Testing for Adverse Selection and Moral Hazard in
Consumer Loan Markets
February 10, 2004
This paper explores the significance of unobservable default risk in mortgage and
automobile loan markets. I develop and estimate a two-period model that allows for
heterogeneous forms of simultaneous adverse selection and moral hazard. Controlling for
income levels, loan size and risk aversion, I find robust evidence of adverse selection, with
borrowers self-selecting into contracts with varying interest rates and collateral requirements.
For example, ex-post higher-risk borrowers pledge less collateral and pay higher interest rates.
Moreover, there is strongly suggestive evidence of moral hazard such that collateral is used to
induce a borrower’s effort to avoid repayment problems. Thus, loan terms may have a feedback
effect on behavior. Also, higher-risk borrowers are more difficult to induce into exerting effort,
explaining the counter-intuitive result that higher-risk borrowers sometimes pay lower interest
rates than observably lower-risk borrowers.
*Federal Reserve Board, email:Wendy.M.Edelberg@frb.gov. The views presented are solely those of
the author and do not necessarily represent those of the Federal Reserve Board or its staff. I would like
to thank Pierre-Andre Chiappori, Lars Hansen, Erik Hurst and Annette Vissing-Jorgensen, for their
direction and advice. I also would like to thank the University of Chicago, the National Science
Foundation and the Social Science Research Council for their financial support. Of course, all errors are
The intertemporal interest rate, reflecting the cost of savings and borrowing to
households, is one of the most important prices in economics models. Nearly all multi-period
models of utility maximization take this interest rate as a parameter. The risk-free interest rate
on savings is well grounded in the mar