Signaling-Screening Equilibrium in the Mortgage Market
Tel Aviv University
Banking and Finance, UNSW Business School, UNSW Australia; Financial Research Network (FIRN)
Journal of Real Estate Finance and Economics, Vol. 26, pp. 157-178, 2003
The signaling model of Spence (1973a) and the screening model of Rothchild-Stiglitz (1976) have been separately used to explain economic phenomena when there is asymmetric information. In the real world, however, situations of asymmetric information often simultaneously involve signaling and screening. In this paper, we combine signaling and screening mechanisms and demonstrate a signaling-screening separating equilibrium. We present the analysis within the framework of mortgage markets. Borrowers signal their default risk types to lenders by acquiring different credit records. This partially separates borrowers into subsets. Lenders screen each subset by offering menus of mortgage loan contracts. Borrowers, then, self-select by choosing particular contracts from the menu. We show the conditions under which the signaling-screening equilibrium is Pareto superior to a screening-only equilibrium.
Keywords: Signaling, screening, separating equilibrium, asymmetric information, mortgage markets, default, mortgage maturity, risk premium, welfare, market efficiency
JEL Classification: D82, G21, R29
Date posted: October 4, 2002