Testing for Adverse Selection and Moral Hazard in Consumer Loan Markets

42 Pages Posted: 11 Mar 2004

See all articles by Wendy Edelberg

Wendy Edelberg

U.S. Board of Governors of the Federal Reserve System

Date Written: February 2004

Abstract

This paper explores the significance of unobservable default risk in mortgage and automobile loan markets. I develop and estimate a two-period model that allows for heterogeneous forms of simultaneous adverse selection and moral hazard. Controlling for income levels, loan size and risk aversion, I find robust evidence of adverse selection, with borrowers self-selecting into contracts with varying interest rates and collateral requirements. For example, ex-post higher-risk borrowers pledge less collateral and pay higher interest rates. Moreover, there is strongly suggestive evidence of moral hazard such that collateral is used to induce a borrower's effort to avoid repayment problems. Thus, loan terms may have a feedback effect on behavior. Also, higher-risk borrowers are more difficult to induce into exerting effort, explaining the counter-intuitive result that higher-risk borrowers sometimes pay lower interest rates than observably lower-risk borrowers.

Suggested Citation

Edelberg, Wendy Marianna, Testing for Adverse Selection and Moral Hazard in Consumer Loan Markets (February 2004). FEDS Working Paper No. 2004-09. Available at SSRN: https://ssrn.com/abstract=515903 or http://dx.doi.org/10.2139/ssrn.515903

Wendy Marianna Edelberg (Contact Author)

U.S. Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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