Optimal Collateralized Contracts

63 Pages Posted: 17 May 2016 Last revised: 21 Sep 2018

See all articles by Dan Cao

Dan Cao

Georgetown University - Department of Economics

Roger Lagunoff

Georgetown University - Department of Economics

Date Written: August 20, 2018

Abstract

We examine the role of collateral in a dynamic model of optimal credit contracts in which a borrower values both housing and non-housing consumption. The borrower’s private information about his income is the only friction. An optimal contract is collateralized when in some state, some portion of the borrower’s net worth is forfeited to the lender. We show that optimal contracts are always collateralized. The total value of forfeited assets is decreasing in income, highlighting the role collateral as a deterrent to manipulation. Some assets, those that generate consumable services will necessarily be collateralized while others may not be. Endogenous default arises when the borrower’s initial wealth is low, as with subprime borrowers, and/or his future earnings are highly variable.

Keywords: optimal contract, asymmetric information, collateral, forfeiture, collateralized contract

JEL Classification: D82, D86, D53, D14, G21, G22

Suggested Citation

Cao, Dan and Lagunoff, Roger, Optimal Collateralized Contracts (August 20, 2018). Available at SSRN: https://ssrn.com/abstract=2780020 or http://dx.doi.org/10.2139/ssrn.2780020

Dan Cao (Contact Author)

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States

Roger Lagunoff

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States
202-687-1510 (Phone)
202-687-6102 (Fax)

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