NCPA - National Center for Policy Analysis


December 7, 2007

Borrowers with low incomes and poor credit histories default on loans because they are highly sensitive to cash-on-hand, or liquidity-constrained.  In addition, imperfect information substantially constrains lenders in extending credit to this population, according to the authors of a National Bureau of Economic Research Working Paper.

The evidence on liquidity constraints comes in two forms:

  • First, there is a striking degree of seasonality in purchasing: demand is almost 50 percent higher in February, when consumers receive tax rebate checks, than in other months.
  • This seasonal spike in demand correlates closely with eligibility for the earned income tax credit.
  • In addition, consumers' purchasing decisions are much more sensitive to immediate down payment requirements than to changes in the price of the car, which can be financed.
  • Without liquidity constraints, only an inordinately high degree of impatience would explain these differing sensitivities.

The authors then use the data on borrowing and repayment behavior to estimate the informational problems facing lenders:

  • All else equal, extending a given buyer an additional $1,000 in credit increases the default rate on the loan by around 15 percent.
  • This kind of sensitivity of repayment to loan size is the driving force in moral hazard models of credit imperfections.
  • At the same time, a buyer who chooses to finance an extra $1,000 of purchases (that is, who self-selects into a larger loan) has an even greater default rate, around 24 percent higher than a buyer who opts to pay the $1,000 dollars upfront.

In other words, the decision to finance more heavily reveals additional adverse information about the likelihood of default, as in standard models of adverse selection.

Source: Les Picker, "Why Subprime Auto Loans Default," NBER Digest, December 2007; based upon: William Adams, Liran Einav, and Jonathan Levin, "Liquidity Constraints and Imperfect Information in Subprime Lending," Working Paper No. 13067, National Bureau of Economic Research, April 2007.

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