STRATEGIC DEFAULT, RENEGOTIATION, AND RECOURSE IN RESIDENTIAL MORTGAGE CONTRACTS

Abstract

In this article we model strategic default and renegotiation in residential mortgage contracts. In particular, we study how recourse affects mortgage rates and default. We find that in the presence of recourse, default rates are lower for a given loan-to-value ratio, equilibrium coupon rates are lower, loan-to-value ratios are higher and welfare is improved. We find that higher loan-to-value ratios under recourse, increase welfare but can lead to higher equilibrium default rates. We find that when the bank has monopoly power during renegotiation, contracts with renegotiation are an improvement over contracts without renegotiation. Increase in homeowner renegotiation bargaining power, beyond a threshold, has a negative effect on equity value since the surplus that the homeowner can extract ex-post is priced into the initial mortgage rate. We show that the provision of recourse and the balance of bargaining power during renegotiation alleviates some of the distortions due to moral hazard implicit in debt contracts. Our equilibrium concept is sub-game perfect Nash and we derive closed form solutions in the model.