This study investigates the economic role of penalty interest rates with respect to lenders’ incentive structure toward borrower defaults in mortgage markets. We model a bank’s credit rationing problem with two strategies, screening out bad loans and risk-based pricing, and show that the bank’s strategies vary with the environment of penalty interest rates and loan-to-value (LTV) ratios. As low LTV ratios indicate sufficient buffer between the debt and the collateral value, the lenders could be over-compensated from the default if they are allowed to charge a penalty interest rate exceeding the administrative cost of default. Our findings suggest that tightening LTV constraints while leaving regulations on penalty interest rates relaxed can unexpectedly undermine lenders’ voluntary willingness to monitor and prevent mortgage defaults.

In this paper we study a simple two-period asset pricing model to understand the implications of uninsurable labor income risk and/or borrowing constraints, limited stock market participation, heterogeneous labor income volatilities, and heterogeneous preferences. We appraise the performance of each of these in matching moments of asset returns to the data and show that limited stock market participation generates a significantly large equity premium. We also show that the distribution of wealth between stock market participants and non-participants plays an important role in asset pricing, and that the effect of borrowing constraints on asset returns are similar to that of limited participation. Finally, we discuss the practical implications of our investigation, providing an appraisal of ongoing changes in asset returns.