Liquidity Contractions and Prepayment Risk on Collateralized Asset Markets

Miguel Iraola and Juan Pablo Torres-Martinez

No 1204, Working Papers from Centro de Investigacion Economica, ITAM

Abstract: This paper presents a dynamic general equilibrium model with default and collateral requirements. In contrast with previous literature, our model allows for liquidity contractions and general prepayment specifications. We show that liquidity substantially affects credit and prepayment risks, and that different borrowers may follow differentiated payment strategies: whereas some pay, others prepay or default. The lack of liquidity increases debtors' willingness to continue paying, even thought prepayment cost could be higher than the collateral value. This mechanism rationalizes underwater mortgages. We prove existence of equilibrium, and provide a numerical example illustrating the main determinants of optimal payment strategies.

Keywords: Collaterized asset markets; Liquidity constraints; prepayment risk (search for similar items in EconPapers)
JEL-codes: D50 D52 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2012
New Economics Papers: this item is included in nep-ban and nep-dge
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Working Paper: Liquidity Contractions and Prepayment Risk on Collateralized Asset Markets (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:cie:wpaper:1204

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