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Liquidity Contractions and Prepayment Risk on Collateralized Asset Markets

Author

Listed:
  • Miguel Angel Iraola

    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

  • Juan Pablo Torres-Martinez

    (Department of Economics, Universidad de Chile)

Abstract
This paper presents a dynamic general equilibrium model with default and collateral requirements. In contrast with previous literature, our model allows for liquidity contractions and general prepayment specifications. We show that liquidity substantially affects credit and prepayment risks, and that different borrowers may follow differentiated payment strategies: whereas some pay, others prepay or default. The lack of liquidity increases debtors' willingness to continue paying, even thought prepayment cost could be higher than the collateral value. This mechanism rationalizes underwater mortgages. We prove existence of equilibrium, and provide a numerical example illustrating the main determinants of optimal payment strategies.

Suggested Citation

  • Miguel Angel Iraola & Juan Pablo Torres-Martinez, 2012. "Liquidity Contractions and Prepayment Risk on Collateralized Asset Markets," Working Papers 1204, Centro de Investigacion Economica, ITAM.
    • Handle: RePEc:cie:wpaper:1204
    as

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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Collaterized asset markets; Liquidity constraints; prepayment risk;
    All these keywords.

    JEL classification:

    • D50 - Microeconomics - - General Equilibrium and Disequilibrium - - - General
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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