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What Drives Household Financial Distress? The Role of Earnings Misperceptions

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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. Sánchez & 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
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    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.
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    Keywords

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    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

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