Limited liability, strategic default and bargaining power

Arbeitspapier

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.

Object Details

• ISBN: 978-92-899-4519-6
• Language: Englisch

References and Relationships

• Bibliographic citation: Series: ECB Working Paper ; No. 2519

Classification and Topics

• Classification: Wirtschaft ; Household Behavior: General ; Money and Interest Rates: General ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Urban, Rural, Regional, Real Estate, and Transportation Economics: Household Analysis: General ; Real Estate Markets, Spatial Production Analysis, and Firm Location: General
• Subject: lender recourse ; mortgage contracts ; debt repudiation ; renegotiation ; discontinuity

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Mozzanica, Mirco Balatti ; López-Quiles, Carolina
• Event: Veröffentlichung
• (who): European Central Bank (ECB)
• (where): Frankfurt a. M.
• (when): 2021

Further information

• DOI: doi:10.2866/502561
• Handle: http://hdl.handle.net/10419/234073
• Last update: 10.03.2025, 11:41 AM CET