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Essays on Credit Scores, Strategic Behavior, and Default with Credit Cards Open Access

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This dissertation addresses the question of strategic behavior with respect to unsecured credit, in the presence of vast asymmetry of information between lender and borrower. The theoretical exercise presented below differs from the existing literature on precautionary savings models in a number of ways. Firstly, it analyzes the credit scores from the perspective of a non-transferable asset and determines the effect of exogenous shocks to its value on consumer behavior. Secondly, it introduces a greater degree of asymmetry of information in the form of privately known health shocks. Thirdly, it moves away from the deterministic end of life model by introducing a stochastic shock for end of life, which also serves as an additional layer of information asymmetry between players in the market. Finally, it modifies discounting through a dynamic discount factor. The simulations presented show significant effects from exogenous shocks to the credit allocation dynamics. These effects, however, are diminished with the passage of time, suggesting that strategic behavior is influenced more prominently in the short to medium term. Following the establishment of economic value in the credit score, the dissertation addresses the question of asymmetric information in greater detail. By analyzing the effects of privately held stochastic health shocks in the presence of credit scores, it adds further insight into strategic behavior. Overall, the analysis focuses on the effects of exogenous changes to health that affect the incidence of such negative shocks, the magnitude of the shock, and finally the costs associated with the shock. Key findings show that the interplay between the insurance motif in borrowing and the strategic default motif are correlated with the credit scoring process and the credit allocation decision. Additionally, the dissertation also tests some of the theoretical predictions via a number of simple, stylized empirical models. Specifically, it presents models using data from the Survey of Consumer Finances that supports the hypothesis that, given a pessimistic outlook on life and health, individuals are likely to rely more on unsecured credit. Finally, the dissertation will present extensions of the model under considerations. By expanding the current literature on precautionary savings models via the introduction of heterogeneous and dynamic risk profiles, it explores the implications of such profiles on strategic behavior. The model is estimated for various levels of static risk aversion, as well as a dynamic formulation. The results again show strong correlation between the credit scoring process and strategic behavior; however the impact is mitigated somewhat by the risk profile. To complete the picture of the effects of credit scoring on strategic behavior, an alternative credit allocation process is introduced. This process, which is a quasi-collateralized form of unsecured lending, reduces the incidence of strategic default. The implication is that credit scores have a significant impact on behavior, however, their impact also interacts with other components of the market (such as risk profiles and health shocks). These interactions modify the magnitude of the impact of the credit score on individual behavior, though largely the direction of the impact remains the same.

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