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Optimal Collateralized Contracts

Dan Cao () and Roger Lagunoff ()
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Dan Cao: Department of Economics, Georgetown University, http://faculty.georgetown.edu/dc448/

No gueconwpa~18-18-14, Working Papers from Georgetown University, Department of Economics

Abstract: We examine the role of collateral in a dynamic model of optimal credit contracts in which a borrower values both housing and non-housing consumption. The borrower’s private information about his income is the only friction. An optimal contract is collateralized when in some state, some portion of the borrower’s net worth is forfeited to the lender. We show that optimal contracts are always collateralized. The total value of forfeited assets is decreasing in income, highlighting the role collateral as a deterrent to manipulation. Some assets, those that generate consumable services will necessarily be collateralized while others may not be. Endogenous default arises when the borrower’s initial wealth is low, as with subprime borrowers, and/or his future earnings are highly variable.

Keywords: optimal contract; asymmetric information; collateral; forfeiture; collateralized contract (search for similar items in EconPapers)
JEL-codes: D82 D86 D53 D14 G21 G22 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cta, nep-dge and nep-mic
Date: 2018-09-15
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Persistent link: https://EconPapers.repec.org/RePEc:geo:guwopa:gueconwpa~18-18-14

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Roger Lagunoff Professor of Economics Georgetown University Department of Economics Washington, DC 20057-1036
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