Unsecured Credit Research Articles

An Economic Examination of Collateralization in Different Financial Markets

This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of financial contracts. We also analyze the difference between cleared and OTC markets.

Fresh Start or Head Start? Uniform Bankruptcy Exemptions and Welfare

The 1990's witnessed a historically unprecedented number of personal bankruptcy filings. In response, congressional debate over bankruptcy law has recently led to several proposals aimed at making it more difficult to exempt wealth in bankruptcy. In this paper, I evaluate uniform exemption policy primarily within the context of the recent congressional proposal H.R. 975. I develop an incomplete markets model where secured and unsecured assets coexist and are treated differentially in a bankruptcy proceeding. I find that exemptions are associated positively with filing rates and the amount of equity held at the time of filing. Conversely, exemptions are strongly negatively associated with the availability of unsecured credit. The welfare consequences of exemptions, while small, are positive for high exemptions and negative for low ones. Steady state welfare is maximized under a full exemption, and is worth $28.24 annually to the average household. The results are robust, and show that increases in bankruptcy exemptions beyond current state averages are largely a matter of indifference, and do not merit the heated debate they have generated.

Health Shocks, Credit Scores, and Strategic Behavior with Credit Cards

The paper solves a puzzle related to unsecured credit and the use of credit scores. With credit scores increasingly present in credit decisions, and with the increased use of credit cards, especially in categories at risk of large negative health shocks, asymmetry of information between banks and individuals opens up wider possibilities for strategic behavior on the part of the latter. In this paper I analyze consumer strategic behavior in the credit market when faced with exogenous health shocks in the presence of banking institutions that rely on credit scores as a form of indicator of creditworthiness. By introducing multiple sources for asymmetry of information in the credit market, something not done in prior models, and introducing a dynamic discount factor, I find that the rational consumer engages in strategic behavior specific to their credit score. The paper solves an empirically parameterized model of life cycle consumption and borrowing focusing on unsecured credit and allowing for default in the presence of health shocks. It also allows for the simultaneous holding of both an interest bearing asset and unsecured debt. The findings support the hypothesis that exogenous credit shocks affect the behavior and the degree of strategy involved. While I do not possess actual consumer data on default, I develop some stylized empirical evidence in line with predictions of the theoretical model.

Southern Society and Its Transformations, 1790–1860 (review)

Reviewed by: Southern Society and Its Transformations, 1790–1860 Ami Pflugrad-Jackisch (bio) Keywords South, Markets, Southern economy, Slavery Southern Society and Its Transformations, 1790–1860. Edited by Susanna Delfino, Michele Gillespie, and Louis M. Kyriakoudes. (Columbia: University of Missouri Press, 2011. Pp. 270. Paper $40.00.) In the last decades of the twentieth century, traditional histories of the antebellum South described the region as economically stagnant and [End Page 530] socially backward. More recently, however, new scholarship has brought to light the pervasiveness of market activities in the Old South. Southern Society and Its Transformations builds on this new body of scholarship and makes important contributions of its own. This volume of essays paints a picture of a dynamic South that was constantly evolving and adapting (12). In addition to the preface and editors’ introduction, the book’s nine essays are broken up into four sections that examine race relations, the emergence of the market economy, the rise of a southern middle class, and finance. The essays relocate the origins of regional modernization in the antebellum era and suggest a different timeline and pace for capitalist expansion. The authors depict the ebb and flow of southern economic development that started out slowly in the 1830s, but then rapidly accelerated in the late 1840s and 1850s. Besides these shared contributions, the individual essays in Southern Society and Its Transformations offer three additional assertions that further complicate existing southern historiography. First, antebellum southerners were not only market-oriented, but also willing capitalists. Robert Wright’s essay surveys the economic viability of southern business and argues that southerners were not reluctant entrepreneurs. In fact, Wright demonstrates that southerners adroitly raised needed capital to finance their business ventures. He contends that southerners’ willingness to participate in the market was stifled only by the “negative externality” of slavery (198). Jeff Bremer’s chapter on the evolving consumer economy in Missouri and Gary T. Edwards’s essay on yeomen farmers’ desire to enter into surplus cotton production in western Tennessee further establish southern farmers’ willing engagement in market activities. Elbra David’s chapter on the role of unsecured credit in Natchez illustrates the adaptability of the southern credit system. Like Bremer, David demonstrates the usefulness of examining the whole range of credit relationships, including informal credit transactions that were conducted outside of formal lending channels, because of their importance to regional economic development and in financing southern agriculture. Second, the two essays by Jonathan Daniel Wells and Jennifer R. Green trace the creation of a self-conscious middle-class identity among a growing group of educated southern professionals, and they explore the occupational diversification that accompanied economic and social change in antebellum southern life. Wells examines southern professionals’ efforts to differentiate themselves from planters by forming professional societies, clubs, and organizations. Ultimately these organizations [End Page 531] helped the emerging middle class formulate a new future for the South, one that envisioned slavery comfortably coexisting with urban and industrial modernization. Green explores the educational background of antebellum southerners, concluding that graduates of higher schooling overwhelmingly entered into middle-class professional occupations and sought professional, not agricultural, success. These essays demonstrate the growing presence of a middle-class coalition of southerners who helped to redefine southern social mobility and cultivate bourgeois values long before the Civil War. A third group of essays reveals significant tensions among white southerners. As whites increasingly engaged in market activities, their competing economic interests strained both racial solidarity and the traditional framework of the slave system. Specifically, these tensions underscored the need for nonslaveholding whites to participate in the common defense of slavery (which did not always occur). Keri Leigh Merritt’s chapter on the enforcement of vagrancy laws in antebellum Georgia exposes planters’ uncertainty about poor whites’ commitment to slavery. She argues that vagrancy laws were selectively used to punish poor whites whose allegiance they questioned. Michael J. Pfeifer’s essay highlights the surprising prevalence of extralegal lynching in the antebellum era. Like Merritt, Pfeifer uncovers interesting historical moments when the property rights of individual slaveholders were pitted against the larger community’s interest in reinforcing racial solidarity. Moreover, Max L. Grivno’s chapter on rural wage labor in Maryland...

Default and bankruptcy in an entrepreneurial economy with incomplete markets

We build a general equilibrium model with incomplete markets, production, default, and bankruptcy. The existence of equilibrium is proved. Theoretically, under appropriate conditions, we show that the reduced-form entrepreneurial equilibrium and profit-maximization entrepreneurial equilibrium, as defined by Magill and Quinzii (1996), are equivalent. In addition, we find an inverse relationship between the economy real interest rate and the probability of default. This result is empirically tested by applying the Cox proportional hazards model with time-dependent covariates for a sample of sole proprietorships’ unsecured credit operations in the Brazilian economy. The estimates confirm the findings from the theoretical model.

A Quantitative Theory of Information and Unsecured Credit

Important changes have occurred in unsecured credit markets over the past three decades. Most prominently, there have been large increases in aggregate consumer debt, the personal bankruptcy rate, the size of bankruptcies, the dispersion of interest rates paid by borrowers, and the relative discount received by those with good credit ratings. We find that improvements in information available to lenders on household-level costs of bankruptcy can account for a significant fraction of what has been observed. The ex ante welfare gains from better information are positive but small. (JEL D14, D82, G21)

Information technology and the rise of household bankruptcy

Several studies have 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 large increase in the use of unsecured credit during this period. I explain the simultaneous increase in bankruptcy rates and unsecured credit as the result of improvements in credit-rating technologies. Using an environment where borrowers face heterogeneous default costs (unobservable by creditors), I show that such improvements will lead to agents with high default costs, i.e., “safe” borrowers, being able to borrow more. A quantitative example illustrates that this increased access to credit can be large enough to raise both equilibrium borrowing and default rates.

COSTLY INTERMEDIATION AND CONSUMPTION SMOOTHING

I. INTRODUCTION Financial intermediaries play an essential role in economies, transferring funds from agents who do not wish to use them immediately to those who do, improving the allocation of resources with consequences for efficiency and welfare. As Hahn (1971) pointed out, financial intermediation is not a costless activity: It uses real resources, such as labor and capital, and governments often tax such activity. This generates a wedge between the deposit and borrowing rates and consequently implies that households face different interest rates, depending on whether they are savers or borrowers. We construct a neoclassical growth model with costly intermediation, in order to analyze two positive questions: (1) What are the quantitative welfare implications of intermediation costs? (2) Are the welfare effects evenly distributed across individuals with different levels of wealth? Individuals in our neoclassical growth model face uninsurable idiosyncratic shocks to labor productivity, an endogenous borrowing limit, and costly intermediation. Households smooth consumption over time by making deposits at a financial intermediary in good times and running down credit balances or getting loans in bad times. Intermediation costs generate a wedge between loan and deposit rates, with interest payments on loans higher than the return on deposits. We assume that financial institutions provide all the intermediation, and therefore abstract from direct borrowing and lending between households. (1) As in Martins-da-Rocha and Vailakis (2010), the intermediary has a labor-intensive technology, maximizes profit, is remunerated by the marginal product of labor, and takes regulation as given. (2) See Hahn (1971), Diaz-Gimenez et al. (1992), and Mehra, Piguillem, and Prescott (2011) for similar approaches. Our goal is to analyze the effects of intermediation costs on agents' intertemporal ability to smooth consumption and insure against labor income shocks. As a consequence, we focus on unsecured consumption loans such as personal loans and credit card debt, and abstract from the effects of intermediation costs on entrepreneurship and productivity. Unsecured consumption loans, while only a subset of the total credit market, allow us to construct a direct measure of intermediation costs for our quantitative exercise. In addition, the fraction of unsecured credit over all credit in the data provides another dimension on which we can assess the performance of our model. We use our model to measure key statistics of the U.S. economy, including intermediation costs, and perform counterfactual experiments. Reducing intermediation costs leads to two effects. First, for a given interest rate, decreasing borrowing costs expands net borrowers' consumption possibility frontiers and even current savers may benefit (with positive probability they may need to borrow to smooth consumption in the future due to bad labor productivity shocks). Second, there is an indirect effect: lower intermediation costs imply an increase in the demand for loans, which raises the interest rate. This offsets part of the decrease in borrowing costs and also increases interest income, improving savers' welfare. Determining the net impact of these effects requires a quantitative analysis. We interpret a reduction in intermediation costs as an improvement in the financial intermediation technology or a reduction in taxes on financial transactions. The welfare analysis focuses on stationary equilibria and transitional dynamics. The transition is slow, and abstracting from it can lead to misleading welfare calculations. Also, mobility in wealth means that comparing, for instance, the agent with median wealth in two stationary equilibria may not involve the same household. We find three main quantitative results: First, intermediation costs have a large effect on welfare. For the U.S. economy, the average aggregate welfare gain of all agents from reducing intermediation costs from 3. …

An Economic Examination of Collateralization in Different Financial Markets

Tim Xiao: This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of financial contracts. We also analyze the difference between cleared and OTC markets.

Bankruptcy Reform and the Housing Crisis

Reforms made to the U.S. Bankruptcy Code in 2005 instituted a new means testing requirement that restricts the discharge of unsecured debt under Chapter 7 to filers with income below their state's median, thereby forcing filers with income above their state's median into a costly Chapter 13 repayment plan. We construct a quantitative equilibrium model of the mortgage and unsecured credit markets to assess the impact of this reform on the severity of the housing crisis during the Great Recession. We find that while this reform increased the relative attractiveness of mortgage default, its impact on the housing market during the crisis was largely mitigated by general equilibrium effects on mortgage lending standards. Allowing bankruptcy judges to reduce mortgage principal for underwater homeowners through a policy of cramdown would have had only a small impact on the mortgage default rate during the crisis.

Consumer Credit & the Housing Market: An Examination of Trends in Home Equity Lines of Credit

Any conversation regarding the current financial crisis must include a discussion of home prices. After dramatic home-price increases through the 1990’s and early 2000’s, U.S. home prices began a severe downturn during 2006. During this time period of significant price appreciation, as previous research has shown, consumers used the increased equity in their homes to finance additional consumption. A main financing vehicle for these types of purchases has been the home equity line of credit (HELOC). During the last recession, it is likely that the HELOC served as one of the only sources of additional financing for many homeowners due to job loss and/or maxed out forms of unsecured credit. Given the continued downward trend in home prices since late 2006, though, it is at least plausible that banks have been exposing themselves to greater risk than in previous recessions by continuing to fund additional HELOC lending. It is also possible that some of this added risk has been passed on to other institutions through the securitization of HELOC loans (just as with first mortgages). This paper examines trends in the HELOC segment of U.S. banks’ lending portfolios. Unlike the previous research cited, this paper examines the issue of HELOC lending solely from the bank side rather than the consumer side. The evidence suggests that much of the recent HELOC lending is, at best, no more secure than it was at the onset of the 2006 financial crisis.

Self-Fulfilling Credit Cycles

In U.S. data 1981–2012, unsecured firm credit moves procyclically and tends to lead GDP, while secured firm credit is acyclical; similarly, shocks to unsecured firm credit explain a far larger fraction of output fluctuations than shocks to secured credit. In this paper we develop a tractable dynamic general equilibrium model in which unsecured firm credit arises from self-enforcing borrowing constraints, preventing an efficient capital allocation among heterogeneous firms. Unsecured credit rests on the value that borrowers attach to a good credit reputation which is a forward-looking variable. We argue that self-fulfilling beliefs over future credit conditions naturally generate endogenously persistent business cycle dynamics. A dynamic complementarity between current and future borrowing limits permits uncorrelated sunspot shocks to unsecured debt to trigger persistent aggregate fluctuations in both secured and unsecured debt, factor productivity and output. We show that these sunspot shocks are quantitatively important, accounting for around half of output volatility.

Endogenous Credit Limits with Small Default Costs

We analyze an exchange economy of unsecured credit where borrowers have the option to declare bankruptcy in which case they are temporarily excluded from financial markets. Endogenous credit limits are imposed that are just tight enough to prevent default. Economies with temporary exclusion differ from their permanent exclusion counterparts in two important properties. If households are extremely patient, then the first–best allocation is an equilibrium in the latter economies but not necessarily in the former. In addition, temporary exclusion permits multiple stationary equilibria, with both complete and with incomplete consumption smoothing.

The Effects of Credit Status on College Attainment and College Completion

College students now use various forms of unsecured credit such as private student loans and credit cards to finance college. Access to these credit lines and the interest rates charged on these loans can vary significantly across credit scores. In this paper, we analyze if credit status, as measured by self-reported characteristics of an individual's credit standing, affects college investment. Using data from the Survey of Consumer Finances, we study a sample of young high school graduates to estimate how three different measures of credit status affect college attainment and completion rates. After correcting for selection and endogeneity issues, we find that credit status is more important the longer the student stays in college. For example, having bad credit significantly lowers the probability of completing a four-year college degree, but has a smaller (but significant) impact on attaining some college. We find robust evidence that credit status affects the intensive margin of college investment, but is less important for the extensive margin. Our results suggest that bad credit status, which lowers the availability of unsecured credit to finance college and thereby makes college investment more expensive, significantly reduces college completion rates.

Bankruptcy and Delinquency in a Model of Unsecured Debt

This paper documents and interprets two facts central to the dynamics of informal default or “delinquency” on unsecured consumer debt. First, delinquency does not mean a persistent cessation of payment. In particular, we observe that for individuals 60 to 90 days late on payments, 85% make payments during the next quarter that allow them to avoid entering more severe delinquency. Second, many in delinquency (40%) have smaller debt obligations one quarter later. To understand these facts, we develop a theoretically and institutionally plausible model of debt delinquency and bankruptcy. Our model reproduces the dynamics of delinquency and suggests an interpretation of the data in which lenders frequently (in roughly 40% of cases) reset the terms for delinquent borrowers, typically involving partial debt forgiveness, rather than a blanket imposition of the “penalty rates” most unsecured credit contracts specify.

A dynamic model of unsecured credit

Abstract We study the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender cannot observe the borrowerʼs ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lenderʼs optimal contract has two key properties: delayed settlement and debt forgiveness. Finally, we study the impact of changes in the initial cost of lending on the contract terms.

A Quantitative Theory of Information and Unsecured Credit (Revised July 2011)

Over the past three decades six striking features of aggregates in the unsecured credit market have been documented: (1) rising personal bankruptcy rates, (2) rising dispersion in unsecured interest rates across borrowing households, (3) the emergence of a discount for borrowers with good credit ratings, (4) a reduction in average interest rates paid by borrowers, (5) an increase in aggregate debt relative to income, and (6) an increase in the amount of debt discharged in bankruptcy relative to income. The main contribution of this paper is to suggest that improvements in the ability of lenders to observe borrower characteristics can help account for a substantial proportion of most, though not all, of these observations. A central aspect of our findings is that the power of signaling is likely to be weaker when it is non-pecuniary costs, rather than the persistent component of income, that are unobservable. The ex ante welfare gains from better information are positive but small.

A Dynamic Model of Unsecured Credit

The author studies the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender is unable to observe the borrower's ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender's optimal contract has two key properties: delayed settlement and debt forgiveness. Asymmetric information gives rise to the property of delayed settlement, which is a contingency in which the lender allows the borrower to defer the repayment of his loan in exchange for more favorable terms of credit within the relationship. This property, together with the borrowers' lack of commitment, gives rise to debt forgiveness. When the borrower's participation constraint binds, the lender needs to forgive part of the borrower's debt to keep him in the relationship. Finally, the author studies the impact of the changes in the initial cost of lending on the terms of credit.

Credit Supply to Personal Bankruptcy Filers: Evidence from Credit Card Mailings

Are consumers who have filed for personal bankruptcy before excluded from the unsecured credit market? Using a unique data set of credit card mailings, we directly explore the supply of unsecured credit to consumers with the most conspicuous default risk--those with a bankruptcy history. On average, over one-fifth of personal bankruptcy filers receive at least one offer in a given month, with the likelihood being even higher for those who filed for bankruptcy within the previous two years. However, offers to bankruptcy filers carry substantially less favorable terms than those to comparable consumers without a bankruptcy history, with higher interest rates, lower credit limits, a greater likelihood of having an annual fee, and a smaller likelihood of having rewards or promotions. In addition, our analysis of credit terms typically disclosed only in the fine print suggests that offers to filers tend to include more hidden costs.

Household Borrowing after Personal Bankruptcy

A large body of literature has examined factors leading to filing for personal bankruptcy, but little is known about household borrowing after bankruptcy. This paper augments the existing literature with a comprehensive analysis of postbankruptcy borrowing using data from the Survey of Consumer Finances. We find that filers generally have more limited access to unsecured credit, but borrow more secured debt after bankruptcy, than comparable households that have never filed for bankruptcy. Filers also pay higher interest rates on all types of debt. In addition, as more time passes after filing, credit access and borrowing costs improve. However, filers remain more prone than comparable nonfilers to experience financial distress, accumulate less wealth, and use expensive credit sources like payday loans, even more than 10 years after filing.