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Robbing the Bank: Non-recourse Lending and Asset Prices

Working paper #408
Andrey D. Pavlov and Susan M. Wachter

We investigate the market prices of assets in fixed supply whose purchase is typically financed through non-recourse loans. The largest and most common asset in this category is real estate. We demonstrate that within these markets, lenders’ underpricing of the put option contained in non-recourse loans leads to inflated asset prices within efficient markets, and that lenders with short-term horizons have incentives to underprice the put option. This persistent underpricing of the put option is one of the reasons for the cycles experienced in real estate markets. These results hold when participants in both equity and debt markets are rational. The model also allows for management compensation that is aligned with maximizing bank shareholders’ value. Using real estate transaction data we find empirical evidence consistent with the predictions of the model.

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