis If p falls, x can rise. But x cannot rise beyond 1.

28. Increase in bank financing cost (b) Will lower vacancy rate in both unconditional and conditional lending regimes (θ and θ c ). Decrease in θ c will be larger than that in θ, because b enters both cost and payoff sides of θ c determination. Lower θ will shift p T to left. Lower p T further widens gap between θ and θ c

30. Decrease in output (y) Leads to similar result as increase in b, but of different magnitude. If β is large, then decrease in y will shift p T more to the left. If credit market matching is very sensitive to credit market tightness, then increase in b will bring a larger impact.

31. Decrease in bank bargaining power (β) (A) Bank demand less repayment from the output source. (B1) Quitting of banks will lower finance raising cost (b) for remaining banks. (B2) Quitting of banks will lengthen search cost ( e) for firms. If (A) or (B2) dominates, then p T shifts to the left. If (B1) dominates, then p T may shift to the right.

32. Empirical Evidence Four countries: Portugal, Spain, Luxembourg, Netherlands, over 2003 Q1 to 2013 Q3 Key variable: – Over the past 3 months, how have the following factors affected your bank’s credit standards towards enterprises? ECB Bank Lending Survey.

33. Positive means that more banks have tightened than have eased credit due to increased collateral risk

34. Survey covers 132 banks with 99% response rate. Advantage of survey: solves identification issue. Disadvantage: relative measure.

35. VR: Job Vacancy Rate CC: Credit Tightening due to increased collateral risk Control Variables: – Output per worker – Real output – Business start-up cost (World Bank) – Deposit rate (proxy for bank funding cost) – State and time effects Instrument: Average Credit Standard of all countries within Euro Area – Average credit conditions correlate with country’s credit conditions, but unrelated to labour conditions of a particular country.

40. Conclusion Credit and Labour markets conditions not only interact to determine equilibrium employment, they also determine likelihood and magnitude of collateral crisis outbreak. Likelihood and magnitude of collateral crisis is inversely related. Whether collateral crisis breaks out determines which information regime equilibrium job vacancies will settle in. Future: – Endogenise banks’ decisions to produce information. – Includes feedback between asset price and real economy along Kiyotaki and Moore (1997) framework – Empirically establish regime switch by using switching regression model.