The Design of Foreclosure Punishments: You Just Cannot Walk Away!

Don Schlagenhauf and Carlos Garriga ()

No 396, 2009 Meeting Papers from Society for Economic Dynamics

Abstract: Foreclosure rates have soared during the recent housing crisis. In this paper we argue that exploring the implications of the legal environment pertinent to foreclosures is very relevant to the understanding of the macroeconomic transmission of the financial crises. Foreclosure law is designed to allocate the deficit between the current value of the property and the outstanding debt. In the United State, two different regimes coexist across states: no discharge and full discharge. The empirical evidence seems to suggest that states with full discharge exhibit foreclosure rates that are more sensitive to declines in house values. We study the quanitative importance of default punishments in the determination of foreclosure rates. We modify the housing model with the default option developed in Garriga and Schlagenhauf (2008) to allow for different allocations of deficits and the severity of (present and future) punishments. The model generates testable implications for tenure, housing size, and portfolio allocations consistent with the empirical evidence. Preliminary findings suggest that the design of punishment can have important macroeconomic consequences.

Date: 2009
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