Recent Developments in Consumer Credit and Payments

September 20-21, 2007
Federal Reserve Bank of Philadelphia
Ten Independence Mall, Philadelphia, PA 19106

Abstracts

Liquidity Constraints and Imperfect Information in Subprime Lending (316 KB, 42 pages)

William Adams, Citigroup
Liran Einav, Stanford University
Jonathan Levin, Stanford University

We present new evidence on consumer liquidity constraints and the credit market conditions that might give rise to them. Our analysis is based on unique data from a large auto sales company that serves the subprime market. We first document the role of short-term liquidity in driving purchasing behavior, including sharp increases in demand during tax rebate season and a high sensitivity to minimum down payment requirements. We then explore the informational problems facing subprime lenders. We find that default rates rise significantly with loan size, providing a rationale for lenders to impose loan caps because of moral hazard. We also find that borrowers at the highest risk of default demand the largest loans, but the degree of adverse selection is mitigated substantially by effective risk-based pricing.

Information Technology and the Rise of Household Bankruptcy (257 KB, 27 pages)

Borghan N. Narajabad, Rice University

Several studies attributed the rise of household bankruptcy in the past two decades to the decline of social stigma associated with default. Stigma explanations, however, cannot account for the increase of credit availability during this period. I try to explain both of these facts as a result of a more informative credit rating technology.

I consider an adverse selection environment where borrowers are heterogeneous with respect to their cost of default. Lenders have access to a rating technology which provides an exogenous signal about borrowers’ default costs. Equilibrium contracts subject each borrower to a credit limit such that the lenders’ expected profit, conditional on the signal about the borrower’s default cost, is zero.

As the exogenous signal becomes more informative, the credit market will provide a higher credit limit for borrowers with a high cost of default, and a lower limit for borrowers with a low cost of default. Hence a more informative signal allows those with a high cost of default to borrow more making them more likely to default, while decreasing borrowing and default by those who have a low cost of default.

Using Simulated Method of Moments, I estimate the model to match data on the averages of available credit limits and debt as well as the increase in the spread of the credit limit distribution from the Survey of Consumer Finances 1992 and 1998. The model does well in matching the targeted moments and accounts for about one third of the increase in the number of bankruptcy filings from 1992 to 1998.

JEL Classification: G14, E44, G24, K35, E21.

Keywords: Consumer Bankruptcy, Information and Market Efficiency, Rating Agencies.

Who Makes Credit Card Mistakes? (92 KB, 29 pages)

Nadia Massoud, York University
Barry Scholnick, University of Alberta
Anthony Saunders, New York University

We document that not all individuals who pay penalty fees on their credit cards (e.g. for not paying the minimum monthly payment, or for exceeding their credit limit) do so because they don’t have enough money. In fact, a sizable proportion of those who incur credit card penalty fees do have enough money in their deposit accounts, and so could have avoided those penalties. In other words these penalties are incurred by mistake, caused by the inattention of individuals to their credit card payments and expenditures. Individuals who make such mistakes can be very attractive to the banks, because while they pay the penalty fees, mistakes caused by inattention do not necessarily signal an increased risk of future credit card default. Using a unique database of more than one million data points we show that individuals who make these kinds of unnecessary credit card mistakes are poorer. In particular individuals who make these mistakes (1) live in areas with more renters than owners, (2) receive a greater proportion of income from government sources such as unemployment insurance and government pensions and (3) receive smaller amounts from the ownership of businesses and other investments.

The Age of Reason: Financial Decisions Over the Lifecycle (347 KB, 51 pages)

Sumit Agarwal, Federal Reserve Bank of Chicago
John C. Driscoll, Board of Governors of the Federal Reserve System
Xavier Gabaix, New York University
David Laibson, Harvard University

The sophistication of financial decisions varies with age: middle-aged adults borrow at lower interest rates and pay fewer fees compared to both younger and older adults. We document this pattern in ten financial markets. The measured effects cannot be explained by observed risk characteristics. The sophistication of financial choices peaks around age 53 in our cross-sectional data. Our results are consistent with the hypothesis that financial sophistication rises and then falls with age, although the patterns that we observe represent a mix of age effects and cohort effects.

JEL Classification: D1, D4, D8, G2, J14

Keywords: Household finance, behavioral finance, behavioral industrial organization, aging, shrouding, auto loans, credit cards, fees, home equity, mortgages.

Bankruptcy: Is It Enough to Forgive or Must We Also Forget? (1.15 MB, 58 pages)

Ronel Elul, Federal Reserve Bank of Philadelphia
Piero Gottardi, Università Ca' Foscari di Venezia

In many countries, lenders are not permitted to use information about past defaults after a specified period of time has elapsed. We model this provision and determine conditions under which it is optimal.

We develop a model in which entrepreneurs must repeatedly seek external funds to finance a sequence of risky projects under conditions of both adverse selection and moral hazard. We show that forgetting a default makes incentives worse, ex-ante, because it reduces the punishment for failure. However, following a default it is generally good to forget, because by improving an entrepreneur’s reputation, forgetting increases the incentive to exert effort to preserve this reputation.

Our key result is that if agents are sufficiently patient, and low effort is not too inefficient, then the optimal law would prescribe some amount of forgetting — that is, it would not permit lenders to fully utilize past information. We also show that such a law must be enforced by the government—no lender would willingly agree to forget. Finally, we also use our model to examine the policy debate that arose during the adoption of these rules.

JEL Classification: D86 , G33, K35.

Keywords: Bankruptcy, Information, Incentives, Fresh Start

Interest Rates and Consumer Choice in the Residential Mortgage Market (194 KB, 42 pages)

James Vickery, Federal Reserve Bank of New York

This paper estimates a coefficient of substitution between fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs), exploiting a discontinuity in legal rules governing the secondary market purchases of Fannie Mae and Freddie Mac. It is found that consumer choice between these mortgage types is strikingly price sensitive: a 20 basis point increase in retail FRM interest rates reduces the FRM market share by 17 percentage points, holding the yield curve and other macroeconomic factors constant. Based on this coefficient, it is calculated that around half of the high FRM share in the US relative to the UK can be accounted for as a consumer response to differences in retail mortgage interest rates.

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