Consider a non-recourse mortgage with one payment of $10,600,000 due one year from now. The uncertain future is characterized by the following scenarios and probabilities:

1. Scenario I: 70% probability, property worth $13,000,000
2. Scenario II: 20% probability, property worth $11,000,000
3. Scenario III: 10% probability, property worth $9,000,000

If a foreclosure occurs, the (deadweight) cost paid to third parties will be $2,000,000. One-year US Treasuries are yielding 6% and investors require a risk premium of 1%.

1. What is strategic default, and how is it related to limited liability and the cost of foreclosure?
2. What would this loan sell for today if scenario III results in a deed-in-lieu, and scenario II results in a strategic default in which the difference between the borrower’s and lender’s extreme position is split 50/50?
3. What is the present value cost of credit risk?

Answer rating: 100% (QA)

Str ategic default occurs when a borrower chooses to default on a loan even though they are capable ... View the full answer