Journal of Real Estate Finance and Economics, 28:2/3, 147±160, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Robbing the Bank: Non-recourse Lending and
Simon Fraser University, 8888 University Dr., Burnaby BC V5A 1S6, Canada
The Wharton School, University of Pennsylvania, 256 South 37th Street, Philadelphia, PA 19104-6330
We investigate the market prices of assets in ®xed supply whose purchase is typically ®nanced through non-
recourse loans. The largest and most common asset in this category is real estate. We demonstrate two features of
lenders' underpricing of the put option contained in non-recourse loans leads to in¯ated asset prices within
ef®cient markets, and
lenders with short-term horizons have incentives to underprice the put option.
These results hold when participants in both equity and debt markets are rational. The model also allows for
management compensation that is aligned with maximizing bank shareholders' value. Using real estate
transaction data we ®nd empirical evidence consistent with the predictions of the model.
Key Words: asset pricing, lending markets, price bubbles
As is well known, when a bank makes a non-recourse loan the bank provides a put option
on the underlying asset. If the value of the asset declines, the borrower has the right, but
not the obligation, to ``put'' the asset back to the bank (i.e., walk away from the property).
In other words, the borrower can ``sell'' the asset to the bank for the outstanding loan
balance. This ``right to sell'' limits the losses of the borrower and is a put option, written
by the bank, with a strike price equal to the outstanding loan balance.
If the put option is priced correctly and the price is passed on to the borrower in the form
of higher interest rate, the lending has no impact on asset prices (e.g., property values). We
showin this paper that if the put option imbedded in a loan is underpriced, that is the
interest rate charged is too lowrelative to the deposit rate, then investors incorporate this
mistake into their demand price for the asset. Thus, lending without proper valuation of the
put option results in an in¯ated price of the asset within ef®cient equity markets.
Managers' incorrect valuation of the put option can directly result in the underpricing of
the loan leading to in¯ated asset prices. Moreover, even if managers knowthe correct