Working Paper Series

Mirco Balatti, Carolina López-Quiles Limited liability, strategic default

and bargaining power

No 2519 / January 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank
(ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.
 Abstract
In this paper we examine the effects of limited liability on mortgage dynamics. While
the literature has focused on default rates, renegotiation, or loan rates individually,
we study them together as equilibrium outcomes of the strategic interaction between
lenders and borrowers. We present a simple model of default and renegotiation
where the degree of limited liability plays a key role in agents’ strategies. We
then use Fannie Mae loan performance data to test the predictions of the model.
We focus on Metropolitan Statistical Areas that are crossed by a State border in
order to exploit the discontinuity in regulation around the borders of States. As
predicted by the model, we find that limited liability results in higher default rates
and renegotiation rates. Regarding loan pricing, while the model predicts higher
interest rates for limited liability loans, we find no such evidence in the Fannie Mae
data. We further investigate this by using loan application data, which contains
the interest rates on loans sold to private vs public investors. We find that private
investors do price in the difference in ex-ante predictable default risk for limited
liability loans.

JEL codes: D10, E40, G21, R20, R30

Keywords: lender recourse, mortgage contracts, debt repudiation, renegotiation, discon-

tinuity.

ECB Working Paper Series No 2519 / January 2021 1

Non-technical summary

The rise of household debt before the financial crisis combined with high default rates

was a root cause of the Great Recession and highlighted the role of consumer finance for the
macroeconomy. Mortgage debt, in particular, constitutes two-thirds of US household total
debt. Outstanding mortgage amounts declined substantially during the Great Recession,

but have since reached new historical highs.

While there are several factors that determine the rate of mortgage default, such as
adverse economic shocks that leave households unable to honour their debt, default may

also be a voluntary choice, commonly referred to as strategic default. One particular

aspect the household may consider before choosing to default is whether there is limited
or full liability in place. Under limited liability, the lender is not allowed to seize the

household’s assets after default.

Limited liability constitutes the legal protection of a stakeholder’s liabilities beyond a

fixed sum. In the context of loans, and in particular of mortgage contracts, limited liability

implies a fixed limit on the borrower’s obligations, which amounts to the handover of the

mortgaged property. In the absence of limited liability, the borrower is liable for the
repayment of the full loan amount, and the lender is entitled to seize the borrower’s

personal assets.

In contrast to the literature, which has studied several effects of limited liability indi-
vidually, we analyse default decisions, renegotiation and loan pricing together. These are,

in fact, equilibrium outcomes of the strategic interaction between lenders and borrowers.

To this end, we first develop a simple model of default and renegotiation where the degree
of limited liability plays a key role in agents’ strategies. Borrowers who can afford to pay

the loan may choose to default if their mortgage is underwater. Limited liability encour-

ECB Working Paper Series No 2519 / January 2021 2

ages this behaviour since borrowers can walk away from their debt more easily. In turn,
lenders may be inclined to offer renegotiated loan prices to these borrowers, as they know

under limited liability they would not be able to recover more than the foreclosure value
of the home. Borrowers thus have greater bargaining power over lenders under limited
liability. These interactions also have an effect on loan prices, as the expected value of

each loan will depend on the equilibrium of this game. Thus, the model provides three
main predictions. First, limited liability leads to higher default rates. Second, lenders
renegotiate more under limited liability. Lastly, loan prices are higher for limited liability

loans.

We then use Fannie Mae loan performance data to test the predictions of the model. We
exploit the difference in regulation in different States. In particular, we limit our analysis

to Metropolitan Statistical Areas (MSAs) that are crossed by a State border, where one

side has limited liability laws in place and the other does not. This allows us to isolate the
effect of limited liability on loan outcomes, as other factors such as economic shocks are

expected to be the same within each MSA. As predicted by the model, we find that limited

liability results in higher default and renegotiation rates. Regarding loan pricing, while

the model predicts higher interest rates for limited liability loans, we find no such evidence

in the Fannie Mae data. We further investigate this by using loan application data from
the Home Mortgage Disclosure Act (HMDA) database, which contains the interest rates

on loans sold to private and public purchasers. We find that private investors do price

in the difference in ex-ante predictable default risk for limited liability loans, while their
public counterparts, such as Fannie Mae, do not. This has important policy implications,
as it imposes price distortions in a multi-trillion dollar market.

ECB Working Paper Series No 2519 / January 2021 3

1 Introduction

The rise of household indebtedness before the financial crisis combined with high default

rates was a root cause of the Great Recession and underlined the importance of consumer
finance for the macroeconomy. Mortgage debt, in particular, constitutes two-thirds of
US household total debt, as shown in Figure 1. Outstanding mortgage amounts declined

substantially during the Great Recession, but have since reached new historical highs.

Figure 1: US households debt

Notes: Share of mortgage and other debt types as a percentage

of total household debt. Total US outstanding mortgage amount
in trillion US dollars. Source: New York Fed Consumer Credit
Panel/Equifax and authors own calculations, 2003-2019.

While there are several factors that determine the rate of mortgage default, such as

adverse economic shocks that leave households unable to honour their debt, default may

also be a voluntary choice, commonly referred to as strategic default. One particular

aspect the household may consider before choosing to default is whether there is limited

in place. Under limited liability, the lender is not allowed to seize the household’s assets

ECB Working Paper Series No 2519 / January 2021 4

after default.

Precisely because of the widespread presence of mortgage debt, and in order to prevent

strategic default, some jurisdictions allow for lender recourse. Under recourse, lenders
are allowed to seize borrowers’ assets after default. This aspect of mortgage contracts is
predominant in Europe, as noted by Campbell (2012). In the case of the United States,

the existence of mortgage recourse is heterogeneous across States, a feature which we will
exploit in our analysis.

Strategic default has been widely studied for sovereign debt (e.g. Grossman and

Van Huyck (1988); Atkeson (1991)), and other types of unsecured debt (e.g. Jeske (2006)).
Mortgage debt is a particular case, and it is interesting to evaluate it in isolation. First,
agents making decisions are not sovereign States or investors, but households. Second,

debt contracts are highly structured and backed by a real estate property. Third, this

type of collateral, in addition to providing an investment opportunity, grants housing ser-

vices to the borrower. This non-monetary function allows households to derive additional

utility from the asset and can thus heavily influence their choices. Fourth, mortgage con-

tracts typically allow borrowers to reach levels of leverage uncommon in other types of

debt. Lastly, mortgage contracts are typically longer, the most common contract length

being around 30 years. It is worth noting that the decisions made by agents may differ
substantially as the loan is amortised.

In order to understand the mechanisms at hand, it is important to review the chain of

events after default, and the payoffs from which agents will derive their decisions. When a
household defaults on a mortgage, the lender recovers the collateral through foreclosure,

short sale, or a deed in lieu. Under limited liability, the borrower is freed from their

debt and the lender only recovers the proceedings from the sale of the property. In
contrast, under recourse or full liability, the lender can pursue a deficiency judgement.

ECB Working Paper Series No 2519 / January 2021 5

A deficiency judgement is a ruling through which the lender calculates the difference
between the mortgage balance outstanding and the amount recovered through the sale

of the collateral. Should the sale of the collateral not be enough to cover the mortgage
balance, the lender is entitled to claim the difference from the borrower.

This paper relates to two bodies of literature. The first one exploits different legislative

discontinuities around State borders to study several aspects of limited liability and its
effect on different market outcomes. Some papers have focused on the effect of limited
liability on loan origination. Pence (2006) studies loan origination volumes through the

difference in the size of loans on recourse and non-recourse States and finds that non-

recourse loans are smaller on average. Curtis (2014) finds that lender-friendly foreclosure
is associated with an increase in subprime originations, but has less effect on the prime

market. Li and Oswald (2017) leverage on the abolition of deficiency judgements in the

State of Nevada in 2009 and find that it led to a decline in equilibrium loan sizes and

approval rates. Some other papers have studied the effect of limited liability on loan rates

and housing prices. Meador (1982) finds that States with judicial foreclosure exhibit lower
interest rates on loans. Pennington-Cross and Ho (2008) inquire whether laws intending

to reduce predatory lending behaviour have an effect on loan rates. Their results suggest

that these laws have only a modest effect on loan prices. Mian et al. (2015) use judicial
requirements for foreclosures across States as an instrument for foreclosures and find
that higher foreclosure rates lead to a decline in house prices, residential investments

and consumer demand. Another set of papers is concerned with forbearance and loan
modifications. Gerardi et al. (2013) find that laws designed to protect borrowers delay
but do not prevent foreclosure. Conditional on a loan being underwater, these laws do not

increase the probability of cure. Collins et al. (2011) test the extent to which distressed
mortgage borrowers benefit from different types of State foreclosure polices. They find
that judicial foreclosure proceedings and foreclosure prevention initiatives are associated

ECB Working Paper Series No 2519 / January 2021 6

with modest increases in loan modification rates. Finally, another group of papers focus
on the effect of different legislation on default rates. Ghent and Kudlyak (2011) compare

recourse and non-recourse States and find higher mortgage default rates in the latter.
Chan et al. (2016) examine how factors affecting mortgage default spill over to other credit
markets. They find that, while non-recourse mortgage laws increase mortgage default,

they are associated with lower credit card default. Gianinazzi et al. (2019) investigate
default behaviour in Europe, where all mortgages have lender recourse and conclude that
many households default when the value of the house is greater than the outstanding

mortgage balance. They find this result puzzling because it is suboptimal. The authors
rationalise it by arguing that, under recourse, the fear of a decline in house prices pushes
these households to anticipate their default decision, thereby ‘leaving money on the table’.

While these papers focus on individual aspects on limited liability, one contribution of

this paper is to encompass default, renegotiation and loan pricing in an integrated setting.
We consider this an important aspect, as these elements are all equilibrium outcomes of

the strategic interaction between borrowers and lenders, which we show in our model.

The second strand of the literature this paper relates to deals with discrepancies between
Government-Sponsored Enterprises (GSEs) and the private market. Most notably, Hurst

et al. (2016) find that despite large regional variation in predictable default risk, GSE

mortgage rates for otherwise identical loans do not vary spatially. In contrast, they find

that the private market does set interest rates which vary with local risk. In this regard,

Dagher and Sun (2016) find similar results for credit supply by exploiting an exogenous
cutoff in loan eligibility to GSE guarantees. They find that judicial requirements reduce

the supply of credit only for jumbo loans, which are ineligible for GSE guarantees.

In this paper we connect these two strands of the literature by analysing default and

renegotiation choices by borrowers and lenders, as well as loan pricing, and to highlight
the difference in pricing between private and public investors.

ECB Working Paper Series No 2519 / January 2021 7

 In addition, this paper is related to the theoretical literature that studies debt and
renegotiation, of which the closest papers are Hart and Moore (1998) and Bester (1994).

Some other papers have studied mortgage contracts and default decisions through the lens
of a dynamic heterogeneous agents model in general equilibrium. Some examples of such
models are Kaplan et al. (2017) and Guren et al. (2018). Guren et al. (2018) investigate the

interaction of adjustable and fixed-rate mortgage contracts with monetary policy. Kaplan
et al. (2017) propose a life-cycle model of housing decisions with both idiosyncratic and
aggregate shocks. Their goal is to replicate the macroeconomic dynamics observed in

the data during the Great Recession. These papers focus exclusively on non-recourse
mortgages.

In what follows, we present a model of debt renegotiation where the strategic choices of

lenders and borrowers depend on the extent to which recourse is enforced. In the model,
both house prices and the income of the borrower are stochastic. In some states of the
world, the household has enough income to pay their mortgage, whereas in other states of

the world it does not. Likewise, in some states of the world, the house value is higher than

the mortgage amount, i.e. the household has positive equity, whereas in other states of
the world the house value is lower, i.e. the mortgage is underwater. Households who can

afford to meet their payments, but whose mortgage is underwater, may find it optimal

to default, in particular on instances where it is unlikely that they will be liable with

their personal assets after default. Lenders who know this may find it optimal to offer

these households a renegotiated mortgage price in order to prevent them from walking
away from their obligations. At the same time, the price of these loans will reflect these

mechanisms.

We test the predictions of this model exploiting the difference in mortgage laws in

different US States. We focus on Metropolitan Statistical Areas that are crossed by a

State border, where one State has limited liability laws in place while the other does

ECB Working Paper Series No 2519 / January 2021 8

not. Using Fannie Mae loan performance data we find, as predicted by the model, that
default rates are higher for lower levels of lender recourse, and so are renegotiation rates.

However, one result is at odds with our model: there appears to be no significant difference
in the interest rate charged on loans across State borders. Importantly, this finding adds
to the notion that GSEs do not appropriately price regional differences in the likelihood

of default, as pointed out by Hurst et al. (2016). We further investigate this by using
loan application data from loans that were sold to private and public buyers. We find
a statistically and economically significant difference in loan rates in the private market,

as opposed to the findings on GSE pricing. We hence advance to the debate on the
differences in pricing between private and public entities by including its interaction with
limited liability.

These results have non-negligible economic and policy implications. Since observable
differences in local mortgage regulation yield different ex-ante predictable default risk, the
lack of price discrimination implies mispricing by GSEs. This is an important distortion in

a multi-trillion dollar market. The GSE’s single rate policy across jurisdictions generates

inefficiencies, which is a cost to taxpayers. On the contrary, private investors of securitised

loans are less subject to such costs. In addition, friendly borrowing conditions can increase

demand for homes in limited liability jurisdictions, which could generate divergence in

house prices across States.

In sum, this paper contributes to the literature along several dimensions. First, we

add to the theoretical literature by modelling limited liability explicitly. Furthermore, we

incorporate it as a key parameter defined on a continuum, which allows us to identify

the different equilibria of the game for different degrees of enforcement of limited liability

law. Other features of the model, such as stochastic income and house prices enhance

its richness and permit a better characterisation of the equilibria in different states of
the world. This is needed to formalise pricing of mortgages theoretically, taking into

ECB Working Paper Series No 2519 / January 2021 9

account the propensity of default and renegotiation observed in equilibrium, as well as
the expected values of household income and house prices. We thus also contribute to the

empirical literature, which has studied default and renegotiation individually in partial
equilibrium by using this model as a guide for the empirical testing of its implications.

The conclusions of the model are non-trivial. Ex-post, i.e. once a mortgage contract

is sealed, the bargaining power given to borrowers by limited liability intuitively points
to higher default and renegotiation. Yet, ex-ante lenders know the limited liability law
and could be expected to adjust their strategies accordingly, via higher prices or ex-

ante commitment to a lower renegotiation propensity in order to disincentivise strategic

default. The model suggests that equilibrium pricing should be different but does not
point to less renegotiation offering, as in this setting it would represent a non-credible

threat.

While the data confirms model predictions regarding default and renegotiation, we find
mispricing of ex-ante known strategic default risk in GSEs. This represents an additional

dimension of inefficiencies in GSEs, previously unknown in the literature. We therefore

also contribute to the literature that has studied loan pricing by GSEs by highlighting

the lack of differential pricing along a regulatory dimension.

The rest of the paper is organised as follows. Section 2 proposes a simple model of

the strategic interactions between lenders and borrowers and outlines the optimal rates
of default, renegotiation, and loan prices. Section 3 describes the data and explains

the identification strategy. Section 4 lays out the results for the empirical tests of the

model predictions and elaborates on the loan pricing difference between private and public
investors. Finally, Section 5 concludes.

ECB Working Paper Series No 2519 / January 2021 10

2 The Model

This model draws from Bester (1994) model of debt renegotiation with collateral, where

we incorporate lender recourse. There are two time periods t = {0, 1}. Consider a house-
hold who wants to buy a house. The house has a purchase price R in period 0. In period
1, the house changes value stochastically to R(s), where s ∈ {sH , sL } denotes the state of

the world. We assume sH realises with probability n, and sL with probability 1 − n. The
household has no initial wealth so it borrows an amount M = R to purchase the property.
In t = 1, the household will have to pay an amount P equal to the principal plus some

non-negative interest, so P ≥ M . In period t = 1 the household receives an exogenous

income, which can be either high, YH , with probability p, or low, YL with probability 1−p.

There is asymmetric information about the realisation of income, but the market value

of the house in t = 1 is public information. All distributions are public information, so

the bank knows the probability that YH or YL realise, that is, it knows p. Asymmetric

information implies that the lender cannot write a contract contingent on income.

In the event of default, the bank can choose to foreclose the property, which yields a

return of ΦR(s) (where Φ < 1 represents the recovery rate considering foreclosure costs),

or to renegotiate the payment price, offering an alternative payment P 0 .

If the bank chooses to foreclose the property, and in order to model the mortgage
recourse laws outlined in the previous section, we assume that after foreclosure, there is
a judge ruling about the deficiency judgement, which can entitle the bank to seize the

household’s income for the difference between the amount owed, P , and the amount re-
covered in foreclosure, ΦR(s). We assume the judge rules for a deficiency judgement with
probability λ. The limited liability case, or non-recourse, is the nested case where the

ECB Working Paper Series No 2519 / January 2021 11

parameter λ = 0, i.e. the law rules out deficiency judgements.

It is clear that in the event of a low income realisation, the household is forced to de-
fault. With a high income realisation, however, the household may default strategically.
Then, the right to foreclose, together with the extent of lender recourse play an important

role in incentivising payment by the high income household.

To sum up, a debt contract specifies a payment amount P , and entitles the lender

to seize the borrower’s personal assets (income) with exogenous probability λ. Lender
recourse is a threat that may induce the high income household to pay. At the same time,
the extent of lender recourse will affect the incentives for the lender to renegotiate and

offer a lower payment price. This is because, under limited liability, i.e. non-recourse, by

not renegotiating the bank may be committing to an ex post inefficient outcome. This
happens when the foreclosure value of the property is lower than the potential renegotiated

payment P 0 . It is therefore interesting to consider the following game in t = 1:

ECB Working Paper Series No 2519 / January 2021 12

 Figure 2: Game in t = 1

N ature

1−p p

Household Household

d 1−d

def ault Bank

(YH − P + R(s),
P − M)
r 1−r r 1−r

N ature N ature
(YL − P 0 + R(s), (YH − P 0 + R(s),
P0 − M) P0 − M)
1−λ λ 1−λ λ

(YL , (YH ,
ΦR(s) − M ) ΦR(s) − M )
(max{YH − (P − ΦR(s)), 0},
(max{YL − (P − ΦR(s)), 0}, ΦR(s) + min{(P − ΦR), YH } − M )
ΦR(s) + min{(P − ΦR(s)), YL } − M )

where p denotes the probability of high income, d denotes the probability with
which the household chooses to default, r denotes the probability with which the bank

chooses to renegotiate the payment amount, and λ indicates the probability of a deficiency

judgement. The dotted area indicates the information set of the bank in the second stage.
It observes that the household has defaulted, but it doesn’t know whether this default
was strategic, i.e. whether the household has high income. The payoffs of the household

and the bank are reported below the ending nodes, respectively.

In order to simplify the game and to focus on the most interesting parts of the mech-
anism, we make the following assumptions about the relative values of the parameters:

Assumption 1. YH > P > YL . The household can only afford the mortgage payment
amount if it receives a high realisation of income.

ECB Working Paper Series No 2519 / January 2021 13

 This assumption places the model in the interesting case where some households are
financially unable to meet their obligations.

Assumption 2. ΦR(s) < YL . The foreclosure value of the house is lower than the
low realisation of income in all states of the world s.

This assumption yields the interesting case where the bank would be able to recover
more by renegotiating than by foreclosing the property.

Assumption 3. P − ΦR(s) > YL . The low income household cannot afford the
deficiency judgement for all s.
From the assumption that YH > P it is clear that YH > P − ΦR(s), i.e. the high in-

come household can always afford the deficiency judgement. If the low income household

could also pay the deficiency judgement, i.e. if YL > P − ΦR(s), then the asymmetry of
information around the realisation of income would be irrelevant to the bank’s decision to

renegotiate because it would get the same expected return whether the household has high

or low income. We impose P − ΦR(s) > YL in order to focus on the more interesting case

where asymmetric information about the borrower’s realisation of income, together with

the fact that the low income household cannot pay the deficiency judgement, introduces
an interesting mechanism for the renegotiation of the price.

Corollary 1. P 0 = YL . The renegotiated price is equal to the low realisation of

income.

It is clear that if P 0 > YL , the low income household cannot afford the renegotiated

price, and will pay at most YL , so the renegotiation price must be equal to the low real-
ization of income.

In order to characterise the equilibria of the game, it is important to note two cases:

ECB Working Paper Series No 2519 / January 2021 14

whether P < R(s), i.e. the household has positive equity on the mortgage, or P > R(s),
i.e. the mortgage is underwater.

Assumption 4. R(sL ) < P < R(sH ). The values of the house in different states of
the world are such that the repayment price of the mortgage falls between them. That is,

the low value of the house is lower than the price of the mortgage, while the high value of
the house is higher, i.e. the mortgage is underwater when sL realises.

In the case of positive equity, i.e. state sH , the equilibria of this game imply no default
and no renegotiation. The borrower would not find it optimal to give up the house when
they can afford the mortgage, given that the house value is higher than the payment

amount unless it gets a renegotiation offer. In turn, the lender would not find it optimal

to renegotiate if they know this is the case. In fact, by choosing r = 0 the lender can
guarantee that the borrower will choose d = 0 since for the high income household

YH − P + R(sH ) > YH − λ(P − ΦR(sH ))

where the inequality comes from the fact that λ ∈ [0, 1] and P < R(sH ).

In sum, r = 0 is a dominant strategy for the lender, independently of λ, in which case

only the low income household defaults.

In state sL , when the mortgage is underwater, one can show that the dominant strategy
is not to default if YH realises, i.e. d = 0 unless
P − R(sL )
λ≤ (1)
P − ΦR(sL )
In this case, the lender will choose r = 1 if
YL ≥ ΦR(sL ) + λ[(1 − p)YL + p(P − ΦR(sL ))], i.e.
YL − ΦR(sL ) (2)
λ≤
p(P − ΦR(sL )) + (1 − p)YL

ECB Working Paper Series No 2519 / January 2021 15

 Alternatively, the lender will choose r = 0 if

YL ≤ ΦR(sL ) + λ[(1 − p)YL + p(P − ΦR(sL ))], i.e.

YL − ΦR(sL ) (3)
λ≥
p(P − ΦR(sL )) + (1 − p)YL

In the case where (2) holds with equality (and therefore (3) as well), the lender will
first observe the borrower’s strategy, and choose r = 0 if d = 0, or mix r ∈ (0, 1) if d = 1.

Proposition 1. If P < R(s) there is a unique pure strategy equilibrium with d = 0

and r=0 independently of λ. If P > R(s) the is a pure strategy equilibrium when condition

(1) and (2) are satisfied with strict inequality with d = 1 and r = 0, while if (1) and (3)
are satisfied with strict inequality, the equilibrium is given by d = 1 and r = 1; therefore,

when (1) is satisfied with strict inequality and (3) is satisfied with equality, any r ∈ (0, 1)

and d = 1 is an equilibrium, and when (1) is satisfied with equality and (3) is satisfied
with strict inequality, any d ∈ (0, 1) and r = 1 is an equilibrium.

The equilibria of this game will therefore depend on the value of λ and the relative

position of thresholds (1) and (2) when they hold with equality. Figure 3 provides a
graphical representation of the equilibria as a function of λ when when (1) > (2). As can

be seen, for high values of λ, there is no default or renegotiation in equilibrium. This is

because high lender recourse imposes too high a cost for the high income household to
default, as it may risk a deficiency judgement. Knowing this, the lender chooses to not

renegotiate. As lender recourse decreases, the borrower starts facing higher incentives to

default, as the risk of a deficiency judgement is lower. When (1) holds with equality, there
is no renegotiation and the borrower mixes between default and repayment. For values

of lambda between (1) and (2), it is optimal for the household to default, as the risk of

a deficiency judgement is below the threshold, but it is still not optimal for the lender

ECB Working Paper Series No 2519 / January 2021 16

to renegotiate, as the expected payoff from doing so continues to be lower than that of
renegotiating. This is because, for the lender, the probability of a deficiency judgement is

still high enough such that in expectation they would recover more from the judgement
than from the low renegotiated price YL . For λ below (2), the incentive for renegotiation
kicks in for the lender, as the probability of a deficiency judgement is too low and hence the

renegotiated price is higher than the expected recovery value from a foreclosed property.
Equilibria for the cases where (1) < (2) and (1) = (2) can be found in Appendix A. In
all cases, the equilibria with default and renegotiation appear as λ decreases. Hence, the

testable implication is that default and renegotiation are higher in non-recourse States.
We will test this in the next Section.

Figure 3: Equilibria when (1) > (2) as a function of λ

We now turn to the pricing decision by the bank. With bank competition, a risk-
neutral bank will set a repayment price P in t = 0 so as to set the expected value of

the game in t = 1 equal to zero. The bank knows the value of λ, and it anticipates the
equilibrium of the game for each state of the world. Hence, there are three cases:

ECB Working Paper Series No 2519 / January 2021 17

 First, when λ > (1), the bank knows that under any realisation of the house value, it
is always optimal for the high income household not to default. It therefore anticipates

the equilibrium where d = 0 and r = 0. The expected value of the game is then

h i
(1 − p) Φ(nRH + (1 − n)RL ) + λYL − M + p(P − M ) = 0 (4)

so

(1 − p) h i
Pλ>(1) = M − Φ(nRH + (1 − n)RL ) − λYL + M (5)
p

Second, when (1) > λ > (2), the bank anticipates that the household will default if

the low house value realises. Therefore the expected value of the game is

h i
n (1 − p)[ΦRH + λYL − M ] + p(P − M )
h i (6)
+(1 − n) (1 − p)[ΦRL + λYL − M ] + p[ΦRL + λP − M ] = 0
so
(1 − p) [M − λYL − nΦRH − (1 − n)ΦRL ]
P(1)>λ>(2) =
p n + (1 − n)λ
(7)
M − φRL
+
n + (1 − n)λ
Third, when λ < (2), the bank anticipates that under the low realisation of the house

value the household will default, and it also finds it optimal to renegotiate, that is, d = 1
and r = 1. The expected value of the game is then

h i
n (1 − p)[ΦRH + λYL − M ] + p(P − M )
(8)
+(1 − n)[YL − M ] = 0
so

(1 − p) M (1 − n)
Pλ<(2) = [M − ΦRH − λYL ] + + [M − YL ] (9)
p n np

ECB Working Paper Series No 2519 / January 2021 18

 It can be shown that P is decreasing in λ in all cases, that is, that for higher lender
recourse, mortgage rates are lower.

This model outlines the mechanism we want to highlight and provides testable impli-
cations. Namely, that for higher levels of lender recourse, underwater borrowers default
at a higher rate even when they have the means to pay for their mortgage. Lenders are

incentivised to renegotiate the price of the mortgage in cases where lender recourse is
low, as is the case in limited liability States. Loan prices therefore should reflect this.
However, as we will see in the next Section, Government Sponsored Enterprises such as

Fannie Mae, do not set loan prices differently across jurisdictions with different levels of
lender recourse. The fact that in the US most mortgages are bought by GSEs, which
are government-guaranteed, implies that in the end this deadweight loss is borne by the

taxpayer. We now turn to empirically verify the relationship between recourse laws and

mortgage prices, default probabilities, and renegotiation.

3 Data and Methodology

3.1 Fannie Mae Single Family Loan Database

This database contains acquisition data from all the mortgage loans acquired by Fannie

Mae, together with monthly performance data of said loans. Acquisition data includes
variables such as the seller name, original unpaid balance, original loan term, origination

date, original loan-to-value (LTV) ratio, original debt-to-income (DTI) ratio, borrower

credit score (FICO score), loan purpose, property type and mortgage insurance percent
and type. Performance data includes variables such as current interest rate, current

unpaid balance, loan age, remaining months to maturity, delinquency status, last paid

instalment date, foreclosure date, foreclosure costs, asset recovery costs and other costs,
taxes, net sale proceeds and other proceeds and principal forgiveness amount. Location

data of the property is also available. In particular, the State, the Metropolitan Statistical

Area (MSA) and the 3-digit Zip code are reported. Data is available on a monthly basis

ECB Working Paper Series No 2519 / January 2021 19

from 2004 to 2016.

We focus exclusively on purchase loans for principal home, to abstract from the dif-

ference in default incentives that may be present for mortgage loans used for investment
purposes. We consider a loan to have defaulted once it is over 90 days delinquent, as is
standard in the literature. However, we note that our results are robust to other definitions

of default.1

3.2 Home Mortgage Disclosure Act Database

The Home Mortgage Disclosure Act (HMDA) Database contains the universe of all

mortgage loan applications filed by reporting banks in the United States. Banks are
obliged to report if their balance sheet size is above a certain threshold. The information

on each application includes loan characteristics such as the loan amount and the purpose

of the loan (purchase, refinance or home improvement); borrower and co-borrower char-

acteristics such as income, race and gender; and characteristics of the property such as its

geographical location (Metropolitan Statistical Area, census tract, State, ...), occupancy
and type of dwelling (single-family, multifamily, ...).

In addition, the database includes information about whether the loan was granted or

not, and the reasons for denial where applicable.

We use this database to explore the differences in the characteristics of the demand for
loans, as well as lenders’ willingness to lend conditional on loan characteristics between

recourse and non-recourse States.

1
For instance, we consider a loan to have defaulted if it has been delinquent for over 90 days at any
point in time and has not gone back to current status in the 12 months prior to the end of its reporting
life, i.e. no recovery in the 12 months prior to it being sold to a third party, foreclosed or otherwise
finalised. Another definition, used by Ghent and Kudlyak (2011), considers a loan to have defaulted
when it is terminated by short sale, deed in lieu or REO sale.

ECB Working Paper Series No 2519 / January 2021 20

 This data is available on a yearly basis from 2004 to 2016.

3.3 Federal Housing Finance Agency database

In order to assert the value of the collateral of each mortgage at each point in time, we
use House Price Indices from the Federal Housing Finance Agency. They are estimates

using all transactions of sold houses in a given period and 3-digit ZIP code. These data
are used to estimate the current value of the property and the current equity value of the
mortgage owner.

Following the literature, we compute the market price of a house at time t as follows:
HP It
Pt = P0 (10)
HP I0
where P0 is the purchase price of the house at the time it was acquired by the borrower,
HP It
and HP I0
is the growth of the Housing Price Index in the period between the home

purchase (time 0) and the present time.

3.4 Identification

Our identification strategy consists of comparing mortgage loans of homes located in

recourse and non-recourse States over their life cycle in order to understand the effect of

different regulations on different outcomes.

In order to exploit the discontinuity around the border of recourse and non-recourse
States, we focus on Metropolitan Statistical Areas that are crossed by a State border.

First, let us define what an MSA is:

The United States Office of Management and Budget (OMB) delineates metropoli-
tan and micropolitan statistical areas according to published standards that are

applied to Census Bureau data. The general concept of a metropolitan or mi-

cropolitan statistical area is that of a core area containing a substantial pop-
ulation nucleus, together with adjacent communities having a high degree of

ECB Working Paper Series No 2519 / January 2021 21

 economic and social integration with that core.
United States Census Bureau.

Mortgages in the same MSA are arguably exposed to the same economic shocks since

MSAs are delineated by definition to encompass geographical areas that are ‘economi-
cally and socially integrated’. Households on either side of such borders are expected to
be exposed to the same economic shocks, so a difference in our variables of interest can

be interpreted as stemming from the difference in borrower liability.

We define recourse and non-recourse States following Ghent and Kudlyak (2011). The

resulting dataset, in which we select MSAs that are crossed by a State border where

one side of the border enforces recourse and the other does not, spans 6 Metropolitan

Statistical Areas and 9 States, as shown in Table 1. For the Fannie Mae monthly loan

performance data, this implies over 100,000 individual loans over and 4 million observa-
tions, while for the Home Mortgage Disclosure Act loan application data we have almost

3.5 million individual loan applications.

Table 1: Metropolitan Statistical Areas

MSA Name Recourse side Non-recourse side

Charlotte-Concord-Gastonia SC NC
Davenport-Moline-Rock Island IL IA
Lewiston ID WA
Omaha-Council Bluffs NE IA
Sioux City SD, NE IA
Virginia Beach-Norfolk-Newport VA NC
Notes: Names of the Metropolitan Statistical Areas that are crossed by a State
border where one State enforces lender recourse and the other does not. The second
and third columns present the abbreviations of the States on either side. Recourse
and non-recourse are defined following Ghent and Kudlyak (2011).

ECB Working Paper Series No 2519 / January 2021 22

4 Empirical Analysis
4.1 Testing the Model predictions: the pricing puzzle

In this section we use the Fannie Mae Single Family Loan Performance database to test
the predictions from the model. Table 2 shows the mean values for some key variables,

separated by recourse and non-recourse, together with the p-values for the two-sided t-test
of whether they are statistically different from each other.

Table 2: Descriptive Statistics

Non-recourse Recourse p-value

Variables at origination
Rate of default (%) 3.24 2.15 <.001
Loan Amount ($) 196,477 181,003 <.001
Credit Score 750.9 755.6 <.001
Interest Rate (%) 4.85 4.84 .06
Debt-to-income (%) 33.46 33.83 <.001
Loan-to-value (%) 80.32 80.01 <.001
Current variables
Current Balance ($) 170,202 157,804 <.001
Current Interest Rate (%) 4.98 4.97 <.001
Market Price ($) 250,118 227,611 <.001
Months to Maturity 311 310 <.001
N. of loans 48,406 51,892 .
N. of observations 2,044,322 2,174,763 .
Notes: Loan amount, current balance and market price are in US dollar
amounts, interest rate, current interest rate, debt-to-income (DTI) and loan-
to-value (LTV) are reported as percentages. DTI is calculated as the ratio
between the borrower’s total monthly obligations and their stable monthly
income. Credit score is the FICO score. Source: Fannie Mae Single Family
Loan Database, Federal Housing Finance Agency and authors own calcula-
tions, 2004-2016.

We consider a loan to have defaulted, as is standard in the literature, when it has

delinquency status for longer than 3 months. Default rates are higher in non-recourse
States, as predicted by the model, while interest rates at origination are not statistically

different across jurisdictions. This is puzzling, as one would expect the higher risk of
default to be reflected on prices. We will explore this more formally in the course of

ECB Working Paper Series No 2519 / January 2021 23

this section. Credit scores are lower on average on the non-recourse side of the border.
While this difference is statistically significant, it is not economically significant as the

magnitude of the difference is only 5 points in the FICO score. One may worry that
there is self-selection into purchasing a house on either side of the border. Lower quality
borrowers may choose to live on the non-recourse side of the border since they expect

they may need to default with higher probability. This would bias our results. However,
this small difference in the credit score is reassuring that borrower quality is similar on
either side of the border.

In addition, Debt-to-income ratios are also very similar. Debt-to-income ratios are a
good way to measure the likelihood of default of a household, as it measures the strain

that their debt places on their finances. The fact that these ratios are similar across

jurisdictions, together with our use of the discontinuity around the border which ensures
similar exposure to economic shocks, indicates that households can be expected to be
able to meet their financial obligations with similar probability. This relates to the model

along parameter p, that is, the probability that the household will receive a low income

realisation and not be able to meet their payments. Furthermore, Loan-to-value ratios
seem to also be similar across jurisdictions, and very close to the regulatory soft limit of

80%. We call this a soft limit because banks are allowed to issue loans for more than 80%

of the value of the property, but in order to do so, they must meet additional requirements,

which makes 80% the effective limit for a wide majority of loans. Overall, it appears that

most variables are similar in recourse and non-recourse States, which allows us to compare
these loans and draw conclusions on the relevant variables of interest.

Next, we formally test the model predictions using different regressions. First, the

model predicts that default rates should be higher in non-recourse States. We test this
using the following Logit regression:

ECB Working Paper Series No 2519 / January 2021 24

 LD = β0 + β1 DN R + β3 Xi,t + i,t (11)

where LD denotes the log odds of default, DN R is a dummy variable that takes value
1 if the house is located in a non-recourse State and 0 otherwise, and Xi,t is the set of
control variables. Control variables include the credit score of the borrower, the remain-

ing loan term, the debt-to-income ratio of the borrower, the loan’s current outstanding
balance and the market price of the property.

Second, the model shows that, when faced with a delinquent borrower, the bank must

choose whether to renegotiate the loan payment or let the household default. The model
predicts that the bank chooses to renegotiate with lower probability as λ decreases. That

implies that we should expect lower levels of renegotiation, conditional on the borrower

being delinquent, in non-recourse States. We test the difference in renegotiation rates

between recourse and non-recourse States, conditional on the loan being more than 3

months delinquent, which is consistent with the standard definition of default used in the
literature. The Logit regression in this case reads:

LM = β0 + β1 DN R + β3 Xi,t + i,t (12)

where LM denotes the log odds of loan modification and the rest of the variables are

defined as in the previous regression.

Finally, the model prediction is that prices should be higher on non-recourse States,

owing to the higher level of ex-ante predictable risk. We run an OLS regression to test
for the difference in loan prices at origination:

ratei,t = β0 + β1 DN R + β3 Xi,t + i,t (13)

where ratei,t is the interest rate agreed in the initial terms, and Xi,t are a set of con-

ECB Working Paper Series No 2519 / January 2021 25

trol variables. The control variables, in this case, are the credit score of the borrower, the
initial loan term and the debt to income ratio of the borrower at origination.

Table 3 shows the results from these regressions. Columns 1-4 report Logit coefficient
estimates in odds ratios to facilitate the comparison and interpretation of the relative

probability of default and renegotiation between recourse and non-recourse States. Val-
ues above (below) unity indicate a positive (negative) relation between the independent
variable and the likelihood of default or renegotiation. As shown in Column 2, default

rates are higher in non-recourse States, as predicted by the model. In terms of magni-
tude, borrowers in non-recourse States are around 42% more likely to default on their
mortgage.2 Column 4 shows that the probability of loan renegotiation is 28% higher in

non-recourse States. This result is also in line with the model’s predictions.

Moving on to pricing, Column 8 shows a puzzling result: the difference in the interest

rate between recourse and non-recourse loans is economically negligible at less than 1bp.

In addition, the sign of this difference is the opposite of what is predicted in the model.
In a regression specification with no time or MSA fixed effects, we find that this difference

is not statistically significant. Recalling that these results come from Fannie Mae’s loan

performance data, they provide evidence of an additional dimension of mispricing by

GSEs. In addition to Hurst et al. (2016), who find that GSEs do not correctly price

regional risk, we show that such enterprises do not take into account ex-ante predictable
non-recourse risk. In order to shed light on this issue, in the next section we take a step

2
These results are qualitatively robust if we only use the cross-section of loans rather than the full
panel. In the baseline, we opt to use a period by period approach to account for time spent in delinquency
and possibility of cure. This also allows including running variables as controls, such as house price, in
line with the model.

ECB Working Paper Series No 2519 / January 2021 26

 back and use the HMDA dataset to evaluate loan prices at the loan application stage,
where data is available also for the private sector.

Table 3: Regression Results

Logit - odds ratios OLS

(1) (2) (3) (4) (5) (6)
VARIABLES Default Default Renegotiation Renegotiation Interest Rate Interest Rate

DN R 1.474*** 1.416*** 1.268*** 1.282*** 0.009** -0.008***

(0.084) (0.079) (0.092) (0.095) (0.004) (0.003)
Credit Score 0.982*** 0.990*** -0.002***
(<.001) (0.001) (<.001)
Months to Maturity 1.004*** 1.037*** 0.003***
(0.001) (0.001) (<.001)
DTI 1.051*** 1.030*** 0.002***
(0.002) (0.003) (<.001)
Current Balance 1.000*** 1.000***
(<.001) (<.001)
Market Price 0.999*** 0.999***
(<.001) (<.001)

Observations 4,052,363 3,436,163 3,650,449 3,124,426 100,298 98,617

R-squared 0.859 0.904
Pseudo R2 0.149 0.250 0.053 0.396

MSA FE YES YES YES YES YES YES

Time FE YES YES YES YES YES YES
Heteroskedasticity robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Notes: Columns 1-4 report Logit coefficient estimates in odds ratios to facilitate the comparison and interpretation of the relative
probability of default and modification between recourse and non-recourse States. Values above (below) unity indicate a positive
(negative) relation between the independent variable and the likelihood of default or modification. The standard errors reported
in parentheses for the Logit regressions are computed via Delta method to match the odds ratio coefficients. Columns 5-6 report
OLS estimates estimated using observations at origination only. Source: Fannie Mae Single Family Loan Database, Federal
Housing Finance Agency and authors own calculations, 2004-2016.

4.2 Understanding loan pricing

In this section we focus on loan applications data in order to examine whether there are

differences in loan demand, loan origination, and loan sales that could explain the pricing
puzzle outlined in the previous section.

ECB Working Paper Series No 2519 / January 2021 27

4.2.1 Loan origination and sale

Table 4 shows the mean values for some key variables in the HMDA Dataset, separated

by recourse and non-recourse, together with the p-values for the two-sided t-test of whether
they are statistically different from each other.

Both origination rates and sales to third parties are higher in recourse States. The

average income of the applicant is higher in non-recourse States, whereas the median
income is equal across jurisdictions, indicating the presence of outliers. Loan amounts
of all received applications, as well as those of accepted loans, are significantly different

in statistical terms, but are very similar in economic terms, differing by roughly $1,500.

Importantly though, loan-to-income ratios of all applications as well as of originated loans

are significantly higher in recourse States. The loan-to-income ratio is a measure of the

burden that the loan repayment poses on the borrowers’ payment capacity, hence higher

loan-to-income is associated with a higher risk of default. The fact that recourse States

display higher loan-to-income ratios of granted loans may indicate that lenders are more

willing to take on risk in recourse States because they have a higher recovery ratio given
that they can seize the borrowers’ personal assets in the event of default.

ECB Working Paper Series No 2519 / January 2021 28

 Table 4: HMDA

Non-recourse Recourse p-value

All Applications
Annual income of applicant ($) 84,723 80,846 <.001
Median annual income ($) 67,000 67,000 .
Loan amount ($) 151,716 153,358 <.001
Loan-to-income 2.055 2.155 <.001
Originated Loans
Annual income of applicant ($) 89,592 84,430 <.001
Median income ($) 72,000 71,000 .
Loan amount ($) 157,237 155,573 <.001
Loan-to-income 2.012 2.101 <.001
Loan acceptance rate (%) 54.04 55.27 <.001
Sold to 3rd party (%) 67.39 68.83 <.001
N. of observations 1,370,430 2,013,317 .
Notes: Income and loan amounts are in US dollars. Loan-to-income is the ratio
of the loan amount over the annual income of the applicant. The acceptance rate
is the percentage of loan applications that were granted. Loans sold to 3rd parties
reflect the percentage of granted loans that were sold to a 3rd party in the natural
year in which the loan was originated. Source: Home Mortgage Disclosure Act
Database and authors own calculations, 2004-2016.

First, we focus on the characteristics of loan applications, as well as on the lenders’

willingness to lend given the applications it receives on either side of the border.
The distribution of income of applications is depicted in Figure 4. There are no

significant differences in the distribution of income of applicants on either side of the

border. We can therefore conclude that any differences in the probability to originate a
loan are due to differences in limited liability.

Figure 5 illustrates the differences in reasons for denial. The most common reason

for denial is the credit history of the borrower in both types of States. The second most
frequent reason in recourse States is the debt-to-income ratio, followed by the value of

the collateral (the real estate property). Notably, this order is reversed in non-recourse

States, indicating that collateral value is more important to lenders in States with limited

liability. This is intuitive since limited liability implies that the lender may be limited
in how much they can recover from the borrower in case of default, making the value of

ECB Working Paper Series No 2519 / January 2021 29

 Figure 4: Income distributions

Notes: Distributions of yearly income is US Dollars at the loan application stage

split by recourse and non-recourse States. Source: Home Mortgage Disclosure
Act Database and authors own calculations, 2004-2016.

ECB Working Paper Series No 2519 / January 2021 30

 Figure 5: Reasons for loan denial

Notes: The height of the bars in the histograms indicate the frequency of dif-
ferent reasons for loan denial split by recourse and non-recourse States. Source:
Home Mortgage Disclosure Act Database and authors own calculations, 2004-
2016.

collateral an important source of compensation for this risk.

Next, we are also interested in the originate-to-distribute behaviour of banks. Leading

up to the Financial Crisis in 2007, and ever since, it has become increasingly evident that

the business model of many lenders is to originate mortgages and sell them to third parties,

thereby eliminating credit risk from their balance sheets. Figure 6 contains information
about the proportion of loans that were sold to a third party in the year of its origination

and the identity of the purchaser.

It can be seen from the Figure that lenders sell just under 70% of their loans to third

parties. The most common purchasers are State Agencies, Fannie Mae and Freddie Mac.
Banks sell slightly more non-recourse loans than recourse loans.

ECB Working Paper Series No 2519 / January 2021 31

 Figure 6: Loan sales

Notes: The height of the bars in the histograms indicate the percentage of
loans kept on the issuer’s balance sheet or sold to a range of public and private
purchasers split by recourse and non-recourse States. Source: Home Mortgage
Disclosure Act Database, 2004-2016.

We would like to examine how recourse affects the willingness of banks to grant a loan

conditional on application characteristics. Following Dell’Ariccia et al. (2012), we use the

loan-to-income ratio at origination as a proxy for the ex-ante risk of a loan.3 A higher

loan-to-income is associated with a higher risk of default since the loan obligation weighs

heavier on the borrower’s ability to pay. We use a Logit model of the following form:

LO = β1 + β2 DN R + β3 LtIi + β4 DN R LtIi + i (14)

where LO are the log odds of a loan being originated; DN R is a dummy variable that

3
The only further borrower characteristics included in HMDA are self-reported ethnicity, race and
gender. Results are robust to including this set of controls.

ECB Working Paper Series No 2519 / January 2021 32

takes value 1 if the property is located in a non-recourse State and 0 otherwise, LtIi
is the loan-to-income ratio of application i. β4 is then the regression coefficient for the

interaction term between the non-recourse dummy and the loan-to-income ratio.
We also run a Logit model of the same form to assess the difference in the probability
of selling a loan to a third party:

LS = β1 + β2 DN R + β3 LtIi + β4 DN R LtIi + i,t (15)

where LS are the log odds of a loan being sold.

Table 5 shows the results of these regressions. The interpretation of interaction terms in

Logit regression needs careful consideration. First, it is worth noting that the regression
results are expressed in terms of log odds. While Logit models are linear in log odds,
they are not linear in other metrics such as probabilities. We want to be able to interpret

the results of these regressions in terms of the difference in the probability of originating

a loan between recourse and non-recourse, conditional on the ex-ante risk of the loan as
proxied by the loan-to-income ratio. This probability difference will therefore depend on

the different values of the model variables. Furthermore, the interaction term is composed

by a categorical variable and a continuous variable, so in order to interpret the results, it

will be necessary to evaluate the coefficient at different levels of loan-to-income.4

4
While we follow Dell’Ariccia et al. (2012) in the use of loan-to-income as a key variable to measure
the riskiness of a mortgage, results are comparable if we use income instead.

ECB Working Paper Series No 2519 / January 2021 33

 Table 5: Loan Origination and Sale

(1) (2) (3) (4)

VARIABLES Origination Origination Loan Sale Loan Sale

DN R -0.158*** -0.106*** -0.261*** 0.111***

(0.004) (0.008) (0.005) (0.011)
LtI -0.051*** -0.042*** 0.310*** 0.394***
(0.002) (0.002) (0.002) (0.003)
DN R LtI -0.022*** -0.179***
(0.003) (0.005)
Constant 0.677*** 0.653*** 0.584*** 0.408***
(0.004) (0.005) (0.006) (0.008)

Observations 1,286,996 1,286,996 796,090 796,090

Heteroskedasticity robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Notes: This table shows Logit regression results for loan origination and loan
sale. The coefficients are expressed in log odds. The dependent variable in
Columns 1-2 are the log odds of a loan being originated, and in Columns 3-4
the log odds of an originated loan being sold. Dependent variables include a
dummy variable (DN R ) that denotes non-recourse States, the Loan-to-income
ratio (LtI) as a proxy for loan riskiness, and the interaction between the two.
Source: Home Mortgage Disclosure Act Database and authors own calculations,
2004-2016.

We therefore use the margins of responses to retrieve the estimated probabilities of orig-

ination and sale for recourse and non-recourse. We then plot the differences in estimated
probabilities for different values of loan-to-income, together with their 95% confidence

intervals. Figure 7 presents the results.

As can be seen, banks are less likely to originate loans in non-recourse States, and this
probability is decreasing in the loan-to-income ratio. This is an intuitive result since non-

recourse loans can be considered ‘riskier’ because of limited liability. For a given level of

LtI risk, banks would rather lend in a State where they can seize the borrower’s assets in
the event of default. At the same time, banks are less likely to sell non-recourse loans to

third parties, and this probability is also decreasing in loan-to-income.

ECB Working Paper Series No 2519 / January 2021 34

 Figure 7: Differences in probability of Origination and Sale

Notes: The solid line plots the difference in the probability of origination and
sale between recourse and non-recourse States for different levels of loan-to-
income ratios (a proxy of the riskiness of the loan). The dashed lines trace the
95% confidence intervals. Source: Home Mortgage Disclosure Act Database
and authors own calculations, 2004-2016.

4.2.2 Interest rate on sold loans

One of the striking results from Table 3 is that for loans bought by Fannie Mae, the

interest rate at origination does not differ between recourse and non-recourse loans. Given
that non-recourse loans are expected to have a lower recovery rate in the event of default,

one could expect the interest rate for these loans to be higher. We ask whether the fact

that the interest rate at origination does not differ across jurisdictions for loans that were

sold to Fannie Mae is due to the fact that banks anticipated they would sell this loans to
a third party and therefore did not have an incentive to price in their risk. To this end,

we use the HMDA loan application database to test whether loans that were not sold to

a third party were priced differently, conditional on observables.

ECB Working Paper Series No 2519 / January 2021 35

 While the loan application data does not include the interest rate of each loan, banks
report the spread between the rate charged for a given loan and the average interest rate

that a loan with similar characteristics would have in the market. Banks must report the
spread (difference) between the annual percentage rate (APR) and the applicable average
prime offer rate if the spread is equal to or greater than 1.5 percentage points for first-lien

loans. Due to this, there is a selection issue on the spread variable: we do not observe the
spread if it is lower than the reporting threshold. In order to overcome this issue, some
papers in the literature, for instance Pennington-Cross and Ho (2008), have applied the

Heckman two-stage procedure for selection correction to this dataset. Hence, we run the
following Probit regression:

Yi = δXi + ui (16)

where Yi takes value 1 if the spread of loan application i is observed (i.e. if the

spread is greater than 1.5 percentage points), and Xi is a set of variables that influence

the probability of the spread being above the reporting threshold. We use all available

borrower information in Xi , which includes income and dummy variables for self-reported
race and gender.
φ(X δ̂)
We then use δ̂ to compute the inverse Mills ratio, λ(X δ̂) = Φ(X δ̂)
, and it to different

second stage regressions in order to answer different questions. First, we examine the
difference in the spread between recourse and non-recourse States using the following
regression:

spreadi = β0 + β1 DN R + γλ(X δ̂) + i (17)

where DN R takes value 1 for non-recourse loans and 0 otherwise. Then, we ask whether
the spread is higher for loans that are sold to third parties, and whether this differs across

jurisdictions. The regression reads:

ECB Working Paper Series No 2519 / January 2021 36

 spreadi = β0 + β1 DN R + β2 DSold + β3 DN R DSold + γλ(X δ̂) + i (18)

where DSold takes value 1 for loans that were sold to third parties and 0 otherwise and
DN R DSold is an interaction term of both dummy variables.

Hurst et al. (2016) show that public agencies such as Fannie Mae and Freddie Mac
are less efficient at pricing mortgage loan risk than the private market. They argue

that this price difference leads to cross subsidisation from low risk mortgages to high
risk mortgages. We explore whether this issue extends to the difference in risk between
recourse and non-recourse loans in the following way:

spreadi = β0 + β1 DN R + β2 DP rivate + β3 DN R DP rivate + γλ(X δ̂) + i (19)

where DP rivate takes value 1 for loans that were sold to private buyers (securitisation

agencies, commercial banks, insurance companies, funds...) and 0 for loans that were sold
to public buyers (Fannie Mae, Freddie Mac, Ginnie Mae and Farmer Mac).

The results of these regressions are laid out in Table 6. Regression 17 is shown in

Column 1. The loan spread is significantly lower in non-recourse States which is a sur-

prising result. We are interested, however, in whether there is a significant difference in

loan pricing for loans that were sold to third parties, and among those, whether there is a
difference between private and public buyers. Column 2 presents the results of Regression

18. The constant term implies that the average spread of a recourse loan that was kept

by the bank is around 6.7%. The coefficient of DN R captures the difference in the interest
rate between non-recourse and recourse for unsold loans. The interest rate on unsold

loans is 24bp lower for non-recourse loans. The coefficient for DSold equals the difference

between sold and kept loans in recourse States. It implies that, among recourse loans, the
spread is around 5bp lower for those that were sold. The coefficient for the interaction

term DN R DSold is equivalent to a difference-in-differences estimator. It represents the

ECB Working Paper Series No 2519 / January 2021 37

difference in the spread between recourse and non-recourse loans for loans that were sold.
The fact that it is positive and statistically significant indicates that in the market for

loan sales the spread is higher for non-recourse mortgages. This result is intuitive, since
non-recourse implies a higher rate of default as predicted by the theoretical model, and
shown empirically in the previous section. We note that there may be an endogeneity

issue in interacting DN R and DSold , as we have shown before that non-recourse loans are
less likely to be sold to third parties than their recourse counterparts.
This phenomenon is further investigated in Column 3, where the pool of sold loans

is split between private and public buyers, as outlined in regression 19. The coefficient
for DP rivate indicates the difference between loans sold to private and public agents in
recourse States. The estimate of this difference is almost 200bp, which is an order of

magnitude higher than the DSold coefficient in Column 1. This implies that most of the

variation in the spread of sold loans is driven by pricing behaviour of private investors.
The coefficient for the interaction term DN R DP rivate is also positive and statistically

significant. It means that for non-recourse loans, private purchasers demand a higher

spread than public agencies. This suggests that private markets price in the higher risk

associated with non-recourse loans (or limited liability) to a greater extent than their

public counterparts. We conclude from this analysis that banks do charge significantly
higher interest rates on non-recourse loans when selling the loan to a private third party,

while loans bought by Fannie Mae seem to have the same interest rate at origination, as

was shown in Table 2. These results are in contrast with Hurst et al. (2016), who find
that interest rates do not vary across recourse and non-recourse States for both private
and public loans.

ECB Working Paper Series No 2519 / January 2021 38

 Table 6: Heckman Regression Results

(1) (2) (3)

EQUATION VARIABLES spread spread spread

Second Stage DN R -0.085*** -0.242*** -0.006

(0.008) (0.013) (0.025)
DSold -0.052***
(0.011)
DN R DSold 0.266***
(0.017)
DP rivate 1.978***
(0.021)
DN R DP rivate 0.222***
(0.032)
Constant 6.722*** 6.731*** 4.913***
(0.047) (0.048) (0.123)
First Stage Income -0.002*** -0.002*** -0.002***
(0.000) (0.000) (0.000)
Female 0.051*** 0.051*** 0.040***
(0.002) (0.002) (0.004)
Native -0.014 -0.014 -0.082***
(0.015) (0.015) (0.030)
Asian -0.149*** -0.149*** -0.046***
(0.008) (0.008) (0.014)
Black 0.339*** 0.339*** 0.314***
(0.003) (0.003) (0.005)
Hawaiian 0.051*** 0.051*** 0.049
(0.017) (0.017) (0.031)
Constant -1.363*** -1.363*** -2.112***
(0.002) (0.002) (0.004)

Observations 3,072,488 3,072,488 2,897,723

Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Notes: This table shows the first and second stage of the two-step Heckman
procedure for selection correction. The first stage is a Probit regression where
the probability of being selected depends on borrower observables. We include
as selection variables the borrower’s income, gender, and race. The inverse Mills
ratio is computed from the first stage and is used in the second stage regression
as an independent variable together with other explanatory variables. DN R is
a dummy variable that takes value 1 for non-recourse States and 0 for recourse
States, DSold is a dummy variable that takes value 1 for loans that were sold an
0 for loans that were kept by the bank, DP rivate is a dummy variable for loans
that were sold to a private entity and 0 for loans that were sold to a public
enterprise (GSE). Standard errors are corrected to account for the two-step
procedure. Source: Home Mortgage Disclosure Act Database and authors own
calculations, 2004-2016.

ECB Working Paper Series No 2519 / January 2021 39

5 Conclusion

The rise of household indebtedness before the Financial Crisis combined with high

default rates was a root cause of the Great Recession and underlined the role of consumer
finance for the macroeconomy. Mortgage debt in particular, constitutes two-thirds of US
household total debt, and it currently follows an increasing trend.

While there are several factors that determine the rate of mortgage default, such as
adverse economic shocks that leave households unable to honour their debt, default may
also be a voluntary choice, commonly referred to as strategic default. One particular

aspect the household may consider before choosing to default is whether there is limited

liability in place. Under limited liability, the lender is not allowed to seize the household’s

assets after default. On the contrary, under lender recourse, the lender is allowed to claw

back the borrower’s assets after default.

While the literature has analysed the consequences of limited liability, such as default

rates, loan renegotiation or forbearance, and interest rates in isolation, we embody all

these features in our analysis as equilibrium outcomes of the strategic interaction between
borrowers and lenders.

We use a model of default and renegotiation to highlight the mechanisms at hand, and

we test them empirically by exploiting the difference in legislation across US States. We

do this by comparing loans for houses situated in Metropolitan Statistical Areas that are

crossed by a State border, where one State enforces lender recourse and the other does

not. Given than MSAs are defined by the US Census Bureau as a core area containing a
substantial population nucleus, together with adjacent communities having a high degree

of economic and social integration with that core’, we argue that borrowers on either

side of the border are exposed to the same economic shocks, and the difference in their

ECB Working Paper Series No 2519 / January 2021 40

behaviour towards their mortgage loans can be thought to stem exclusively from the
presence or absence or limited liability.

In the model, both house prices and the income of the borrower are stochastic. In some
states of the world, the household has enough income to pay their mortgage, whereas in
other states of the world it does not. Likewise, in some states of the world, the house

value is higher than the mortgage amount, i.e. the household has positive equity, whereas
in other states of the world the house value is lower, i.e. the mortgage is underwater.
Households who can afford to meet their payments, but whose mortgage is underwater,

may find it optimal to default, in particular on instances where it is unlikely that they

will be liable with their personal assets after default. Lenders who know this may find it
optimal to offer these households a renegotiated mortgage price in order to prevent them

from walking away from their obligations. At the same time, the price of these loans will

reflect these mechanisms. Loan rates are expected to be higher under limited liability,

because of the higher ex-ante predictable default and renegotiation risk, and the lower

recovery rate for the lender after default.

These predictions are confirmed by the data. In fact, non-recourse loans are around

42% more likely to default, and 28% more likely to receive a renegotiation offer. However,

while the model predicts that loan rates should be higher for non-recourse loans (as they
have a higher expected default rate), loan performance data from Fannie Mae does not

confirm this. This lack of price differentiation has been noted in the literature, for instance

by Hurst et al. (2016). They note that Government-Sponsored Enterprises (GSEs) fail
to appropriately price in regional differences in ex-ante predictable default risk. In this

paper, regional risk is expected to be the same within each MSA, as they are by definition

integrated economic areas. However, we still find a lack of price differentiation on the side
of GSEs, which fail to account for the risk of default and renegotiation brought about

by the difference in legislation. We test this by using additional data from the Home

ECB Working Paper Series No 2519 / January 2021 41

Mortgage Disclosure Act (HMDA) in order to compare the interest rates on loans that
were sold to private investors vs GSEs, for recourse and non-recourse States. We find

that the difference in default risk implied by different recourse laws is indeed priced into
loans that are securitised by private investors. Overall, rates on non-recourse loans sold
to private investors are around 22bp higher than their recourse counterparts.

These results overall speak to the distortions imposed by the differences in limited
liability across States, together with the heterogeneity of public and private market par-
ticipants. Given the size of the market and the importance of mortgages in households’

balance sheets, our findings have important macroeconomic implications. Further theoret-

ical research should fill the gap in how these mechanisms interact in general equilibrium.

ECB Working Paper Series No 2519 / January 2021 42

Appendix A: Equilibria under different relative values
of thresholds (1) and (2)

Figure 8a shows the same graphic representation for the case when (1) < (2). In this
case, for values of λ weakly greater or smaller than the threshold, the above logic still

holds. However, for values between (1) and (2), the household would find it optimal
not to default, so the lender would not renegotiate. For λ = (1), the borrower would
mix between defaulting and repaying. If it defaults, then the lender would mix between

renegotiating or not. The same logic holds when λ = (1) = (2), which is represented in
figure 8b.

(a) (1) < (2) (b) (1) = (2)

Figure 8: Equilibria for different relative values of (1) and (2)

ECB Working Paper Series No 2519 / January 2021 43

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Acknowledgements
We are grateful to Chris Brooks, Michael Clements, Russell Cooper, Juan José Dolado, Matteo Escudé, Nadia Kappou, David K.
Levine, Ramón Marimón, Steven Ongena, Giorgio Primiceri, Rafael Repullo, Paul Voß, and various seminar participants at EUI, ICMA
Centre at the Henley Business School, and at the 2019 EDP Jamboree in UCLouvain for useful comments and suggestions. We also
thank the Editorial Board of the ECB Working Paper Series, as well as an anonymous referee. The views expressed are our own and do
not necessarily reflect those of the European Central Bank or the Eurosystem.

Mirco Balatti
European Central Bank, Frankfurt am Main, Germany; ICMA Centre, Henley Business School, Reading, United Kingdom;
email: [email protected]

Carolina López-Quiles
European Central Bank, Frankfurt am Main, Germany; European University Institute, Florence, Italy;
email: [email protected]

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