The Option Value of Non-Recourse Lending and Inflated Asset Prices

Abstract

We investigate the market prices of assets in fixed supply whose purchase is typically financed through non-recourse loans. The largest and most common asset in this category is real estate. We demonstrate the following two important features of such markets: - Lenders' underpricing of the put option contained in the non-recourse loans leads to inflated asset prices within efficient markets, and - Under certain conditions, the presence of short-term players in the debt market induces all lenders to underprice the put option in equilibrium. We further show that the probability of entering the "underpricing" equilibrium (i.e., all lenders underprice the put) increases with the time since the last negative demand shock, increases with the volatility of the asset market, and decreases with the size of the debt market. These results hold even when all participants in both equity and debt markets are fully rational. Furthermore, the model allows for management compensation that is aligned with maximizing bank shareholders' value. Using real estate transaction data we find strong empirical support for the predictions of the model.