Optimal loan-to-value ratio and the efficiency gains of default

We study the optimal loan-to-value (LTV) ratio in a monetary general equilibrium model with heterogeneous agents, collateral default, production and a banking sector. We find that the welfare of the debtor is not monotonically increasing in the LTV ratio, i.e. tighter financing constraints can be welfare-improving for the debtor. Moreover, the optimal LTV ratio for both the debtor and the creditor allows for the possibility of ex post default. Collateral default enhances efficiency by allowing for better consumption smoothing and risk hedging. Our result improves the argument in Dubey et al. (Econometrica 73(1):1–37, <CitationRef CitationID="CR4">2005</CitationRef>) and Zame (Am Econ Rev 83(5):1142–1164, <CitationRef CitationID="CR19">1993</CitationRef>), which use default penalties instead of collateral to induce repayment and show the efficiency gains of default. Copyright Springer-Verlag Berlin Heidelberg 2014