What Drives Household Financial Distress? The Role of Earnings Misperceptions

Juan Sanchez and Stefan Song ()
Additional contact information
Stefan Song: https://economics.wustl.edu/people/yingrui-song

No 2025-030, Working Papers from Federal Reserve Bank of St. Louis

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.

Keywords: income; information frictions; overreaction; delinquency; bankruptcy (search for similar items in EconPapers)
JEL-codes: D14 D84 E21 G51 (search for similar items in EconPapers)
Pages: 56 pages
Date: 2025-10-24, Revised 2026-07-02
New Economics Papers: this item is included in nep-dge
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://doi.org/10.20955/wp.2025.030 Full text (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedlwp:101999

Ordering information: This working paper can be ordered from

DOI: 10.20955/wp.2025.030

Access Statistics for this paper

More papers in Working Papers from Federal Reserve Bank of St. Louis Contact information at EDIRC.
Bibliographic data for series maintained by Scott St. Louis ().