This paper studies a market for secured loans to information-problematic borrowers. Competitive banks grant mortgages to households to …nance a …xed supply of homes. There are two contracting frictions: households privately observe their endowments, and they cannot commit to a contract. Banks can commit to eviction after payment default. Households honor contractual repayments as long as i) they can a¤ord it, and ii) they prefer to do so rather than exercise endogenous outside options in mortgage and housing markets. Loan-to-income ratios, home prices, trading volume, and default rates are joint equilibrium outcomes that we characterize in quasi-closed forms. Both the systematic and idiosyncratic components of income risk reduce debt capacities, albeit through quite distinct channels. Thus, the net impact of the diversi…ability of income risk on mortgage capacity and home prices is ambiguous. The paper also shows that these contracting frictions rule out some types of rational bubbles that would be sustainable in a frictionless economy, and studies the impact of bubbly equilibrium price paths on mortgage terms
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