Unbiased Analysis of Today's Healthcare Issues

Subprime Lending

Written By: Jason Shafrin - Dec• 12•07

One of the biggest news stories this year is the collapse of the subprime mortgage lending market. Why did this happen? How much do we really know about subprime lending?

A working paper by William Adams, Liran Einav and Jonathan Levin examines the subprime market for automobile loans. The authors find that liquidity constraints are a major force in shaping the subprime loan market. They find that car loans spike in January through March. Why is this? Poor individuals often take out a loan against their tax rebates. These rebates can be very high–up to $4500–and these individuals will use these rebates to help finance a car purchase.

Finance charges for these loans are very high. Interest rates usually surpass 20% and often at the state-mandated 30% interest cap. A $11,000 loan paid off over 42 months would incur $6000 of finance charges.

Yet it seems that loan demand within the subprime market is not very responsive to interest rates. It is, however, much more responsive to the amount of the down payment.

We estimate that a 100 dollar increase in the minimum down payment reduces the probability that an applicant will purchase by 0.0301, while a 100 dollar increase in the car price reduces the purchase probability by only 0.0034. That is, a 100 dollar increase in the minimum down payment has the same e¤ect as a 900 dollar increase in car price. This can still be explained in the absence of liquidity constraints, but it requires a much higher annual discount rate of 427 percent.

The authors found evidence of both moral hazard and adverse selection in the subprime market. Moral Hazard means that individuals are more likely to default on large loans. Adverse selection occurs when high risk borrowers desire large loans. The authors find that when a loan amount increases $1000, the default rate increases 24%. Sixteen percentage points is due to moral hazard and the rest is due to adverse selection.

Are there any ways to mitigate these market failure problems? The authors find that “risk-based minimum payments play a substantial role in mitigating adverse selection in financing choices.” These factors lead to the observation that “in practice, observably risky buyers end up with smaller rather than larger loans because they face higher down payment requirements.” Modern credit scores give the lender more information regarding the credit-worthiness of the borrower and help to match high-risk borrowers with smaller loans.

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  1. […] One of the biggest news stories this year is the collapse of the subprime mortgage lending market. Why did this happen? How much do we really know about subprime lending? A working paper by William Adams, Liran Einav and Jonathan Levin examines the subprime market for automobile loans. The authors find that liquidity […] Read more… […]