| Abstract: |
This paper analyzes mortgage-market equilibrium when borrower default costs are private information. By applying the approach of Rothschild and Stiglitz (1976), it is shown that asymmetric information regarding default costs distorts the contract choices available in the mortgage market, preventing safe borrowers (those with high default costs) from fully satisfying their demand for mortgage debt. Large loans are available for a substantial interest-rate premium, but only risky borrowers find this premium worth paying. The paper builds on an empirical literature designed to test the ruthless-default principle from option-based models of mortgage pricing. That literature provides evidence against ruthless behavior, suggesting that default costs play an important role in borrower decisions. The paper takes a further step by arguing that such costs are private information, which has important implications for market equilibrium.
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