A Finite-Life Private-Information Theory of UnsecuredDebt

We present a theory of unsecured consumer debt that recognizes a debtor’s legal right to default. Our theory does not rely on psychological costs of default (or stigma) nor does it rely on enforcement mechanisms that arise in repeated-game settings. Our theory is based on private information about a person’s type and on a person’s incentive to signal his type by avoiding default in the credit market. People in our model differ with respect to patience and in the likelihood of an insurable (i.e., observable) loss. More patient types are assumed to be less likely to suffer the loss and these (correlated) differences in patience and probability of loss are private information. Crucially, in our model the opportunity to repay debt occurs at an earlier date than the opportunity to purchase insurance. This means that debtors who are also good insurance risks have an opportunity to signal their type by repaying debt. The signal works because the benefit of a lower cost of insurance comes in the future and the type who is a good insurance risk is also the type who values the future more. Our theory is consistent with the well-known fact that the cost of some kinds of insurance is positively related to the presence of derogatory information in a person’s credit history. Our theory also provides an example of the more general point that people avoid opportunistic behavior in one social context because doing so has positive spillover effects in other social contexts.