Collateral Pledge, Sunk-Cost Fallacy and Mortgage Default
37 Pages Posted: 7 Jun 2014 Last revised: 11 Aug 2014
Date Written: August 2014
Individuals and firms pledge collateral to mitigate agency costs or contracting frictions in a world with asymmetric information. However, the option value theory suggests that once the mark-to-market asset valuation is below the current debt, the firms and individuals should default on their debt contract irrespective of the initial collateral pledged. In this paper, we estimate default models and find that after controlling for mark-to-market asset valuation, initial collateral remains an important predictor of mortgage default. Specifically, individuals that pledge higher collateral have a lower hazard to default. Our results are consistent with models of sunk cost fallacy.
Keywords: Household Finance, Mortgages, Collateral, Option Value, Financial Crisis, Sunk Cost
JEL Classification: D12, D14, G11, G21
Suggested Citation: Suggested Citation