What Drives Household Financial Distress? The Role of Earnings Misperceptions

Sanchez, Juan M.; Song, Stefan

doi:10.20955/wp.2025.030

Working Paper Revision

What Drives Household Financial Distress? The Role of Earnings Misperceptions

Abstract: Why do households borrow heavily and experience financial distress? We develop and estimate a heterogeneous-agent model of unsecured credit and default in which households learn about income persistence and overreact to recent income realizations. We estimate overreaction using survey measures of income expectations and forecast errors, and the remaining parameters to match household debt and financial distress. Information frictions and estimated overreaction account for roughly half of delinquencies and one-third of bankruptcies, and improve the model’s fit of the observed negative relationship between income and interest rates. Because the models with earnings misperceptions do not need extremely impatient households to match financial distress, policies that substantially reduce financial distress by restricting risky borrowing entail much smaller welfare costs.

JEL Classification: D14; D84; E21; G51;

https://doi.org/10.20955/wp.2025.030