Economic Quarterly

This paper studies the effect of monetary incentives on mortgage renegotiation. Lenders are sometimes willing to renegotiate mortgage contracts with homeowners who are at risk of foreclosure. This paper models the renegotiation process as a simple sequential move game in which the homeowner first seeks renegotiation and the lender responds by deciding whether or not to modify the terms of the mortgage. The model is used to examine outcomes in the presence of monetary incentives given to the homeowner and lender like those given by U.S. government programs during the recent foreclosure crisis. The results show that, in the absence of monetary incentives, lenders renegotiate with a subset of homeowners who avoid foreclosure as a result. The introduction of incentives expands the set of homeowners who receive modifications and avoid foreclosure. We show that under certain conditions, incentives also lead lenders to renegotiate with homeowners who subsequently end up in foreclosure.