The Value of Equitable Redemption in Commercial Mortgage Contracting

Abstract

Equitable redemption is a feature of all common law mortgages that allows a borrower a
chance to “redeem” the real estate in the event of default. What is puzzling is that
equitable redemption is universally enforced in all mortgages, including commercial
mortgages. The purpose of this study is to understand if there might be conditions under
which the universal enforcement of equitable redemption could be an efficient legal
doctrine. We build a model of asymmetric information where the cash flows from the
investment are known to the borrower but not to the lender. We show that there exists a
separating equilibrium where high-risk borrowers choose to include equitable redemption
(and pay a higher interest rate) while low-risk borrowers choose not to (and pay a lower
interest rate). We then show that there exist conditions under which a universal
enforcement of equitable redemption results in a higher total surplus than this separating
equilibrium.