Description:
During the Global Financial Crisis, there were increasing concerns about the effects of mortgage market activity on the stability of the financial system. Given the important role of banks for extending mortgage funding, how does the legal environment regarding mortgage default impact mortgage market activity and thus financial fragility? What is the optimal degree of mortgage recourse? We study these questions in a version of Diamond and Dybvig (1983) where banks with limited commitment issue mortgages through maturity transformation and can raise liquidity by selling loans on secondary markets. In particular, we demonstrate that if borrowers incur lower costs in the event of foreclosure, intermediaries will generally be compensated for default risk with higher interest rates on mortgages. Interestingly, the banking system is not necessarily less stable at lower penalties for default. In addition, regardless of the probability of a financial crisis, relatively high protections for borrowers are likely to increase expected utility. In general, however, neither a no-recourse policy nor a full-recourse regime maximizes social welfare