A previous version of this working paper was originally published in 2005.

Stabilization can occur in this model because lenders are imperfectly informed as to borrowers’ propensity to default; as a result it is too costly for lenders to impose borrowing constraints that guarantee repayment in every possible eventuality. This allows some borrowers to default when house prices are low, thereby leaving them with more wealth; this then serves as an endogenous stabilizing force.