Household Finance Working Group

October 16, 2009
Nicholas S. Souleles and Peter Tufano, Organizers

Tomasz Piskorski, Columbia University; Amit Seru, University of Chicago; Vikrant Vig, London Business School
Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis

Piskorski, Seru and Vig examine whether securitization affects the decision of servicers to foreclose a delinquent loan. Using a quasi-experiment that exploits a plausibly exogenous variation in the securitization status of a delinquent loan, they find evidence that securitization did increase foreclosure of distressed loans. Their findings support the view that foreclosure bias in the decisions of servicers of securitized loans may have exacerbated the foreclosure crisis.

Motohiro Yogo, University of Pennsylvania and NBER
Portfolio Choice in Retirement: Health Risk and the Demand for Annuities, Housing, and Risky Assets

Yogo develops a consumption and portfolio-choice model of a retiree who allocates wealth in four asset classes: a riskless bond; a risky asset; a real annuity; and housing. The retiree chooses health expenditure endogenously in response to stochastic depreciation of health. The model is calibrated to explain the joint dynamics of health expenditure, health, and asset allocation for retirees in the Health and Retirement Study, aged 65 and older. It is also used to assess the welfare gain from private annuitization. The welfare gain ranges from 13 percent of wealth at age 65 for those in worst health, to 18 percent for those in best health.

Susan E. Woodward, Sand Hill Econometrics, Inc.; and Robert E. Hall, Stanford University and NBER
The Equilibrium Distribution of Prices Paid by Imperfectly Informed Customers: Theory, and Evidence from the Mortgage Market

Mortgage transactions occur between generally inexperienced consumers and highly specialized agents of lenders. These transactions are leading examples of how the experts on one side of the market may be able to take advantage of the lack of experience on the (other) consumer side. Woodward and Hall study data on several thousand mortgages where the agent is an independent mortgage broker and the full compensation of the broker is known. They use a novel econometric specification to separate the broker's revenue into cost and the margin over cost and they relate the two components to characteristics of the mortgage and of the borrower. An important minority of borrowers pay far above cost in fees to their brokers. The incidence of high fees not related to cost is greatest for larger loans and less educated borrowers. The researchers relate their findings to a model of imperfect shopping behavior among borrowers.

Bruce I. Carlin, UC, Los Angeles and NBER; and Simon Gervais, Duke University
Legal Protection in Retail Financial Markets

Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, what legal rules maximize social welfare in the market? Carlin and Gervais address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. The researchers characterize the optimal law within their modeling context, and derive how the legal system splits the blame between parties to the transaction. They also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.

Marianne Bertrand, University of Chicago and NBER; and Adair Morse, University of Chicago
Information Disclosure, Cognitive Biases and Payday Borrowing

If people face cognitive limitations or biases that lead to financial mistakes, how can lawmakers help? One approach is to remove the option of the bad decision; another approach is to increase financial education so that individuals can reason through choices when they arise. A third, less discussed, approach is to mandate disclosure of information in a form that enables people to overcome limitations or biases at the point of the decision. This third approach is the topic of the paper by Bertrand and Morse. Via a field experiment at a national chain of payday lenders, they study whether and what information can be disclosed to payday loan borrowers to lower their use of high-cost debt. They find that information that helps people think less narrowly (over time) about the cost of payday borrowing, and in particular information that reinforces the adding-up effect over pay cycles of the dollar fees incurred on a payday loan, reduces the take-up of payday loans by about 10 percent in a 4 month-window following exposure to the new information. Overall, these results suggest that consumer information regulations based on a deeper understanding of cognitive biases might be an effective policy tool when it comes to regulating payday borrowing, and possibly other financial and non-financial products.

Shawn Cole, Harvard University; Xavier Gine, The World Bank; Jeremy Tobacman, University of Pennsylvania and NBER; Petia Topalova, IMF; and James Vickery, Federal Reserve Bank of New York
Barriers to Household Risk Management: Evidence from India

Financial engineering offers the potential to significantly reduce consumption fluctuations faced by individuals, households, and firms. Yet much of this promise remains unrealized. Cole and his co-authors study the adoption of an innovative rainfall insurance product designed to compensate low-income Indian farmers in case of deficient rainfall during the primary monsoon season. They first document relatively low levels of adoption of this new risk management technology: only 5-10 percent of households purchase insurance, even though rainfall variability is overwhelmingly cited by households as the most important risk they face. They then conduct a series of randomized field experiments to test theoretical predictions of why adoption may be low. Insurance purchase is sensitive to price, with an estimated extensive price elasticity of demand between -0.66 and -0.88. Credit constraints, identified through the provision of random liquidity shocks, are a key barrier to participation, a result also consistent with household self-reports. Several experiments find an important role for trust in insurance participation. The authors find mixed evidence that subtle psychological manipulations affect purchase, and no evidence that modest amounts of financial education changes participation decisions. Based on their experimental results, they suggest preliminary lessons for improving the design of household risk management contracts.

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