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Limited liability, strategic default and bargaining power

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  • Balatti, Mirco
  • López-Quiles, Carolina

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

Suggested Citation

  • Balatti, Mirco & López-Quiles, Carolina, 2021. "Limited liability, strategic default and bargaining power," Working Paper Series 2519, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20212519
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    debt repudiation; discontinuity; lender recourse; mortgage contracts; renegotiation;
    All these keywords.

    JEL classification:

    • D10 - Microeconomics - - Household Behavior - - - General
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • R20 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis - - - General
    • R30 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - General

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