Abstract
Equitable redemption is a feature of all common law mortgages that allows a borrower a chance to “redeem” the real estate in the event of default. What is puzzling is that equitable redemption is universally enforced in all mortgages, including commercial mortgages. The purpose of this study is to understand if there might be conditions under which the universal enforcement of equitable redemption could be an efficient legal doctrine. We build a model of asymmetric information where the cash flows from the investment are known to the borrower but not to the lender. We show that there exists a separating equilibrium where high-risk borrowers choose to include equitable redemption (and pay a higher interest rate) while low-risk borrowers choose not to (and pay a lower interest rate). We then show that there exist conditions under which a universal enforcement of equitable redemption results in a higher total surplus than this separating equilibrium.
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Notes
There is other literature that contemplates the right to freely contract in real estate markets, and in particular, focuses on the tension between real property law and contract law. Jaffe and Sharp (1996) investigate foreclosure moratoria in which the courts interfere with private contracts. While they cannot find a compelling argument in the theory of contracts to warrant such interference, they acknowledge that the institutions of property are different from contracts. Rose (2004) explores whether the famous decision in Shelley v. Kraemer which deemed racial covenants unenforceable was an interference with the freedom of contracting.
The main exception to universal enforcement of the doctrine against clogging has been with respect to installment land contracts also called a contract for deed or land contract.
We assume that this information is known to the lender.
The reason for this assumption is simple. If the reinvestment funds and returns were contractible and available for repayment of the mortgage, or if the reinvestment opportunity were on the same property so that it would affect the property value and cash flows, then the lender would in fact be eager to offer financing for the reinvestment opportunity as long as the expected return from the reinvestment project is positive. This would eliminate the role of PER in the mortgage contract since the lender and the borrower would always renegotiate the contract to pursue the reinvestment opportunity regardless of whether or not the original contract involved PER.
Alternatively, the borrower could choose to pursue another lender for a loan. For our purposes here, we assume that there are sufficient transaction costs involved such that the outside option is too costly. For example, the investment might be for an emergency expenditure in which there is insufficient time to obtain new financing. Or it could simply be that the investment is in an asset that is difficult for this or another lender to monitor and hence the borrower needs to rely on the existing real estate asset as security.
Note that it is always in the borrower’s best interest to attempt to stay in possession of the real estate for an additional period in order to claim the third period’s cash flow.
Since the lenders operate in a competitive market, their expected profits, including from re-lending the prepayment amount, will be zero.
Also note that without the \( P + E{\left( y \right)} - L < F \) condition, the zero-profit condition would result in negative interest rates.
The additional foreclosure cost reflects the fact that PER is typically associated with a lengthier and more costly foreclosure process.
Here we refer to the risk of default as opposed to volatility of the cash flows.
It is well known that there may exist no equilibrium if the proportion of risky borrowers is not high enough (Rothschild and Stiglitz 1976). The possibility of non-existence of an equilibrium could provide one possible rationale for a universal enforcement of PER. In this paper, however, we confine our attention to markets where there are enough risky borrowers so that a separating equilibrium exists.
Recall that lenders’ expected surplus under each contract is zero.
An important related question is whether we can make both borrower types better off with a lump sum transfer from high-risk borrowers to low-risk borrowers. Since universal enforcement of PER creates a pooling equilibrium where both types (have to) choose the same contract, and since risk type of a borrower is private information to that borrower, such a lump sum transfer becomes impossible because every borrower will have incentives to claim to be of low risk type. However, it is possible to come arbitrarily very close to such a wealth distribution through a transfer scheme (see Crocker and Snow 1985, for a discussion of implementation of such transfer schemes under informational asymmetry).
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Acknowledgement
We thank Richard Buttimer, Brendan O’Flaherty, Steve Ott and participants at the March 2005 CRER Third Annual Symposium in Dublin, Ireland, the January 2005 meeting of the Weimer School of Advanced Studies in Real Estate and Land Economics in West Palm Beach, FL, the 2005 American Real Estate and Urban Economics Association Annual Meeting in Philadelphia, PA, and the Finance Workshop at Syracuse University for helpful comments.
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Fisher, L.M., Yavas, A. The Value of Equitable Redemption in Commercial Mortgage Contracting. J Real Estate Finan Econ 35, 411–425 (2007). https://doi.org/10.1007/s11146-007-9064-4
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DOI: https://doi.org/10.1007/s11146-007-9064-4