Loan Insurance, Market Liquidity, and Lending Standards

Third parties often assume default risk at loan origination in return for a fee. Insurance, various guarantees and external credit enhancements protect the owner of the loan against borrower default. Governments often assume such default risk through guarantees for various types of loans, including mortgages, student loans and small business loans. The widespread use of loan default insurance raises important questions: What is the impact of loan insurance on secondary market liquidity and on lending standards in primary markets? And is there a role for government intervention? We propose a simple model of lending where borrowers are screened at loan origination and lenders can learn about loan quality over time. Lenders can transfer the loan default risk to outside financiers at loan origination through loan insurance. Alternatively, they can transfer the default risk after a liquidity shock or after learning about loan quality by selling the loan in the secondary market. The model features a trade-off between secondary market liquidity and lending standards. The timing of risk transfer affects this trade-off. Loan insurance lowers the lending standards but improves the liquidity in secondary markets with a net improvement in welfare. Since lenders do not take into account the positive benefit of insurance on the liquidity in the market for uninsured loans, there is insufficient loan insurance in equilibrium. This implies that a regulator can improve welfare by subsidizing loan default insurance. We also consider a policy of outright loan purchases and show that while it is optimal to have it as an option to rule out inferior equilibria, only a policy of insurance subsidy is optimally used in equilibrium.