Contract Pricing in Consumer Credit Markets

Abstract

We analyze subprime consumer lending and the role played by down payment requirements in screening high-risk borrowers and limiting defaults. To do this, we develop an empirical model of the demand for financed purchases that incorporates both adverse selection and repayment incentives. We estimate the model using detailed transaction-level data on subprime auto loans. We show how different elements of loan contracts affect the quality of the borrower pool and subsequent loan performance. We also evaluate the returns to credit scoring that allows sellers to customize financing terms to individual applicants. Our approach shows how standard econometric tools for analyzing demand and supply under imperfect competition extend to settings in which firms care about the identity of their customers and their postpurchase behavior. September 2009Please do not circulate or post online Abstract. We study pricing and contract design in the subprime auto sales market. We develop a model of the demand for …nanced purchases that incorporates both adverse selection and moral hazard e¤ects, and estimate the model using detailed transactionlevel data. We use the model to quantify selection and repayment problems and show that di¤erent contracting terms, in particular car price and required down payment, resolve very di¤erent pricing trade-o¤s. We also evaluate the returns to credit scoring that allows sellers to customize …nancing terms to individual applicants. Our empirical approach shows how standard tools for analyzing demand and supply in traditional product markets extend to contract markets where agreement and performance are separated in time, so …rms care about both the quantity and quality of demand.We are grateful to many seminar participants for many useful comments.

How Do Lenders Price Energy Efficiency? Evidence From Personal Consumption Loans

“…Considering that our data are immune from sorting bias, we interpret this finding as lenders using loan designations as a screening device of unobserved borrower characteristics in a way conducive to rationing. Our finding echoes Einav et al (2012)'s one that down payments can also be used as screening device. Altogether, these findings contribute to the scarce literature on price discrimination by lenders facing ex ante hidden information on borrower characteristics (Zinman, 2014;Allen et al, 2014a,b).…”

Assessment of the Deadweight Loss Arising from the Information Asymmetry in The Banking Market

“…Empirical literature on testing for asymmetric information (Chiappori, Salanié, 2000;Einav, Jenkins, Levin, 2012;Ioannidou, Pavanini, Peng, 2022) shows that collaterals are used in the models to capture the presence of asymmetric information. Thereby authors have used the following approach to assess the deadweight loss:…”

The Industrial Organization of Financial Markets

“…In their setting, Karlan and Zinman (2009) show that the moral hazard margin is more important than the selection margin for explaining the positive correlation between rate and default. Adams et al (2009) and Einav et al (2012) develop a framework to identify and measure the importance of moral hazard and adverse selection using observational data on subprime car loans.…”

“…The shape of this function implies that the profit function is concave in the quantity of credit allowed which leads to credit rationing in equilibrium, as in the classic theory models of Jaffee and Russell (1976) and Stiglitz and Weiss (1981). Einav et al (2012) formalize this relationship by analyzing the lender's profit maximization problem. To do so they estimate jointly the demand function, repayment probability and pricing function.…”