Limited liability, strategic default and bargaining power

Mirco Balatti and Carolina López-Quiles

No 2519, Working Paper Series from European Central Bank

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

Keywords: debt repudiation; discontinuity; lender recourse; mortgage contracts; renegotiation (search for similar items in EconPapers)
Date: 2021-01
New Economics Papers: this item is included in nep-ban, nep-cta, nep-gth, nep-rmg and nep-ure
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20212519

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