Default Probability and Information Asymmetry: An Analysis of Income-Contingent Loan Contracts

Abstract

This thesis offers an analysis of default decisions in a market with considerable information asymmetry. We first develop a mechanism design framework to study the credit rationing problem in the market for income-contingent loans. Our empirical work follows the theoretical results by examining the determinants of default for student loan debtors. We add to the limited knowledge of student loan default by presenting a probit model of default probability for over two thousand borrowers of income-contingent student loans backed by the federal government. The exercise illustrates how borrower characteristics largely determine default probabilities across multiple specifications. We analyze the implications of this exercise by elucidating how borrower risk is perceived by government-sponsored agencies, which serve to as sist creditors in originating income-contingent loans in an illiquid market. Looking at debt issues in the secondary loan market, we provide a decomposition of the origination costs associated with raising capital and bringing the debt instruments to market. The results suggest that borrower risk is priced into the cost of debt issuance and government agencies are cognizant of repayment uncertainty. Upon reconciling the theoretical and empirical results, we provide commentary on the role of government intervention in providing liquidity for inefficient markets.