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Credit Cycle and Adverse Selection Effects in Consumer Credit Markets: Evidence from the HELOC Market

Credit Cycle and Adverse Selection Effects in Consumer Credit Markets: Evidence from the HELOC Market

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The authors empirically study how the underlying riskiness of the pool of home equity line of credit originations is affected over the credit cycle. Drawing from the largest existing database of U.S. home equity lines of credit, they use county-level aggregates of these loans to estimate panel regressions on the characteristics of the borrowers and their loans, and competing risk hazard regressions on the outcomes of the loans. The authors show that when the expected unemployment risk of households increases, riskier households tend to borrow more. As a consequence, the pool of households that borrow on home equity lines of credit worsens along both observable and unobservable dimensions. This is an interesting example of a type of dynamic adverse selection that can worsen the risk characteristics of new lending, and suggests another avenue by which the precautionary demand for liquidity may affect borrowing.
The authors empirically study how the underlying riskiness of the pool of home equity line of credit originations is affected over the credit cycle. Drawing from the largest existing database of U.S. home equity lines of credit, they use county-level aggregates of these loans to estimate panel regressions on the characteristics of the borrowers and their loans, and competing risk hazard regressions on the outcomes of the loans. The authors show that when the expected unemployment risk of households increases, riskier households tend to borrow more. As a consequence, the pool of households that borrow on home equity lines of credit worsens along both observable and unobservable dimensions. This is an interesting example of a type of dynamic adverse selection that can worsen the risk characteristics of new lending, and suggests another avenue by which the precautionary demand for liquidity may affect borrowing.

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Published by: Federal Reserve Bank of Philadelphia on Apr 22, 2011
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04/22/2011

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WORKING PAPER NO. 11-13
CREDIT CYCLE AND ADVERSE SELECTION EFFECTS INCONSUMER CREDIT MARKETS –EVIDENCE FROM THE HELOC MARKET
Paul CalemBoard of Governors of the Federal Reserve SystemMatthew CannonCoreLogicLeonard NakamuraFederal Reserve Bank of PhiladelphiaMarch 2011
 
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Credit Cycle and Adverse Selection Effects in Consumer Credit Markets –Evidence from the HELOC Market
Paul CalemBoard of Governors of the Federal Reserve SystemMatthew CannonCoreLogicLeonard NakamuraFederal Reserve Bank of PhiladelphiaMarch 2011We would like to particularly thank CoreLogic for its support. We would also like to thank Elif Sen for exceptional and tireless research assistance. The views expressed here are those of theauthors and do not necessarily reflect those of CoreLogic, the Federal Reserve Bank of Philadelphia, the Board of Governors of the Federal Reserve System, or the Federal ReserveSystem. This paper is available free of charge at www.philadelphiafed.org/research-and-data/publications/working-papers/.
 
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Credit Cycle and Adverse Selection Effects in Consumer Credit Markets – Evidence fromthe HELOC Market
Paul S. CalemBoard of Governors of the Federal Reserve SystemMatthew CannonCoreLogicLeonard I. NakamuraFederal Reserve Bank of Philadelphia
Abstract
 We empirically study how the underlying riskiness of the pool of home equity line of credit originations is affected over the credit cycle. Drawing from the largest existing database of U.S. home equity lines of credit, we use county-level aggregates of these loans to estimate panelregressions on the characteristics of the borrowers and their loans, and competing risk hazardregressions on the outcomes of the loans. We show that when the expected unemployment risk of households increases, riskier households tend to borrow more. As a consequence, the pool ohouseholds that borrow on home equity lines of credit worsens along both observable andunobservable dimensions. This is an interesting example of a type of dynamic adverse selectionthat can worsen the risk characteristics of new lending, and suggests another avenue by which theprecautionary demand for liquidity may affect borrowing.Address correspondence to:Paul Calem, Division of Banking Supervision and Regulation, Board of Governors of the FederalReserve System, 20
th
and C Streets NW, Washington D.C. 20551, phone: (202) 452-2836Matthew Cannon, Credit Risk Products and Analytics, CoreLogic, 188 The Embarcadero, 3
rd
 Floor, San Francisco, CA, 94105, phone: (215) 893-1503Leonard I. Nakamura, Research Department, Federal Reserve Bank of Philadelphia, TenIndependence Mall, Philadelphia, PA, 19106-1574, phone: (215) 574-3804,fax: (215) 574-4303e-mail:Leonard.Nakamura@phil.frb.org.

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