The Loan Market, Collateral, and Rates of Interest

This paper develops a theoretical model in which collateral is a mechanism for enforcing loan contracts. Collateral functions in two ways in the model. First, default on a loan triggers the loss of collateral value to the borrower, where this value is stochastic at the time when the loan is negotiated. The assignment of collateral provides incentive for the borrower to repay the loan. Second, default implies that the property nght to the collateral is transferred to the lender. The lender valuation of collateral, which may diverge from the borrower valuation, is also stochastic at the time of loan negotiation. The relation of lender to borrower valuation plays an important role in the loan process. If, because of costs of collection and marketing, moral hazard problems, or other types of costs, the lender valuation is much below the borrower valuation, then the process of default will entail dead-weight losses. Interest rates charged on loans will reflect these losses-appropriately weighted by the probability of default-and the expected interest charge paid by the borrower will be correspondingly above the underlying, transaction-cost-free rate of return. The more important these costs associated with default, the greater would be the dead-weight losses incurred and the amount of (otherwise) profitable loan opportunities foregone. Section 1 sets out the basic model and discusses the expected interest costs from the viewpoint of the borrower. Section 2 introduces transaction costs associated with default, discusses the expected interest return from the viewpoint of the lender, and analyzes the maximum size loan that would be issued by lenders on the basis of a given quantity of collateral. Section 3 uses the assumption that the lending industry yields a competitive rate of return to analyze the determination of