More Punishment, Less Default?

The nature and intensity of punishment following contractual default varies greatly across economies. For instance, in the residential mortgage context, some US states limit the liability of the borrower to the home, while other states grant the lender much broader recourse. Intuitively, we would expect these differences to matter for default behavior at the micro-economic level and for equilibrium quantities. The objective of this paper is to study an equilibrium model in the spirit of Dubey, Genakoplos and Shubik (2004) where the implications of lender recourse for default choices can be studied. I show, however, that the equilibrium concept they define can generate equilibria that are incompatible with competitive behavior on the part of lenders. I show, in fact, that the existence theorem they produce only obtains because their concept allows for pathological equilibria. I propose a selection procedure that rules out these pathological equilibria and show that in the context of a simple model of mortgage markets, this procedure yields unique equilibria. Having so guaranteed uniqueness, I show that under fairly general conditions, greater recourse causes yields at origination and default rates to fall for given set of observable borrower characteristics. On the other hand, the effect of broader recourse on average default rates and the quantity of loans is deeply ambiguous because the composition of the pool of borrowers can change. Raising the fraction of assets subject to recourse can well increase equilibrium default rates. Preliminary and incomplete, comments welcome.