Adverse Selection in a Model of Real Estate Lending

Authors

  • V. V. CHARI,

  • RAVI JAGANNATHAN

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    • Chari is from the Research Department, Federal Reserve Bank of Minneapolis; Jagannathan is from the Department of Finance, University of Minnesota and the J. L. Kellogg Graduate School of Management, Northwestern University. We would like to thank Anjan Thakor for useful comments. All errors are our own. This research was supported in part by the Banking Research Center, Northwestern University. Ravi Jagannathan gratefully acknowledges support from a grant by the McKnight Foundation to the University of Minnesota. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.


ABSTRACT

We provide a rationale for the presence of points in mortgage loan contracts. Our analysis builds on two key features. First, insurance markets are unavailable for labor income. Second, the “due-on-sale” clause allows banks to offer loan contracts which partially insure against fluctuations in labor income. If explicit prepayment penalties are prohibited by law, points serve effectively as prepayment penalties. We also examine environments where such penalties are not prohibited and show that points will be used if interest rates cannot depend on the size of the loan.

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