Behavioral Biases and Consumer Credit Markets

Bob promised that I will talk about "behavioral biases that affect consumer credit markets."  Since I don't want to disappoint anyone, let me say a few words about this subject.  You don't have to be a psychologist (I am not a psychologist) to recognize that consumers are subject to biases and that biases affect markets, specifically credit markets.  Myopic consumers underestimate how much they will borrow on their credit card.  Optimistic consumers underestimate the likelihood of suffering financial hardship that will make it difficult to repay mortgage debt, credit card debt or any other type of debt.  Etc'.  Biases, and mistakes more generally, reduce consumer welfare.  No surprise so far. 

What is more interesting to me is the interaction between consumer mistakes and market forces (perhaps this is because I am an economist).  How do markets respond to consumer mistakes?  How do sophisticated sellers and lenders on the supply side of the market respond to biases and mistakes on the demand side of the market?  Such responses are common.  Rebate pricing responds to consumer overestimation of the likelihood of rebate redemption.  Low printer prices and high ink prices respond to underestimation of printer and ink use.  And credit card teaser rates respond to consumers' underestimation of the likelihood that they will stick around long enough to pay the high post-introductory rates.  (I should emphasize that these pricing schemes can also be explained within a no-mistake, rational choice framework; but, as I argue elsewhere, these alternative explanations are only partially successful.)

Market reactions to consumer mistakes are interesting in their own right.  But my interest in them is mainly functional.  First, market reactions to consumer mistakes often exacerbate the welfare costs of mistakes.  Second, market reactions provide evidence for the persistence of consumer mistakes.  This merits some elaboration.  That consumers make mistakes is self-evident.  But the persistence of these mistakes in any given market is far from evident.  Consumers learn from their mistakes and sellers often have powerful incentives to correct consumer mistakes.  Accordingly, an important question is whether the mistake persists, since only a persistent mistake can justify legal intervention.  And since mistakes are often difficult to observe and measure directly, looking at market reactions to these mistakes provides an indirect way to identify the mistakes.  In a sense, this is an example of the researcher delegating a research task to the market.  If I can't tell whether a mistake is robust and persistent in a given market context, I'll simply ask the market.  Sellers will only respond to mistakes that are sufficiently robust and persistent.  And seller responses, specifically pricing strategies, are generally much more readily observable than the underlying mistake.

Credit Cards: On the Optimal Design of Disclosure Regulation

Designing effective disclosure regulation is difficult.  I mentioned some of these difficulties in my previous post.  Here I want to focus on the type of information that should be disclosed, and I want to draw a distinction between two categories of information: (1) product attribute information, e.g., the late fee is $35; and (2) use-pattern information, e.g., there is a 30% chance that you will pay late and trigger a late fee.  Both types of information are necessary for the efficient operation of markets.  Specifically, use pattern information is crucial.  A consumer who knows that the overlimit fee charged by issuer A is much higher than the overlimit fee charged by issuer B might still get a card from issuer A if he optimistically thinks that he will never exceed his credit limit.

However, disclosure regulation in general and TILA in particular have largely focused on product attribute information.  This focus may be explained by the belief that consumers have better information about how they will use the product.  But it is not at all clear that consumers have better information than issuers about use patterns. Duncan McDonald, former general counsel of Citigroup’s Europe and North America card businesses, observed that: "No other industry in the world knows consumers and their transaction behavior better than the bank card industry. It has turned the analysis of consumers into a science rivaling the studies of DNA …. The mathematics of virtually everything consumers do is stored, updated, categorized, churned, scored, tested, valued, and compared from every possible angle in hundreds of the most powerful computers and by among the most creative minds anywhere. In the past 10 years alone, the transactions of 200 million Americans have been reviewed in trillions of different ways to minimize bank card risks." (Duncan A. MacDonald, “Viewpoint: Card Industry Questions Congress Needs to Ask,” American Banker, Mar. 23, 2007, at 10)

If this is the case, why not require disclosure of use-pattern information in addition to product attribute information?

Credit Cards: Is Enhanced Disclosure Enough?

Public outcry about practices like universal default has led to several legislative and regulatory proposals.  A first-cut analysis distinguishes between proposals advocating enhanced disclosure and proposals that seek legal intervention beyond disclosure, including the outright ban of certain practices.  The disclosure side is led by the FRB who recently proposed an overhaul of Reg Z, which specifies disclosure mandates for credit card issuers.  The OCC also supports disclosure regulation.  On the other side, bills introduced in the House (by Rep. Keith Ellison) and in the Senate (by Sen. Jon Tester), seek to ban universal default, and other bills seek to ban various fees and practices.

Disclosure regulation has its advantages.  During his testimony before a subcommittee of the House Committee on Financial Services, Comptroller Dugan said, “Effective disclosure can have three fundamental benefits for consumers: first, informed consumer choice; second, enhanced issuer competition to provide consumers the terms they want; and third, greater transparency that will hold the most aggressive credit card practices up to the glare of public scrutiny and criticism, making issuers think long and hard about the costs of such practices before implementing them.”  (OCC News Release, "Comptroller of the Currency Calls for Better Credit Card Disclosures," June 7, 2007).

Let's consider these benefits of disclosure.  The basic goal of disclosure is to facilitate informed choice. Informed consumer choice is surely a good thing, and disclosure can facilitate informed choice.  But to facilitate informed choice disclosure must inform.  Much disclosure does not inform.  Even rational consumers will not become informed, if becoming informed is too costly.  And imperfectly rational consumers might not become informed even if it is cost-effective to become informed.  The challenge is to design simple disclosure mandates that require little time and effort to digest.  On this regulatory design metric many current Reg. Z disclosures do not score very high (although some, e.g., Schumer Box disclosures, score higher).  The FRB is aware of the challenge of designing effective disclosure mandates, and it uses focus groups and interviews to test the efficacy of existing and proposed disclosures.  Let's hope that this process will produce effective disclosure regulation.

Equity Stripping

Today’s New York Times Business Section includes an interesting article on equity stripping: “Predators Bilk Struggling Homeowners” by Gretchen Morgensen and Vikas Bajaj.  The article explains how sophisticated predators target desperate homeowners and steal the equity that they have in their homes:

“The schemes take various forms and often involve promises to distressed homeowners of cash upfront, free monthly rent and a chance to retain their houses in the long run. But in the process, someone else takes over the deed, borrows as much as possible against the value of the house and pockets the cash. And, almost always, the homeowners still end up losing their homes.”

These schemes, which are attracting the attention of regulators, pray on the imperfect rationality of distressed homeowners.  First, they exploit myopia by offering short-term benefits, while downplaying future risks.  Second, they hide the true costs and benefits of this complex transaction in lengthy incomprehensible form contracts. 

But, most importantly, these fraudulent schemes are driven by simple lies: Knowing that their targets will not read the contracts and would not understand them even if they did try to read, the predators blatantly mischaracterizing the transaction in the representations they make to homeowners.

Worth a read.

Is Anyone Rational?

Many people, myself included, believe that consumer behavior deviates in important ways from the predictions of the rational choice model. This belief has led to the development of alternative, more realistic models of decisionmaking, and to the application of these new models in studying consumer markets. But while the rational choice model inadequately describes consumer behavior, it is believed to offer a fairly accurate description of the behavior of more sophisticated parties, like sellers and lenders.

Of course, sellers and lenders are also human and prone to error, but the assumption is that organizational and market forces serve as an effective check on the behavior of these sophisticated parties, preventing substantial departures from the predictions of the rational choice model. As Milton Friedman famously argued, it is not that firms are necessarily rational profit-maximizers, but firms behave "as if" they are rational profit-maximizers. Otherwise, they would be selected out of the market.

Recent events have caused me to question this belief that sellers and lenders behave rationally. I am referring to the rise in foreclosures in the subprime mortgage market, and its effect on lenders. It is not a surprise that irresponsible practices in the subprime market have caused substantial harm to consumers. The surprise is that allegedly sophisticated lenders, and the Wall Street firms that back them, have been suffering substantial losses. Numerous lenders have filed for bankruptcy. Bear and Stearns recently invested $3.2 billion to rescue a hedge fund that was heavily invested in the subprime market—the biggest such bailout since 1998. Wall Street is supposed to be good at managing risks. But here it looks like some top-of-the-line professionals have made big mistakes. Of course, suffering losses is a part of taking risks. But this looks like more than absorbing the foreseeable downside of a calculated bet.