The Interplay Between Different Types of Unsecured Credit and Amplification of Consumer Default

Felicia Ionescu
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Felicia Ionescu: Colgate University

No 912, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: We analyse, theoretically and quantitatively, the interactions between different forms of unsecured credit and their implications for default behaviour of young U.S. households. One type of credit mimics credit cards in the U.S. and the default option resembles a bankruptcy filing under Chapter 7 and the other type mimics student loans in the U.S. and the default option resembles Chapter 13 of the U.S. Bankruptcy Code. In the credit card market financial intermediary offers a menu of credit limits and interest rates based on individual credit scores. Scores evolve based on past borrowing and repayment behaviour. In the student loan market default has no effect on credit scores. The government sets the interest rate and chooses a wage garnishment to pay for the cost associated with default. We prove the existence of a steady-state equilibrium and characterise the circumstances under which a household defaults on each of these loans depending on household characteristics as well as on the financial arrangements in both markets. Our model is consistent with the main facts regarding borrowing and default on both forms of unsecured credit for young U.S. households. We show that there are important cross-market effects: financial arrangements in one market non-trivially affect default in the other market. We plan to use the model to quantify the effects of increased college debt burdens and more severe credit card terms on the increase in default rates in recent years and to conduct policy analysis regarding loan terms and bankruptcy arrangements in both markets.

Date: 2011
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed011:912

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