Your House or Your Credit Card, Which Would You Choose? Personal Delinquency Tradeoffs and Precautionary Liquidity Motives

TL;DR: This article found evidence that individual-level liquidity concerns lead many individuals to pay credit card bills even at the cost of mortgage delinquencies and foreclosures, while the popular press and some recent literature have suggested that this choice may emerge from steep declines in housing prices.

Abstract: This paper presents evidence that precautionary liquidity concerns lead many individuals to pay credit card bills even at the cost of mortgage delinquencies and foreclosures. While the popular press and some recent literature have suggested that this choice may emerge from steep declines in housing prices, we find evidence that individual-level liquidity concerns are more important in this decision. That is, choosing credit cards over housing suggests a precautionary liquidity preference. By linking the mortgage delinquency decisions to individual-level credit conditions, we are able to assess the compound impact of reductions in housing prices and retrenchment in the credit markets. Indeed, we find the availability of cash-equivalent credit to be a key component of the delinquency decision. We find that a one standard deviation reduction in available credit elicits a change in the predicted probability of mortgage delinquency that is similar in both direction and nearly double in magnitude to a one standard deviation reduction in housing price changes (the values are -25% and -13% respectively). Our findings are consistent with consumer finance literature that finds individuals have a preference for preserving liquidity - even at significant cost.

Summary

Introduction

• Assess the compound impact of reductions in housing prices and retrenchment in the credit markets.
• Indeed the recent crisis has highlighted that many may do so because of housing price declines.
• This past year, the Credit Card 1While to their knowledge, this paper is to rst to tackle the question of delinquency priority, a recent paper (Lusardi and Tufano, 2009) makes the argument that a study of consumer credit must include the joint-probabilities across types of credit and delinquency behavior.
• This nding mirrors the corporate nance literature's conclusions on the use of lines of credit as committed liquidity insurance.

I.1 Stylized Facts

• The authors provide some additional information here to motivate the study.
• A large fraction of these individuals choose delinquency on mortgages while continuing payment on credit cards, also known as Fact 2.
• Of the sample of individuals that have a mortgage in 2006 and 2007, 9,290 have had some type of credit card delinquencies in the sample time period.
• Individuals that were mortgage delinquent but not credit card delinquent increased 127% during the 18 month period.

II Literature

• The nascent literature on consumer nancial decision making has not yet, to the authors' knowledge, tackled the question of delinquency priority, or its effects on the economy.
• Tufano (2009) also provides an overview of this new literature.
• Consumer bankruptcy emerges out of the same patterns of nancial distress that, in generally smaller amounts, lead to the delinquency tradeoffs discussed in this project.
• The second category is the role of the changes in the credit market environment that have made bankruptcy more attractive or expanded credit to a broader set of households, including higher-risk ones (see Dick and Lehnert, 2009, for a recent example).
• The implication, for delinquency tradeoffs, is that strategic consumers that nd themselves in a nancial stress situation, may resort to protecting their credit cards rather than their houses.

III The Market

• While credit card and mortgage products are likely understood by most readers, a short description is useful.
• Credit cards are consumer orientated lines of credit.
• Furthermore, most credit scoring systems currently in use are based on a logarithmic scale, meaning the difference in risk between 200 and 201 will not be equal to the change from 201 to 202.
• One a line has been opened, issuers routinely assess borrowers' probability of payment and adjust lines accordingly.
• In practice, most credit card and mortgage lenders will wait to enforce a default provision until payments are 90 days or more late.

IV Econometric Methodology

• The authors goal, as discussed, is to highlight the decision making amongst individuals facing moderate nancial distress.
• Neither those facing extreme distress nor those under little distress must choose between paying a household mortgage or paying credit card debt.
• Speci cally, the authors include individuals that have at least one mortgage and at least one revolving credit line in June of 2006.
• That is, a wealthy individual may need to be hit with a series of large shocks or a poor individual with one minor shock to reach this economic condition.
• The authors believe that individuals choose the type of delinquency based on two factors: one, the economic value of the underlying asset, the house and two, the consumption value of consumer credit in relieving the individual budget constraint.

V Data

• This paper draws primarily on a very large proprietary data set provided under contract by Transunion, one of the three large US credit agencies.
• As is customary, account les have been purged of names, social security numbers, and addresses to ensure individual con- dentiality.
• The authors exploit this vari12For their measure to be appropriate, they need that individuals, prior to delinquency, have then-optimal desired levels of available credit.
• The Transunion data also have a number of advantages for their study.
• Census Data and Other Information Together with the credit information, the paper uses an individual's geo-coded census block address from the Transunion data and links a wide variety of information on location characteristics.

VI.1 The Revolving vs Mortgage decision

• As explained above, their core methodological approach is to isolate the population of interest and illustrate the primary factors impacting their decision.
• Columns 1-3 show that, in general, housing price trends are positively correlated with the dependent variable.
• When faced with lower liquidity, individuals appear to choose mortgage delinquency in order to protect the available remaining credit on their credit cards.
• Table II reports all regressions with details on demographic and nancial control variables.
• The authors do nd that those with higher credit scores will choose to protect their houses.

VI.2 Nonlinearities

• As their liquidity indicator appears strongly signi cant, one would expect that this effect would be stronger for individuals with low liquidity; lack of access to cash equivalent resources becomes a signi cant issue only the closer one is to a binding nancial constraint.
• From an empirical standpoint, this implies that individuals with the lowest availability of credit will have the highest marginal propensity to default on their mortgages for the liquidity reasons suggested.
• These lines have a few principal differences.
• In most states, a chapter 13 bankruptcy restructuring allows a borrower to 'strip' off second and third liens, making HELOCs effectively junior to unsecured credit card debt.
• Second, revolving bank loans and retail cards are particularly easy to use as cash substitutes.

VI.4 Payday Lending

• The authors continue evaluating whether access to alternate forms of cash substitutes impact their results.
• In particular, Table V includes the prevalence and regulations on payday lending at the state level to determine if the ease of access to alternate nancing impacts the preference for liquidity.
• Essentially, if an individual is willing to maintain open lines of credit based on a precautionary demand for liquidity, on the margin, the presence and ease of access of payday loans should ameliorate this demand.
• Indeed, these are the only states in which any of their payday regulations appear signi cant.
• When a lender noticed a default on another card, it would trigger default provisions on its own lines, typically increasing interest rates to a penalty rate or lowering available credit lines.

VI.5 Credit Constraints

• The dearth of liquidity and its impact on delinquency decisions may be particularly salient for those that would have a higher chance of being credit constrained.
• Table VI reports the age dependent results of their baseline regression.
• This effect carries over into short term housing price uctuations as well where they are more apt to stop paying on mortgages than their elder counterparts.
• The magnitude for these individuals re ect the same liquidity preservation seen earlier, however the smaller coef cient on the short term price uctuations re ect the increased housing services that are derived from home ownership for middle aged individuals.
• As credit quality falls, available credit becomes increasingly important; the coef cient for the low credit quality is more than three times as large as the coef cient for the high credit quality individuals.

VI.6 Housing Prices and Local Distress

• The authors further explore the role of housing prices in predicting the type of delinquency.
• Speci cally, the authors highlighted the importance of three particular states that saw large drops in housing prices and the apparent magni ed impact, in those states, on changes in the delinquency decision.
• For each group, the authors estimate a separate regression identical to those above.
• The asymmetry of coef cient changes between the housing price and liquidity variables across speci - cations is strong evidence that their liquidity variable is not biased.
• Notice that the liquidity variable shows a signi cant and large effect across states with varying degrees of price changes and across circumstances.

VI.7 Scale and delinquency

• The authors sample in 2007 shows mean revolving credit card balances of approximately $17,000 and mean mortgage balances of $148,000.
• For those with mortgage delinquency, the authors see that mortgage balances increase versus the average and credit cards decline.
• Monthly payments on credit cards during the time period of their study were typically 3% of outstanding principal.
• The results of this exercise are in Table VIII.
• Importantly for their study, the coef cient on the liquidity variable of interest changes only slightly.

VI.8 New Credit Access

• Recall that the authors de ned their sample to include only individuals that had no delinquencies; as such, an unexpected nancial shock would leave the individual access to the credit that he or she had at the beginning of the sample.
• This indeed is part and parcel of the motivation for using the pre-shock credit access as a measure of liquidity insurance.
• During the time of this study, 3% was the norm.
• Next, the authors estimate the credit score penalty, conditional on delinquency type, for individuals that were delinquent in 2007 by subtracting the estimated credit score in (2) from the actual observed credit score in 2007.
• Indeed, the credit score penalty for being late on revolving credit is only 18 points larger than for a similar delinquency on the mortgage side.

VI.9 Speci cation Choice

• In Table X, the authors begin by adding county-level xed effects to absorb any unobserved heterogeneity across counties in income, habits, etc.
• The authors results are consistent with those above.
• Because a probit imposes a functional form on the error distribution, the authors repeat their speci cation with ordinary least squares, both with and without xed effects.
• The combination of these provide evidence that their results are not a product of their particular estimation choice.
• The authors can then observe the same relationship as above: higher available credit per dollar of income leads to more credit delinquencies, even controlling for total credit lines.

VI.11 Assessing the Shock

• First, the authors evaluate the correlates of having any delinquency at all.
• Recall that because individuals may face an exogenous shock of some type, this equation does not allow inference on the decision to become delinquent, but rather simply its correlates.
• The authors sample here is all individuals that had no delinquencies in 2006.
• Note that the authors have not isolated the individual decision here as they did in Table XI.
• That is, the result in the section above that lower cash-equivalent credit leads to the decision to default on a mortgage is a relative one.

VII Economic Spillovers

• The authors illustrate this link by showing that falling housing prices are correlated with increased mortgage delinquency in Table XIII.
• This is supportive of the spillover concept.
• The authors show that this choice for consumer credit leads to local spillovers in the form of increased delinquency.
• Results from this speci cation are available in Table IX, Columns 5 and 6.

VIII Conclusion

• This paper has found evidence on the drivers of individual delinquency decisions.
• In this regard their study contributes to the eld in two important ways; rst the authors identify a subset of the population - those who face moderate nancial shocks - that to their knowledge has not been the focus of existing studies.
• The authors analysis then examines this effect in the broader context of regional variations in delinquency rates.
• This extension is important, not only from a political economy perspective but also as an important quali cation of the emerging literature which documents individuals decisions to become delinquent on their mortgages as a function of their debt to equity ratio on their homes.
• The authors results suggest that while the CARD act provided a range of regulations that are bene cial vis-a-vis assisting consumers in understanding often complex credit contracts, the direct consequence of the act will likely be to limit issuer fee income from low quality borrowers and thus may decrease access to credit for these same borrowers.

Figures

TABLE Va: DELINQUENCY REGRESSION RESULTS

TABLE VII: SPECIFICATION CHOICE

TABLE II: DELINQUENCY PENALTIES

TABLE IVb: ALTERNATE SOURCES OF LIQUIDITY

TABLE I: DELINQUENCY CHOICE

TABLE VIII: DISTRESSED STATES

TABLE IVb: ALTERNATE SOURCES OF LIQUIDITY

TABLE Va: DELINQUENCY REGRESSION RESULTS

TABLE IX: SPILLOVERS

TABLE IIIb: BASELINE REGRESSIONS

TABLE X: SCALE OF PAYMENTS

TABLE VI: AGE AND CREDIT SCORES

TABLE IIIb: BASELINE REGRESSIONS

Full text

YOUR HOUSE OR YOUR CREDIT CARD, WHICH
WOULD YOU CHOOSE?
PERSONAL DELINQUENCY TRADEOFFS AND
PRECAUTIONARY LIQUIDITY MOTIVES
Working Paper No. QAU09-5
Ethan Cohen-Cole
University of Maryland – College Park
Jonathan Morse
Federal Reserve Bank of Boston
This paper can be downloaded without charge
from:
The Quantitative Analysis Unit of the Federal
Reserve Bank of Boston
http://www.bos.frb.org/bankinfo/qau/index.htm
The Social Science Research Network Electronic
Paper Collection:
http://www.ssrn.com/link/FRB-Boston-Quant-
Analysis-Unit.htm

Your House or Your Credit Card, Which Would You Choose?
Personal Delinquency Tradeoffs and Precautionary Liquidity Motives
Ethan Cohen-Cole

University of Maryland - College Park
Jonathan Morse
Federal Reserve Bank of Boston
January 28, 2010
Abstract
This paper presents evidence that precautionary liquidity concerns lead many individuals to pay
credit card bills even at the cost of mortgage delinquencies and foreclosures. While the popular press
and some recent literature have suggested that this choice may emerge from steep declines in housing
prices, we nd evidence that individual-level liquidity concerns are more important in this decision. That
is, choosing credit cards over housing suggests a precautionary liquidity preference.
By linking the mortgage delinquency decisions to individual-level credit conditions, we are able to
assess the compound impact of reductions in housing prices and retrenchment in the credit markets.
Indeed, we nd the availability of cash-equivalent credit to be a key component of the delinquency
decision. We nd that a one standard deviation reduction in available credit elicits a change in the
predicted probability of mortgage delinquency that is similar in both direction and nearly double in
magnitude to a one standard deviation reduction in housing price changes (the values are -25% and -
13% respectively). Our ndings are consistent with consumer nance literature that nds individuals
have a preference for preserving liquidity - even at signicant cost.

Ethan Cohen-Cole: Robert H Smith School of Business. 4420 Van Munching Hall, University of Maryland, College Park,
MD 20742. email: ecohencole@rhsmith.umd.edu. (301) 541-7227. Jonathan Morse: 600 Atlantic Avenue, Boston MA. email:
jonathan.morse@bos.frb.org. The authors are grateful to Yiorgos Allayannis, George Aragon, Ezra Becker, Zahi Ben-David,
Jonathan Berk, David Dicks, Janice Eberly, Alex Edmans, Mark Flannery, Paolo Fulghieri, Diego Garcia, Adair Morse, Judit
Montoriol-Garriga, David Musto, Adriano Rampini, Anil Shivdasani, Anjan Thakor, Peter Tufano, Haluk Unal, and seminar par-
ticipants at the American Economic Association meetings, the FDIC-JFSR 9th annual research conference, George Washington
University, Fannie Mae and the Jackson Hole Finance Group for helpful comments. Cohen-Cole thanks the FDIC Center for Fi-
nancial Policy and the Robert H Smith School of Business for nancial support. The views expressed in this paper are those of the
authors and do not necessarily reect those of the Federal Reserve Bank of Boston or the Federal Reserve System.

For years, the conventional wisdom in the consumer nance industry has been that a consumer will pay
their mortgage bill long after they have gone delinquent on other nancial obligations. This paper nds
strong evidence that many individuals in fact make the opposite choice, paying credit card bills even at the
cost of mortgage delinquencies and foreclosures. Indeed the recent crisis has highlighted that many may do
so because of housing price declines. We nd an alternate motivation for this choice: the availability of cash
equivalent credit. Empirically, a one standard deviation drop in available credit on credit cards lead to an
increase in mortgage delinquency of 25%. Indeed, the number of people choosing to become delinquent on
mortgages while paying on their credit cards increased by a full 127% between June of 2006 and December
of 2007.
1
Our inference from these patterns is the presence of a high precautionary demand for liquidity;
individuals wish to ensure future access to lines of credit to cover regular costs of living.
2
The fact that housing loans come with collateral not only makes these decisions particularly surprising,
but also had led to the general perception that mortgages were a much safer lending option than credit
cards. In the past couple of years; however, the decline in housing prices has called into question consumer
preference for paying mortgages before other obligations.
3
As almost a quarter of US homeowners are
now underwater on their mortgages by the end of November, 2009, this concern remains in the political
spotlight.
4
Our analysis below shows that amongst the varied potential explanations for this phenomenon, liquidity
concerns play a central and dominant role. Indeed, they are of larger magnitude than housing price changes,
which have been highlighted both in the popular press and the nance literature as a primary cause of
mortgage delinquency. This result suggests that recent attempts to modify mortgages to assist borrowers
may be unsuccessful; not because of strategic default decisions of borrowers but because lack of access
to alternate forms of liquidity means that continued economic distress or a subsequent minor shock can
push a borrower to protect his credit cards and drop even the modied mortgage. In addition to individual
level shocks, a reduction in the supply of credit can have similar impacts. This past year, the Credit Card
1
While to our knowledge, this paper is to rst to tackle the question of delinquency priority, a recent paper (Lusardi and Tufano,
2009) makes the argument that a study of consumer credit must include the joint-probabilities across types of credit and delinquency
behavior. They also provide survey evidence from 1000 individuals for a wide panel of behaviors and product usage.
2
Indeed, Transunion has found evidence that "consumers...have become more conscientious in protecting those
credit instruments still available to them and are making every effort to pay their credit card bills on time."
http://newsroom.transunion.com/index.php?s=43&item=516. Downloaded April 15, 2009.
3
Guiso, Sapienza and Zingales, (2009) nd that 26% of all individuals who default on their mortgage are capable of pay-
ing their mortgage. The topic of strategic default has become ever more salient in the current environment. This litera-
ture, in general, considers if housing price declines are a sufcient condition for agents to engage in strategic default be-
havior. A WSJ editor also published his own potential plan to default strategically as recently as December 2008 (see
http://online.wsj.com/article/SB10001424052748704240504574585873167451840.html)
4
23% of homeowners according to data from First American CoreLogic. See
http://online.wsj.com/article/SB125903489722661849.html
2

Accountability, Responsibility, and Disclosure (CARD) Act imposed additional requirements on lenders
that will limit fee income and likely reduce lending to low quality borrowers. This could exacerbate existing
difculties with mortgage modication programs.
We believe the role of liquidity is important for a few reasons. One, the consumer nance literature has
found liquidity concerns to be particularly salient (see, for example, Telyukova, 2009). Our paper supports
these ndings. Individuals under increasing credit constraints nd liquidity to be of increased relevance.
This nding mirrors the corporate nance literature's conclusions on the use of lines of credit as committed
liquidity insurance.
5
Two, we will show below that when liquidity concerns lead to delinquency increases,
they can have systemic implications. As liquidity concerns increase and foreclosures follow, neighboring
houses can experience price declines, which trigger additional delinquencies.
Our empirical strategy follows four steps. To start, our goal is to isolate a group of individuals that are
in the position to choose between their house and their credit cards. That is, we wish to evaluate individuals
that have faced a shock large enough to force a delinquency, but not one large enough to force a nancial
catastrophe. We do so as follows. We begin with individuals in June of 2006 who had both a credit card and
a mortgage, but no current delinquencies. In December 2007, we assess the individuals again and keep only
those that experienced a delinquency on one type of loan, either their mortgage or their credit cards. We
exclude those that become delinquent on both or none. Thus, we isolate individuals who have an effective
option on the type of debt they wish to keep and on the type they wish to enter delinquency. We highlight
this group as these individuals have some ability to direct their nancial resources, providing us the ability
to assess the tradeoffs they make in isolation of other concerns.
Our second step allows us to marry this information with specics on individual liquidity position. Our
measure of liquidity is the amount of available credit at the beginning of our sample period. Available credit
is measured is the total credit line net of any balances already incurred. Because we begin with individuals
that had no delinquencies in June of 2006, we can interpret this amount as the liquidity already available
at the time of the shock. Similarly to corporate insurance, available credit can be interpreted as liquidity
insurance. Our data permit precise information on all credit lines, mortgages, and other types of debt held
by the individual in June of 2006. We show in Figure 1 the average available credit for individuals during
the months leading up to a delinquency. The pattern in this gure is consistent with individuals preparing
5
See, among others Boot, Thakor, and Udell, 1987, Berkovitch and Greenbaum, 1991, Campello, et al, 2009, Holmstrom and
Tirole, 1998, and Thakor, 1995. This literature broadly nds the nds use lines of credit as liquidity insurance. While some recent
work (Huang 2009) nds that the insurance is imperfect, it nonetheless fullls a role that is conceptually similar to the consumer
need.
3

for the shock by increasing liquidity access ex-ante.
6
Our third step evaluates the rationale for the decision to keep one type of debt versus the other. With
our measure of liquidity, we can now estimate a binary choice model of the decision to choose delinquency
on credit cards or mortgages. Such a choice has many potential inuences; indeed, because of the detail
available in the dataset, we will be able to control for a wide range of them. In addition to the credit
available at the time of the delinquency choice, the choice itself has asymmetric inuences on the ability to
obtain new credit in the future. We will show that missing payments on a credit card costs marginally more
in terms of access to credit cards than missing payment on a mortgage. As well, changes in housing prices
can inuence this choice. If housing princes fall, the incentive to repay mortgages fall, even if individuals
are nancially capable of making payments. This phenomenon is discussed in Guiso, Sapienza and Zingales
(2009). We evaluate each of these concerns as well as a range of other potential inuences, including various
credit constraints, the availability of other types of cash equivalents such as home equity lines of credit, the
availability of payday loans, and the relative scale of mortgages.
We nd in each case that the role of liquidity is the predominant factor in the delinquency decision.
Indeed, individuals in areas with large housing price declines respond to that incentive by choosing to protect
credit cards; remarkably, the liquidity effect is nearly identical in areas that had not yet had price declines in
2007 (see Figure 2). This is consistent with the story that individuals refuse to pay as their mortgages rise
above 100 percent loan to value ratio. However, it shows that the liquidity effect is salient across contexts.
Finally, we briey illustrate the potential for spillovers to the remainder of the economy. This is impor-
tant in particular in understanding the consequences of government intervention programs. The mechanism
for this is straightforward and comes from existing literature on the impact of foreclosures on surrounding
home values.
7
To quantify the magnitude of the choices to stop paying on mortgages rather than credit
cards, we regress community level delinquency rates on the individual-level mortgage delinquency. To han-
dle endogeneity, we instrument the mortgage delinquency decision with the liquidity measure we show to be
a predictor. This sheds light on the pass-through from individual tradeoffs to systemic difculties. Notably,
we nd that this impact is both economically relevant and passes through only to mortgage delinquency, not
to credit cards. Decreases in liquidity actually increase community level credit card payment probabilities.
This implies that changes in regulation on credit cards may have perverse impacts on credit and mortgage
6
It is worth noting that this does not reect increased credit causing delinquency. Indeed, utilization rates decrease linearly
during the time leading up to a delinquency. Emphasizing the role of credit limits as liquidity insurancec for unexpected shocks,
the pattern in Figure 1 is reversed for individuals prior to bankruptcy. Because a bankruptcy ling comes with the ability to
expunge debt, instead of building a precautionary buffer, these borrowers on average use up remaining credit. This suggests that
the predelinquency borrowers in our dataset are not strategically defaulting, at least with the intention of bankruptcy.
7
A survey of this literature is available in Lee (2008) and in a Center for Responsible Lending report (2008).
4