Lenders are frequently accused of mispricing the put option imbedded in non-recourse lending (Herring and Wachter, 1999 and 2003). In this paper we investigate the causes of market-wide mispricing and its effect on asset prices. We find two competitive equilibria–”good” and “underpricing.” In the good equilibrium, lenders accurately price the put option and asset prices reflect their fundamental value. In the underpricing equilibrium,
• Competitive pressures force all lenders to underprice the put,
• Asset prices rise above their fundamental level,
• The spread of lending over deposit rates narrows, and
• Lenders have negative expected profits.
Such continuing operations result from agency frictions between bank shareholders and managers and/or because deposit insurance covers the potential losses and/or because of limited liability for shareholders and managers. We show that the transition from the good to the underpricing equilibrium is only a matter of time. This result holds even when all participants in both equity and debt markets are fully rational.
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