Product Sales Incentive Spillovers to the Lending Market: Evidence From Subprime Auto Loan Defaults

Abstract

This paper shows how convex incentives in vertical contracts between manufacturers and retailers can induce gaming behavior with spillover costs to consumers. We examine this problem in the automotive sector, where manufacturers commonly motivate new vehicle sales through dealer incentive programs with large discrete bonuses determined by monthly sales targets. Using subprime car loans from over 3,500 dealerships, we document high default rates on new car loans originated at the end of the month---the period when dealerships attempt to secure target-based bonuses by intensifying efforts to sell new cars. We provide evidence consistent with the observed higher default rates resulting from customers switching from used to new vehicles at month-end. These upgrades stretch borrower budgets and expose borrowers to rapid depreciation, which consigns the borrower with negative equity through most of the loan term. Our evidence also reveals other default mechanisms as month-end new car buyers forgo default insurance and purchase less reliable vehicles. Although consumers bear high costs from increased defaults, we find no evidence that the dealerships or lenders that purchase the loans are hurt by the default increase. In contrast to prior findings, our results demonstrate that sales incentive gaming is not always beneficial for customers, and show how the costs of such gaming can be borne by parties outside a vertical contract.

* This paper was previously titled, "Product sales incentive spillovers to the lending market."

Keywords: household finance, incentives, auto loans, subprime, agency problems

JEL Classification: D82, G29, G32, G34, L14, R30