Testing for adverse selection and moral hazard in consumer loan markets
Abstract: This paper explores the significance of unobservable default risk in mortgage and automobile loan markets. I develop and estimate a two-period model that allows for heterogeneous forms of simultaneous adverse selection and moral hazard. Controlling for income levels, loan size and risk aversion, I find robust evidence of adverse selection, with borrowers self-selecting into contracts with varying interest rates and collateral requirements. For example, ex-post higher-risk borrowers pledge less collateral and pay higher interest rates. Moreover, there is strongly suggestive evidence of moral hazard such that collateral is used to induce a borrower's effort to avoid repayment problems. Thus, loan terms may have a feedback effect on behavior. Also, higher-risk borrowers are more difficult to induce into exerting effort, explaining the counter-intuitive result that higher-risk borrowers sometimes pay lower interest rates than observably lower-risk borrowers.
Keywords: Loans, Personal;
File(s): File format is text/html http://www.federalreserve.gov/pubs/feds/2004/200409/200409abs.html
File(s): File format is application/pdf http://www.federalreserve.gov/pubs/feds/2004/200409/200409pap.pdf
Part of Series: Finance and Economics Discussion Series
Publication Date: 2004