IDEAS home Printed from https://ideas.repec.org/p/fip/fedlwp/101999.html

What Drives Household Financial Distress? The Role of Earnings Misperceptions

Author

Listed:

Abstract

Why do households borrow heavily and experience financial distress? We develop and estimate a heterogeneous-agent model of unsecured credit and default in which households learn about income persistence and overreact to recent income realizations. We estimate overreaction using survey measures of income expectations and forecast errors, and the remaining parameters to match household debt and financial distress. Information frictions and estimated overreaction account for roughly half of delinquencies and one-third of bankruptcies, and improve the model’s fit of the observed negative relationship between income and interest rates. Because the models with earnings misperceptions do not need extremely impatient households to match financial distress, policies that substantially reduce financial distress by restricting risky borrowing entail much smaller welfare costs.

Suggested Citation

  • Juan M. Sanchez & Stefan Song, 2025. "What Drives Household Financial Distress? The Role of Earnings Misperceptions," Working Papers 2025-030, Federal Reserve Bank of St. Louis, revised 02 Jul 2026.
    • Handle: RePEc:fip:fedlwp:101999
    DOI: 10.20955/wp.2025.030
    as

    Download full text from publisher

    File URL: https://doi.org/10.20955/wp.2025.030
    File Function: Full text
    Download Restriction: no
    File URL: https://libkey.io/10.20955/wp.2025.030?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Satyajit Chatterjee & Dean Corbae & Kyle Dempsey & José‐Víctor Ríos‐Rull, 2023. "A Quantitative Theory of the Credit Score," Econometrica, Econometric Society, vol. 91(5), pages 1803-1840, September.
    2. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
    3. J. Carter Braxton & Kyle Herkenhoff & Jonathan Rothbaum & Lawrence Schmidt, 2025. "Changing Income Risk across the US Skill Distribution: Evidence from a Generalized Kalman Filter," American Economic Review, American Economic Association, vol. 115(12), pages 4438-4475, December.
    4. Greg Kaplan & Giovanni L. Violante, 2010. "How Much Consumption Insurance beyond Self-Insurance?," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(4), pages 53-87, October.
    5. Yueran Ma & Tiziano Ropele & David Sraer & David Thesmar, 2020. "A Quantitative Analysis of Distortions in Managerial Forecasts," NBER Working Papers 26830, National Bureau of Economic Research, Inc.
    6. Chatterjee, Satyajit & Corbae, Dean & Ríos-Rull, José-Víctor, 2008. "A finite-life private-information theory of unsecured consumer debt," Journal of Economic Theory, Elsevier, vol. 142(1), pages 149-177, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Zachary Bethune & Joaquín Saldain & Eric R. Young, 2024. "Consumer Credit Regulation and Lender Market Power," Staff Working Papers 24-36, Bank of Canada.
    2. Kyle Herkenhoff, 2025. "Comment on "Credit Scores and Inequality Across the Life Cycle" 2," NBER Chapters, in: NBER Macroeconomics Annual 2025, volume 40, pages 390-398, National Bureau of Economic Research, Inc.
    3. Satyajit Chatterjee & Dean Corbae & Kyle Dempsey & José-Víctor Ríos-Rull, 2026. "Credit Scores and Inequality across the Life Cycle," NBER Macroeconomics Annual, University of Chicago Press, vol. 40(1), pages 301-375.
    4. Andrew Glover & Dean Corbae, 2015. "A Simple Dynamic Theory of Credit Scores Under Adverse Selection," 2015 Meeting Papers 1265, Society for Economic Dynamics.
    5. Tom Krebs & Moritz Kuhn & Mark L. J. Wright, 2015. "Human Capital Risk, Contract Enforcement, and the Macroeconomy," American Economic Review, American Economic Association, vol. 105(11), pages 3223-3272, November.
    6. Yunho Cho & James Morley & Aarti Singh, 2024. "Did marginal propensities to consume change with the housing boom and bust?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 39(1), pages 174-199, January.
    7. Felicia Ionescu & Marius Ionescu, 2012. "The Interplay Between Student Loans and Credit Cards: Implications for Default," Working Papers 2012-014, Human Capital and Economic Opportunity Working Group.
    8. Daphne Chen & Jake Zhao, 2017. "The Impact of Personal Bankruptcy on Labor Supply Decisions," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 26, pages 40-61, October.
    9. Thomas Hintermaier & Winfried Koeniger, 2016. "Debt Portfolios and Homestead Exemptions," American Economic Journal: Macroeconomics, American Economic Association, vol. 8(4), pages 103-141, October.
    10. J. Carter Braxton & Kyle Herkenhoff & Jonathan Rothbaum & Lawrence Schmidt, 2025. "Changing Income Risk across the US Skill Distribution: Evidence from a Generalized Kalman Filter," American Economic Review, American Economic Association, vol. 115(12), pages 4438-4475, December.
    11. Leonardo Martinez & Juan Hatchondo, 2017. "Credit Risk without Commitment," 2017 Meeting Papers 1326, Society for Economic Dynamics.
    12. Felicia Ionescu, 2011. "The Interplay Between Different Types of Unsecured Credit and Amplification of Consumer Default," 2011 Meeting Papers 912, Society for Economic Dynamics.
    13. Bulent Guler, 2015. "Innovations in Information Technology and the Mortgage Market," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(3), pages 456-483, July.
    14. Felicia Ionescu & Marius Ionescu, 2014. "The Interplay Between Student Loans and Credit Card Debt: Implications for Default in the Great Recession," Finance and Economics Discussion Series 2014-14, Board of Governors of the Federal Reserve System (U.S.).
    15. Carlos Hatchondo, Juan & Martinez, Leonardo & Sánchez, Juan M., 2015. "Mortgage defaults," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 173-190.
      • Juan Carlos Hatchondo & Leonardo Martinez & Juan M. Sanchez, 2011. "Mortgage defaults," Working Paper 11-05, Federal Reserve Bank of Richmond.
      • Mr. Leonardo Martinez & Juan Carlos Hatchondo & Mr. Juan M. Sanchez, 2012. "Mortgage Defaults," IMF Working Papers 2012/026, International Monetary Fund.
      • Juan Carlos Hatchondo & Leonardo Martinez & Juan M. Sanchez, 2011. "Mortgage defaults," Working Papers 2011-019, Federal Reserve Bank of St. Louis.
      • Juan Carlos Hatchondo & Leonardo Martinez & Juan M. Sanchez, 2015. "Mortgage Defaults," CAEPR Working Papers 2015-011, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    16. Juan M. Sánchez, 2018. "The Information Technology Revolution And The Unsecured Credit Market," Economic Inquiry, Western Economic Association International, vol. 56(2), pages 914-930, April.
    17. Dean Corbae & Andrew Glover, 2025. "Employer Credit Checks: Poverty Traps Versus Matching Efficiency," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 92(3), pages 1661-1698.
    18. Kyle Dempsey & Felicia Ionescu, 2019. "Lending Standards and Consumption Insurance over the Business Cycle," 2019 Meeting Papers 1428, Society for Economic Dynamics.
    19. Jeanne Commault, 2025. "Heterogeneity in MPC Beyond Liquidity Constraints: The Role of Permanent Earnings," Working Papers hal-03870685, HAL.
    20. Xavier Mateos-Planas & Giulio Seccia, 2014. "Consumer default with complete markets: default-based pricing and finite punishment," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 56(3), pages 549-583, August.

    More about this item

    Keywords

    ;
    ;
    ;
    ;
    ;

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedlwp:101999. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Scott St. Louis (email available below). General contact details of provider: https://edirc.repec.org/data/frbslus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.