By Joao Cocco and Nuno Clara
We solve a quantitative dynamic model of borrower behavior, whose income is subject to individual specific and aggregate shocks. Lenders provide loans competitively. Recessions are characterized by lower expected earnings growth and a higher likelihood of a large drop in earnings. The model generates procyclical credit demand and countercyclical default. We analyze alternative debt restructuring policies aimed at reducing default during recessions: (i) interest rate reduction; (ii) maturity extension; and (iii) refinancing. Outcomes are best for the maturity extension policy that allows borrowers to temporarily make interest-only payments on the loan. Not all borrowers exercise the option. The maturity extension policy leads to lower default rates, higher consumer welfare, and a smaller drop in consumption during recessions, without significantly increasing cash-flow risk for lenders.
Thus, regulation should be more flexible in allowing for maturity extension. It looks, however, that this may be one of those situations where the interests of the lenders do not exactly align with those of the economy as a whole. But to look into this, one needs to take a stand in weighing consumer and lender welfare.