Essays on default, entrepreneurship, and institutional arrangements

This dissertation consists of three chapters on the implications of the personal default option on the economy. In the first two chapters, I analyze how credit constraints faced by entrepreneurs are shaped by the legal environment for default that they face. In the third chapter, I explore the welfare implications of allowing financial intermediaries to charge different interest rates according to perceived probabilities of consumer bankruptcy. In the first chapter, I build a model where agents can pick a career and decide whether to default on their mortgage. The purpose of this model is to analyze the interaction between these decisions and the existence of different legal environments, regarding the degree of recourse that lenders have over the borrowers’ assets. The model yields three basic predictions. First, as lenders have more recourse, the cost of default for the borrower increases and default becomes less frequent. Second, as lenders have more recourse, the entrepreneurship threshold (i.e. the amount of home equity a homeowner requires to become an entrepreneur) also increases. Third, where lenders have relatively less recourse, the size of the entrepreneurship threshold reduction due to a house price increase is larger. In the second chapter I test the validity of the third prediction of the model, which encompasses the other two. Using U.S. data, I find that the margins of creation for small young firms responded strongly to the increase in house prices between 2000 and 2007. This effect was driven by those areas where mortgage default is relatively less costly (less recourse). This link between house prices and entrepreneurial activity becomes weaker after the Great Recession. The third chapter explores the effects of allowing financial intermediaries to charge different interest rates according to the debt profile of agents. It also studies the welfare implications of different bankruptcy schemes and those associated with removing the default option. My findings indicate that allowing for price discrimination and removing the bankruptcy option are both desirable. However, the welfare gain from a more stringent bankruptcy regulation is negligible compared to those of removing the bankruptcy option and allowing discrimination