Monopoly and Information Advantage in the Residential Mortgage Market

Abstract

Information advantage and entry deterrence incentives are investigated as they affect lending outcomes and competitive structure of the U.S. residential mortgage market. In the model, when assessing a loan applicant, the incumbent monopoly lender employs a proprietary screening technology to produce a privately observed estimate of loan credit quality. When faced with potential competitive entry, the incumbent signals poor credit quality by charging high prices to higher-quality borrowers. Market structure and loan pricing strategy are derived endogenously, where the incumbent deters entry first by segmenting consumers into prime and sub-prime loan markets and second by charging prime market borrowers a uniform rate that is higher than the risk-based monopoly rate. Empirical implications of the model are identified, and evidence is presented that is consistent with predictions.