Recent Developments in Consumer Credit and Payments

September 24-25, 2009
Federal Reserve Bank of Philadelphia
Ten Independence Mall, Philadelphia, PA 19106

Abstracts

Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis

Tomasz Piskorski, Columbia University (with Amit Seru, University of Chicago and Vikrant Vig, London Business School)

We examine whether securitization affects renegotiation of loans by servicers focusing on their decision to foreclose a delinquent loan. We show that securitization induces a foreclosure bias in this servicing decision. Conditional on a loan becoming seriously delinquent, we find a significantly lower foreclosure rate associated with loans held by the bank when compared to similar loans that are securitized: the likelihood of a bank-held delinquent loan foreclosure is lower in absolute terms between 3.8% to 7% (18% to 32% in relative terms). In addition, bank-held delinquent loans resume making payments on average at a rate 7.9% higher in absolute terms relative to comparable securitized loans (20.8% in relative terms). This suggests that the lower foreclosure rate on bank-held loans is not likely to be driven by bank's unwillingness to recognize losses or some other institutional reasons. Finally, consistent with the economic arguments that suggest that loans of better credit quality are most likely candidates for renegotiation, we find that foreclosure bias is larger among loans of better credit quality as measured by initial creditworthiness of the borrowers. Our findings lend support to the view that foreclosure bias in decisions of servicers of securitized loans may have exacerbated the foreclosure crisis.

Liar's Loan? Effects of Origination Channel and Information Falsification on Mortgage Delinquency

Ashlyn Nelson, Indiana University (with Wei Jiang, Columbia University, and Edward Vytlacil, Yale University)

This paper presents a comprehensive predictive model of mortgage delinquency using a unique dataset from a major national mortgage bank containing all of its loan origination information from 2004 to 2008. Our analysis highlights two major agency problems underlying the mortgage crisis: an agency problem between the bank and mortgage brokers that results in lower quality broker-originated loans, and an agency problem between banks and borrowers that results in information falsification by borrowers of low-documentation loans--known in the industry as "liars' loans" — especially when originated through a broker. We also document significant differences in loan performance by race/ethnicity that cannot be explained by observable risk factors or loan pricing.

Information Disclosure, Cognitive Biases, and Payday Borrowing

Adair Morse, University of Chicago (with Marianne Bertrand, University of Chicago)

If people face cognitive limitations or biases that lead to financial mistakes, what are possible ways lawmakers can help? One approach is to remove the option of the bad decision; another approach is to increase financial education such that individuals can reason through choices when they arise. A third, less discussed, approach is to mandate disclosure of information in a form that enables people to overcome limitations or biases at the point of the decision. This third approach is the topic of this paper. We study whether and what information can be disclosed to payday loan borrowers to lower their use of high-cost debt via a field experiment at a national chain of payday lenders. We find that information that helps people think less narrowly (over time) about the cost of payday borrowing, and in particular information that reinforces the adding-up effect over pay cycles of the dollar fees incurred on a payday loan, reduces the take-up of payday loans. We find substantial heterogeneity in the effectiveness of information disclosure across categories of borrowers: information disclosure appears more effective among more self-controlled individuals, individuals with some college education (but not a college degree) and individuals whose average borrowing-to-income ratio is low. Overall, our results suggest that consumer information regulations based on a deeper understanding of cognitive biases might be an effective policy tool when it comes to payday borrowing, and possibly other financial products.

Data Breaches and Identity Theft

William Roberds, Federal Reserve Bank of Atlanta (with Stacey L. Schreft, The Mutual Fund Research Center, LLC)

An environment is analyzed in which agents join clubs (payment networks) in order to facilitate trade. The networks compile personal identifying data (PID) so as to match transactors to transactions histories. Technological limitations cause the networks' data management practices to impact each other's incidence and costs of identity theft. Too much data collection and too little security arise in equilibrium with noncooperative networks compared to the efficient allocation. A number of potential remedies are analyzed: (1) reallocations of data-breach costs, (2) mandated security levels, and (3) mandated limits on the amount of data collected.

The Impact of the U.S. Financial Crisis on Global Retail Lending

Jörg Rocholl, European School of Management and Technology (with Manju Puri, Duke University, and Sascha Steffen, University of Mannheim)

This paper examines the effects of the U.S. financial crisis on global lending to retail customers.
In particular we examine retail bank lending in Germany taking advantage of a unique dataset of German savings banks over the period 2006-2008 for which we have the universe of loan applications and loans granted in this time period. Our experimental setting allows us to distinguish between those savings banks affected by the U.S. financial crisis, through their holdings in Landesbanken with substantial subprime exposure, and unaffected savings banks. We are further able to distinguish between demand and supply side effects of bank lending. We find demand for loans goes down but is not substantially different for the affected and nonaffected banks. We find evidence of a supply side effect in that the affected banks reject substantially more loan applications than non-affected banks. This effect is particularly strong for smaller and more liquidity-constrained banks, for mortgage as compared to consumer loans as well as for customers with worse credit ratings. We also find that bank-depositor relationships help mitigate these supply side effects.

Legal Protection in Retail Financial Markets

Simon Gervais, Duke University (with Bruce I. Carlin, University of California, Los Angeles)

Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, what legal rules maximize social welfare in the market? We address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. We characterize the optimal law within our modeling context, and derive how the legal system splits the blame between parties to the transaction. We also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.

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Disclaimer: The views contained in the papers and presentations are those of the authors and not of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.