The economic role of foreclosures

We consider the economic consequences of changing the foreclosure rules. By incorporating renegotiation into the analysis, we show that although renegotiation decreases the number of foreclosures it can make the effects of foreclosure more significant. Even when foreclosure does not actually occur, a change in foreclosure rules changes the threat points of lender and borrower in any renegotiation, and thus changes the effective interest rate that the lender receives. In the long run, stated interest rates on loans will adjust to compensate for any change in the effective interest rate. We also examine the impact of a change in foreclosure laws on the borrower's welfare.