Research

Consumer debt is an important means for consumption smoothing. In the United States, 70% of households own a credit card, and 40% borrow on it. When borrowers cannot (or do not want to) repay their debts, they can declare bankruptcy, which provides additional insurance in tough times. Since the 2000s, up to 1.5% of households declared bankruptcy per year. Clearly, the option to default affects borrowing interest rates in equilibrium. Consequently, when assessing (welfare) consequences of different bankruptcy regimes or providing policy recommendations, structural models with equilibrium default and endogenous interest rates are needed. At the same time, many questions are quantitative in nature: the benefits of a certain bankruptcy regime critically depend on the nature and amount of risk that households bear. Hence, models for normative or positive analysis should quantitatively match some important data moments.

Four important empirical patterns are identified: First, since 1950, consumer debt has risen constantly, and it amounted to 25% of disposable income by 2016. Defaults have risen since the 1980s. Interestingly, interest rates remained roughly constant over the same time period. Second, borrowing and default clearly depend on age: both measures exhibit a distinct hump, peaking around 50 years of age. Third, ownership of credit cards and borrowing clearly depend on income: high-income households are more likely to own a credit card and to use it for borrowing. However, this pattern was stronger in the 1980s than in the 2010s. Finally, interest rates became more dispersed over time: the number of observed interest rates more than quadrupled between 1983 and 2016.

These data have clear implications for theory: First, considering the importance of age, life cycle models seem most appropriate when modeling consumer debt and default. Second, bankruptcy must be costly to support any debt in equilibrium. While many types of costs are theoretically possible, only partial repayment requirements are able to quantitatively match the data on filings, debt levels, and interest rates simultaneously. Third, to account for the long-run trends in debts, defaults, and interest rates, several quantitative theory models identify a credit expansion along the intensive and extensive margin as the most likely source. This expansion is a consequence of technological advancements.

Many of the quantitative macroeconomic models in this literature assess welfare effects of proposed reforms or of granting bankruptcy at all. These welfare consequences critically hinge on the types of risk that households face—because households incur unforeseen expenditures, not-too-stringent bankruptcy laws are typically found to be welfare superior to banning bankruptcy (or making it extremely costly) but also to extremely lax bankruptcy rules.

There are very promising opportunities for future research related to consumer debt and default. Newly available data in the United States and internationally, more powerful computational resources allowing for more complex modeling of household balance sheets, and new loan products are just some of many promising avenues.

There is active debate over whether borrowers’ cognitive biases create a need for regulation to limit the misuse of credit. To tackle this question, we incorporate overoptimistic borrowers into an incomplete markets model with consumer bankruptcy. Lenders price loans, forming beliefs—type scores—about borrowers’ types. Since over-optimistic borrowers face worse income risk but incorrectly believe they are rational, both types behave identically. This gives rise to a tractable theory of type scoring as lenders cannot screen borrower types. Since rationals default less often, the partial pooling of borrowers generates cross-subsidization whereby overoptimists face lower than actuarially fair interest rates. Over-optimists make financial mistakes: they borrow too much and default too late. We calibrate the model to the US and quantitatively evaluate several policies to address these frictions: reducing the cost of default, increasing borrowing costs, imposing debt limits, and providing financial literacy education. While some policies lower debt and filings, they do not reduce overborrowing. Financial literacy education can eliminate financial mistakes, but it also reduces behavioral borrowers’ welfare by ending crosssubsidization. Score-dependent borrowing limits can reduce financial mistakes but lower welfare. 

Contrary to Chapter 7 bankruptcy in the U.S., many European bankruptcy regimes are stricter and force bankrupts to repay some outstanding debt through wage garnishment. Since wage garnishment raises the effective marginal tax rate, it distorts labor supply. Explicitly modeling the garnishment period and endogenizing labor supply, this paper examines the optimal garnishment regime for Germany: optimal garnishment rates are 18 percentage points lower than the current rates and the optimal garnishment duration is ten years rather than currently six. Consequently, repayment during bankruptcy increases and interest rates fall. This yields welfare improvements of 3.3% on average. Low-income households gain the most due to better access to cheaper credit.

This paper analyzes whether and how to regulate small dollar lending in the United States. To that end, I develop a structural model of unsecured lending where heterogeneous households can not only file for bankruptcy but also become delinquent. Adding fixed cost of loan creation endogenously produces realistic interest rates of up to 300% for small loans. In the face of income and expenditure risk, households can partially insure through bankruptcy that provides legally mandated debt relief. However, lump sum court fees and lawyer costs prevent low income households from filing for bankruptcy protection. Without access to bankruptcy, these households become delinquent and pay late fees to avoid collection efforts from their banks. My quantitative results show that delinquency offers insufficient insurance against adverse events, granting room for welfare-improving policy interventions. In one such intervention, low income households are allowed to repay bankruptcy filing costs after debt relief, making bankruptcy more affordable. I show that bankruptcy filings increase and delinquency decreases. Low income households enjoy a 1% welfare increase, while aggregate welfare increases by 0.1%. The repayment plan proposed by the Consumer Financial Protection Bureau, that allows households to spread repayment over three periods, does not yield any welfare gains.

Financial contracts are complicated and consumers often do not grasp them in their entirety. This may lead to financial mistakes. We develop a quantitative theory of unsecured credit and equilibrium default in a market with sophisticated and naïve borrowers who sometimes misunderstand their contracts and make financial mistakes. Naïves are more prone to mistakes without internalizing this fact. When signing debt contracts, we allow agents to trade off interest rates for penalty fees. These fees make financial mistakes costly. Naïves choose inefficiently high penalty fees and cross-subsidize interest rates for sophisticates. We use this framework to analyze two previously unexplored features of the CARD act: clearer language requirements and a limit on penalty fees in financial contracts. Clearer contract terms lead to fewer financial mistakes by everyone, while limiting fees constrains mostly naïve borrowers. Both policies reduce financial mistakes and increase the welfare of naïve borrowers. The effects on sophisticates differ: clearer language and fewer mistakes benefit sophisticates, too. However, limiting fees reduces the cross-subsidization sophisticates receive in equilibrium and consequently makes them worse off.