Optimal Collateralized Contracts

We examine the role of collateral in a dynamic model of optimal credit contracts in which a borrower values both housing and nonhousing consumption. The borrower's private information about his income is the only friction. An optimal contract is collateralized when in some state, some portion of the borrower's net worth is forfeited to the lender. We show that optimal contracts are always collateralized. The total value of forfeited assets is decreasing in income, highlighting the role of collateral as a deterrent to manipulation. Some assets-those that generate consumable services-will necessarily be collateralized, while others may not be. Endogenous default arises when the borrower's initial wealth is low, as with subprime borrowers, and/or his future earnings are highly variable.