Collateral, Default Penalties and Infinite Horizon Equilibrium

Abstract

Pascoa and Seghir (2009) noticed that when collateralized promises become subject to utility penalties on default, Ponzi schemes may occur. However, equilibrium exists in some interesting cases. Under low penalties, equilibrium exists if the collateral does not yield utility (for example, when it is a productive asset or a security). Equilibrium exists also under more severe penalties and collateral utility gains, when the promise or the collateral are nominal assets and the margin requirements are endogenous: relative inflation rates and margin coefficients can make the income effects dominate the penalty effects. An equilibrium refinement avoids no-trade equilibria with unduly repayment beliefs. Our refinement differs from the one used by Dubey, Geanakoplos and Shubik (2005) as it does not eliminate no trade equilibria whose low delivery rates are consistent with the propensity to default of agents that are on the verge of selling.