Liquidity Constraints and Imperfect Information in Subprime Lending

Abstract

We present new evidence on consumer liquidity constraints and the credit market conditions that might give rise to them. Our analysis is based on unique data from a large auto sales company that serves the subprime market. We first document the role of short-term liquidity in driving purchasing behavior, including sharp increases in demand during tax rebate season and a high sensitivity to minimum down payment requirements. We then explore the informational problems facing subprime lenders. We find that default rates rise significantly with loan size, providing a rationale for lenders to impose loan caps because of moral hazard. We also find that borrowers at the highest risk of default demand the largest loans, but the degree of adverse selection is mitigated substantially by effective risk-based pricing.

Contract Pricing in Consumer Credit Markets

“…Consistent with the results of Adams, Einav and Levin (2007), we …nd that purchasing decisions are highly sensitive to minimum down payment requirements and substantially less sensitive to car prices. Changes in car prices appear to translate primarily into larger loans.…”

“…Second, adding a car choice dimension to the model adds complexity that appears to have little e¤ect on the insights we derive about selection, liquidity and optimal pricing. Adams, Einav, and Levin (2007) provide additional discussion and evidence on the latter point.…”

“…In earlier work (Adams, Einav and Levin, 2007), we found evidence that subprime lenders face both repayment problems (with larger loans less likely to be repaid) and selection problems (substantial observed and unobserved borrower heterogeneity). We take the descriptive …ndings reported in that paper as a guide in formulating the present model.…”

“…First, as emphasized by Adams, Einav and Levin (2007) purchasing decisions are highly sensitive to customer liquidity.…”

Resource Allocation within Firms and Financial Market Dislocation: Evidence from Diversified Conglomerates

“…where Z includes other factors that have been used in the literature to explain the value of a diversi…ed …rm (Size, Leverage, (1) to (3) we use Diversity while in Columns (4) to (6) we use Dispersion and report the results in Table II. The estimate in Column (1) shows that diversi…ed …rms with more dispersed productivity among divisions tend to have lower value as compared to a portfolio of comparable stand-alone …rms of similar productivity. The result is robust to including …rm …xed e¤ects ( i ) and time ( t ) …xed e¤ects with standard errors clustered at the unit of year or …rm.…”