Abstract
In this paper we examine the effects of limited liability on mortgage dynamics. While the literature has focused on default rates, renegotiation, or loan rates individually, we study them together as equilibrium outcomes of the strategic interaction between lenders and borrowers. We present a simple model of default and renegotiation where the degree of limited liability plays a key role in agents' strategies. We then use Fannie Mae loan performance data to test the predictions of the model. We focus on Metropolitan Statistical Areas that are crossed by a State border in order to exploit the discontinuity in regulation around the borders of States. As predicted by the model, we find that limited liability results in higher default rates and renegotiation rates. Regarding loan pricing, while the model predicts higher interest rates for limited liability loans, we find no such evidence in the Fannie Mae data. We further investigate this by using loan application data, which contains the interest rates on loans sold to private vs public investors. We find that private investors do price in the difference in ex-ante predictable default risk for limited liability loans. JEL Classification: D10, E40, G21, R20, R30
Highlights
While there are several factors that determine the rate of mortgage default, such as adverse economic shocks that leave households unable to honour their debt, default may be a voluntary choice, commonly referred to as strategic default
We further investigate this by using loan application data from the Home Mortgage Disclosure Act (HMDA) database, which contains the interest rates on loans sold to private and public purchasers
The rise of household indebtedness before the financial crisis combined with high default rates was a root cause of the Great Recession and underlined the importance of consumer finance for the macroeconomy
Summary
The rise of household indebtedness before the financial crisis combined with high default rates was a root cause of the Great Recession and underlined the importance of consumer finance for the macroeconomy. The authors rationalise it by arguing that, under recourse, the fear of a decline in house prices pushes these households to anticipate their default decision, thereby ‘leaving money on the table’ While these papers focus on individual aspects on limited liability, one contribution of this paper is to encompass default, renegotiation and loan pricing in an integrated setting. We consider this an important aspect, as these elements are all equilibrium outcomes of the strategic interaction between borrowers and lenders, which we show in our model.
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