The Use of Collateral to Enforce Debt Contracts

This paper analyzes the enforcement of debt contracts by treating the adherence to a contract as a matter of choice. Many commonly observed features of debt contracts, including the widespread use of collateral, are shown to be market responses to the costs of enforcing contracts. The characteristics of the collateral asset, including its marketability and expectations regarding its future price are shown to have important effects on the payments schedule of the debt. Since default is treated as a choice variable I am able to demonstrate the effects of macroeconomic fluctuations on default rates and lending decisions. Thus the analysis provides a basis for modeling the multiplier phenomena associated with the collapse of lending markets during severe depressions.