Private Valuation and Private Information: Can Mandatory Non-Recourse Mortgage Legislation Restore a Missing Market?

Abstract

Many US states mandate only non-recourse mortgages for dwellings, thus limiting choice and raising prices. Given the perceived benefit of such mortgages, it is a puzzling fact that no lenders currently offer them in "choice" states. We simulate a housing market with a spectrum of borrowers with privately-known income distributions, and show that under plausible conditions mandating non-recourse can remedy a market failure due to asymmetric information. Non-recourse loans provide valuable insurance to borrowers by protecting assets in worst-case outcomes involving loss of both equity and income. But markets in these mortgages may be missing due to a combination of adverse selection (inability to screen out high-risk borrowers) and adverse incentives (higher prices incentivize additional walk-aways), leading to a "death spiral" of rising rates and shrinking pools. Mandating non-recourse loans obligates the lowest risk borrowers to join the pool, which in our model may increase welfare.