For most of the postwar period the unsecured market for credit has been small. Ellis (1998) shows that truly unsecured credit (credit card and related plans issued by insured banks) did not appear in any significant amount until the late 1960s. Furthermore, as Figure (1) shows the filing rate for Chapter 7 bankruptcy over the past 70 years was flat and very low until the late 1970s, reflecting the absence of significant unsecured indebtedness.
However, over the past three decades there have been dramatic changes in this market. First, the availability of unsecured credit has increased both along the extensive and intensive margin; Narajabad (2007) documents that the fraction of US households with positive credit card limits increased by 17 percentage points between 1989 and 2004, while the average credit limit more than doubled over the same time period. In addition to the increase in availability of credit, Krueger and Perri (2006) measure that unsecured debt (utilized credit) as a fraction of disposable income has risen from 2 percent to 9 percent from 1980 to 2005. Given the presence of exemptions, the best measure of unsecured credit is negative net worth; Sanchez (2008) documents that the mean debt to mean income ratio has risen from 0.63 percent in 1983 to 1.41 percent in 2004 and the percentage of households with negative net worth has risen from 5.04 percent to 6.93 percent.
Several researchers have documented the significant rise in Chapter 7 bankruptcies over the same time period, including Livshits, MacGee, and Tertilt (2006), Athreya (2004), and Sullivan, Warren, and Westbrook (2000), which can easily be seen in Figure. Finally, Sullivan, Warren, and Westbrook (2000) also notes that defaults are not only more common but also much larger; median non-mortgage debt-to-ncome ratio for households filing for bankruptcy doubled from 0.75 to 1.54over the period 1981-1997 (see Figure 2, taken from Sullivan, Warren, and Westbrook 2000).
Recent empirical work on consumer credit markets has also documented striking changes in the sensitivity of credit terms to borrower characteristics. A summary of this work is that credit terms, especially for unsecured loans, exhibited little variation across US households as recently as 1990, even though in the cross-section these households exhibited substantial heterogeneity in income, wealth, and default risk. In the subsequent period, from 1990 to the present, a variety of financial contracts, ranging from credit card lines to auto loans to insurance, now exhibit terms that depend non trivially on regularly updated measures of default risk, particularly a household’s credit score. Three related findings stand out from the literature. First, the sensitivity of credit card loan rates to the conditional bankruptcy probability grew substantially after the mid-1990’s (Edelberg 2006). Second, credit scores themselves became more informative: Furletti (2003), for example, finds that the spread between the rates paid by highest and lowest risk classifications grew from zero in 1992 to 800 basis points by 2002. Third, the distribution of interest rates for unsecured credit was highly concentrated in 1983 and very diffuse by 2004 (Livshits, MacGee, and Tertilt 2008 and Figure 3); furthermore, the distribution of interest rates for delinquent households was indistinguishable from nondelinquent ones in 1983 but shifted significantly to the right by 2004 (Livshits, MacGee, and Tertilt 2008 and Figure 4).
The purpose of this paper is to provide a unified story for these facts. Our story is based around the idea that information about borrowers is much better now than it was in the earlier period. Existing work, which we will detail further below, has attempted to account for the observed rise in debt and default. Critically however, these stories all fail along one key dimension: they all fail to reproduce the dispersion and sensitivity increases noted in the previous paragraph.
In contrast, we show that improved information is capable of generating precisely the observed changes in the dispersion and sensitivity of credit terms. Thus, while these other factors may have played a role, information changes of the kind we posit must have accompanied them in order for the credit market to have changed from an environment in which heterogeneous borrowers were treated homogeneously to one in which this heterogeneity is explicitly priced.
A good deal of recent attention has been given over to the task of accounting for the rapid growth and relatively high incidence of unsecured indebtedness and bankruptcy. First, there is the possibility that the personal costs incurred by defaulters have fallen substantially, either as a result of improved bankruptcy filing procedures, the learning by households from each other about navigating the bankruptcy process, or even lower psychic costs (stigma). Gross and Souleles (2003) argue households did appear to be more willing to default in the late 1990’s than in earlier periods, all else equal. Unfortunately, these explanations tend to produce rising default rates combined with declining discharges on average, as households become less able to borrow and therefore default on less debt. A second class of explanations for rising debt and default hinges on the extent to which transactions costs associated with lending are likely to have fallen as a result of improved information storage and processing technologies available to lenders. Athreya (2004) and Livshits, MacGee, and Tertilt (2006) explore this story; unlike changes in costs at the individual level, falling risk-free rates or transactions costs can produce both an increase in default rates and an increase in the amount of debt discharged in bankruptcy, making this mechanism a more promising candidate. Finally, Ellis (1998) argues that usury ceilings played an important role in the rising default rates and indebtedness observed after the 1978 Supreme Court case Marquette National Bank vs. First Omaha Services Corp. ruled that only the usury ceiling of the state in which a bank is chartered applies to the terms it offers, not the state in which the customer resides; given that some states (Delaware, South Dakota) had very limited restrictions, usury ceilings effectively ceased to exist. Livshits, MacGee, and Tertilt (2007) dismiss usury ceilings as playing an important role even in the rise in bankruptcy filing rates. Furthermore, the homogeneity of interest rates observed in 1983 – 5 years after the Marquette decision – is hard to square with a preeminent role for interest rate ceilings, since the primary issue is why good borrowers did not get discounts.
A common feature of the models that underlie the preceding explanations is full information: the information available to lenders always includes the entire relevant household state vector. In a highly stylized framework, Narajabad (2007) analyzes the effects of an increase in the informativeness of a signal received by lenders on a borrower’s long term income level, showing that such a change is qualitatively consistent with the increased indebtedness, increased default, and increased dispersion in loan terms observed. Importantly, Narajabad (2007) features only ex post asymmetric information; all contracts are executed under symmetric information. An assumption that both lenders and borrowers are committed to the contract ensures that the ex post asymmetric information does not alter equilibrium outcomes. We instead analyze a model in which information is asymmetric between borrowers and lenders and there is no commitment on either side. In this environment, improved information means that lenders can observe more relevant characteristics of borrowers and the lack of commitment implies that any new information is reflected immediately in pricing.
We develop a model that allows for the quantitatively-serious measurement of how unsecured credit markets operate under asymmetric information and how changes in information alter out-comes when loan pricing is individualized. As is well known, equilibria under asymmetric information require a specification of the precise interaction of borrowers and lenders, which we model as a signalling game. We are guided in our choice of market micro structure by the requirement that households perceive a price function for loans as a function of default risk; thus, we need to solve for prices for arbitrary borrowing levels, including those not observed in equilibrium. A second complication that must be dealt with under asymmetric information is the extent to which information is revealed by household decisions. In particular, in a conjectured equilibrium, the information conveyed by a borrower’s chosen debt level must not provide incentives for a lender to deviate in the terms offered, given the information available to the intermediary; in our economy, this requirement states that the beliefs used to construct default rates (on the equilibrium path) must be consistent with the stationary distribution produced by the model.
To understand how improvements in information affect outcomes in the credit market, we study two equilibria. First, we allow lenders to observe all relevant aspects of the state vector necessary to predict default risk. We then compare this allocation to one where lenders are no longer able to observe all of these variables. We follow the literature’s preferred specification of household labor income over the life-cycle. In this formulation, households draw stochastic incomes that are the sum of four components: a permanent shock realized prior to entry into the labor market (representing formal education), a deterministic age-dependent component with a peak several years before retirement, a persistent shock, and a purely transitory shock. Thus, information changes alter the observability of the components of household labor income; specifically, we prohibit the lenders from observing total income and the two stochastic components while the permanent shock is always observable. The difference across these allocations is a quantitative measure of the effect of improved information about shocks in unsecured credit markets.
Our first set of results focuses on the full information economy, where the pricing of debt incorporates all relevant information from the model. In this case, the bulk of borrowing occurs for life cycle purposes, and the bulk of default occurs when income expectations indicate that future borrowing capacity is not very valuable. As a result, default occurs among the unlucky young, and after age 50 is very low, both of which are features of the data. Under full information, our model matches the default rate and median borrowing on the unsecured credit market, while the ratio of the debt discharged through bankruptcy relative to income is somewhat smaller than the only measure available in the data. Given that we abstract from features that generate large defaults (large uninsured expense shocks and self-employment) the appropriate target for discharged debt is indeed smaller than this statistic (net worth shocks play an important role in Livshits, MacGee, and Tertilt 2006 and Chatterjee et al. 2007).
We then demonstrate our central result: moving from full information to a setting where lenders have only partial information produces outcomes consistent with all five features characterizing unsecured credit markets for the bulk of the postwar period. Specifically, equilibrium levels of debt, default, and debt-in-default all fall dramatically, while the sensitivity of credit terms to default risk and discount associated with a clean credit record both virtually disappear. We show constructively that an allocation in which all households can borrow large amounts at the risk-free rate is not an equilibrium: those households with weak future income prospects (high-risk households) have a strong incentive to default at high levels of debt, generating nontrivial default risk and necessitating a default premium. In turn, as the premium for borrowing is raised, the low-risk households refuse to borrow as much, revealing the type of all those who do; the market then requires a further increase in the interest rate, which reduces borrowing by the high-risk types until they pool again with the low-risk types. This process continues until the incentives to deviate for low-risk borrowers are offset by the need to smooth consumption. As a quantitative matter, this pooling equilibrium occurs at a low enough debt level to sustain risk-free lending to every borrower. These changes, in turn, matter for consumption smoothing and welfare; the near- absence of unsecured credit substantially hinders inter temporal smoothing for the young, especially the skilled (college ducated).
Our results are particularly relevant for another welfare-related question: is more information in the credit market better? A view often asserted in policy making circles is that better information in the credit market would harm disadvantaged groups, such as racial minorities, that benefit from pooling. Such views have generated strong legislative actions as well. Our model predicts that all agents are better off under full information, as every individual can borrow more at lower rates. We also show that better information will lead to both “democratization” and “intensification” of credit that is, we obtain increases in both the extensive and intensive margins of the unsecured credit market. In terms of welfare, the intensification is quantitatively more significant: high school educated agents benefit less than college educated agents under full information, mainly because they are less-constrained by low information since their desire to borrow is limited by relatively-flat expected age-income profiles. Thus, a move to full information does not redistribute credit from bad to good borrowers, it expands it for everyone (as in the classic lemons problem). The key policy implication we derive from the model is that the government should not try to reverse the increase in bankruptcies; it is the result of welfare improving improvements in the information available to credit markets. In particular, high filing rates reflect the improved ability of households to borrow against an uncertain future, while high dispersion in interest rates reflect the fact that many who once were effectively credit-rationed, are no longer limited in this way. However, despite the overall welfare gains from full information, all agents in the economy would be willing to rid themselves of the bankruptcy option ex ante; thus, our findings suggest that policymakers should focus on how to make the bankruptcy option less attractive not because it has recently gotten more prevalent but because it is likely to have always been welfare-reducing.
Our paper is related to theoretical work of Chatterjee, Corbae, and R?os-Rull (2008b), which attempts to provide a theory of reputation in unsecured borrowing; relative to that paper we simplify matters by limiting the dynamic aspects of credit terms. Our justification for this approach is that under full information credit scores are irrelevant, while our interpretation of the period of partial information as the 1980s implies that credit scores were not used even though they were collected; in turn, a key payoff of this assumption is quantitative tractability. Our paper is also related to Sanchez (2008), who studies a screening model of unsecured credit but abstracts from life-cycle considerations. Given the clear life-cycle aspect of both unsecured borrowing and bankruptcy, we focus on precisely capturing the interaction of information asymmetries with life cycle earnings growth. Lastly, our work is complementary to Livshits, MacGee, and Tertilt (2007b) and Drozd and Nosal (2007), who offer theories of increased differentiation of borrowers based on declining contracting costs, but abstract from asymmetric information.
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