The authors point out that overborrowing and waiting too long to file for bankruptcy - two financial missteps that have harmful consequences - support the case for regulations that could help overoptimistic consumers. Indeed, the experiment reveals that nearly half of their overborrowing is due to procrastination by waiting too long to dissolve debt through bankruptcy, overoptimistic borrowers grow their indebtedness significantly more than if they had retired their loans sooner. By believing that their future incomes will keep pace with realists’ incomes, they delay filing for bankruptcy (or worse, they don’t file at all). How do these borrowers behave when debt obligations become overwhelming? The answer includes this surprising insight: Overoptimistic borrowers tend to file for bankruptcy too late. Having modeled a credit market that accounts for overoptimistic borrowing, the economists explore the factors that contribute to the negative outcomes faced by overoptimistic borrowers. By the same token, realistic borrowers are issued loans with higher rates than their risk type justifies - a circumstance that creates an interest-rate subsidy for overoptimistic borrowers.) (This means that both types of borrowers are offered loans that bear the same interest rate, and as a result, overoptimistic borrowers are granted loans with lower rates than they would if their true risk type could be identified. In fact, their model shows that overoptimists are actually subsidized by realists - an important interaction that emerges because lenders have no way to distinguish between the two types of borrowers at the time of loan origination. The authors establish, early in their research, that this higher propensity to default does not mean that overoptimistic borrowers are being preyed upon or forced into loans they cannot afford to maintain. Within the model, overoptimistic consumers - despite being confident about their future income streams - are more likely to suffer from bad luck in the form of income disruptions and therefore default on their loans more often than realists. Their experiments show each type's propensity to overborrow (or not), and the effects of regulatory policies on the collective welfare of all borrowers. Their simulations, in which households are subjected to income shocks (sudden disruptions of income, for example) and unforeseen expenses (such as medical bills or other big outlays), help explain how the two types of borrowers absorb unforeseen shocks. In their paper, " Consumer Credit with Over-Optimistic Borrowers," these economists model a pool of borrowers that contains overoptimistic borrowers as well as more-realistic borrowers. Philadelphia Fed economic advisor and economist Igor Livshits and his coauthors, Florian Exler, James MacGee, and Michèle Tertilt, look at several types of such regulations, exploring their effectiveness across two dimensions: 1) preventing overconfident consumers from borrowing more than they can repay, and 2) maintaining credit availability for rational consumers who are not at risk of misperceiving their financial risks. Their misguided sense of optimism and the financial mistakes it enables have stimulated a long debate about the need for regulations that limit the misuse of credit. Such borrowers, who are too optimistic about their future incomes, may be unable to repay loans on time and may wait too long to take corrective action when their finances become overstretched. Embracing credit can have downsides, however, particularly for borrowers who are unrealistic about how much debt they can carry. Borrowing money allows them to meet extraordinary expenses, make important purchases, and endure temporary periods of lost income. Consumers often use credit to manage their finances.
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