Finite-Life, Private-Information Theory of Unsecured Debt

Abstract

We propose a theory of unsecured debt that is based on the existence of private information about a person's type and on the fact that some debtors have the incentive to forego bankruptcy in order to signal their type. The theory formalizes the idea that the type of a person is relevant to trading partners in many exchange situations and by resisting opportunistic behavior in one exchange context, a person may signal valuable information about his type to trading partners in other exchange contexts. In the model, by resisting opportunistic behavior in the credit market borrowers can signal their type to the insurance market. The model is consistent with the observation that insurers use credit scores to predict the likelihood of a person filing insurance claims.Adverse Selection, Insurance, Credit Scores, Default Risk