Optimal Collateralized Contracts
- American Economic Journal: Microeconomics (Forthcoming)
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
of 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.
Forthcoming Article Downloads