Limited Liability, Strategic Default and Bargaining Power

45 Pages Posted: 15 Jan 2021

See all articles by Mirco Balatti

Mirco Balatti

Henley Business School - ICMA Centre; European Central Bank (ECB)

Carolina Lopez-Quiles

European University Institute; European Central Bank (ECB)

Date Written: August 28, 2020

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 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.

Keywords: strategic, default, mortgage, limited liability, renegotiation, discontinuity

JEL Classification: E21, E40, G21, R20, R30

Suggested Citation

Balatti, Mirco and Lopez-Quiles, Carolina, Limited Liability, Strategic Default and Bargaining Power (August 28, 2020). Available at SSRN: https://ssrn.com/abstract=3682550 or http://dx.doi.org/10.2139/ssrn.3682550

Mirco Balatti

Henley Business School - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA, RG6 6JE
United Kingdom

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Carolina Lopez-Quiles (Contact Author)

European University Institute ( email )

Villa la Fonte
Via delle Fontanelle 18
Firenze (Florence), Tuscany 50014
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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