What happens when an academic researcher becomes a policymaker? Recently, President Anthony Santomero shared some thoughts on this topic with members for the Downtown Economists Club in New York City. In particular, he talked about several conundrums he's encountered since moving from the academy to the central bank. We've reprinted his speech "The Complexities of Monetary Policy" in this issue of the Business ReviewConsumer credit

Anthony M. Santomero

English

Research Papers in Economics

  Business Review  Q3 2001   1 www.phil.frb.org
Anthony M. Santomero, President,
Federal Reserve Bank of Philadelphia
BY ANTHONY M. SANTOMERO
I
Perspectives on Research Issues
In Consumer Behavior
Based on the speech President Santomero delivered to the Conference on Consumer Transactions and Credit, March 22-23, 2001
Generally, economic forums
have tended to ignore the broader issues
in consumer credit, preferring to focus
on the valuation of more standard
corporate financial claims.  When the
consumer is discussed, it is typically
consumer consumption and savings
decisions that are studied and analyzed.
This neglect of consumer credit seems
remarkable, given that debt owed by
households represents over 25 percent of
total credit market debt outstanding;
that consumer credit, excluding
mortgages, makes up over 10 percent of
commercial bank credit; and that the
outstanding volume of consumer credit,
including mortgages, exceeds the
volume of U.S. government debt.
There is no single reason for
the omission of consumer financial
assets from the research agenda of the
academic community, but I can offer a
few rationalizations. The first is that
macroeconomists – even those who
specialize in monetary theory – have
had little interest in the detailed
behavior of asset choice at the consumer
level. They prefer to concentrate on
consumption theory and the associated
n this issue’s Third Dimension, President
Santomero discusses the subject of con-
sumer financial assets and its omission
from the research agenda of the academic
community. He also presents a list of issues that need
to be studied to further our understanding of this
rapidly growing part of the financial landscape.
empirical tests of these theories, rather
than analyze the allocation of savings
and wealth dynamics. Second, special-
ists in finance have tended to concen-
trate on firm-level behavior because
firms are viewed as more rational players
than consumers and firms’ behavior is of
more economic value.  Asset sizes are
bigger; representative agents are more
easily modeled; and market discipline
seems to force the decision maker closer
to the optimal economic choice.
Only recently has this begun to
change.  With the emergence of the
asset-based security markets, financial
theorists and empiricists have begun to
examine the behavior of financial assets
that have resulted from the aggregation
of consumer debt. This is most obvious
in the mortgage market, where the
emergence of various types of
securitized mortgage instruments
fostered research on their valuation and
time-series dynamics. This interest has
recently been expanded into other types
of asset-based securities, such as
CARDs, CARs, and CLOs. In each
case, to analyze the underlying asset,
the researcher has to examine optimal
decisions of a representative agent and
the impact of aggregating individual
claims on instrument behavior.
Another development that has
helped spur interest in the micro-
economics of consumer financial
decisions is the intellectual shift that has
taken place in macroeconomics toward
a well-specified microeconomic
foundation for macroeconomic theories.
It is now acknowledged that to under-
stand consumption and savings decisions
on the macro level, we must model the
behavior of individual agents. And this
interest in microfoundations has been
accompanied by the development of
new data sets, such as the Federal
Reserve’s triennial Survey of Consumer
Finances, the Consumer Expenditure
Survey, and the Panel Study of Income
Dynamics, that present information at a
disaggregated level to allow for testing of
these micro theories.
Yet, despite recent interest in
consumer debt instruments, there is2   Q3 2001 Business Review www.phil.frb.org
much work to be done. This conference
is just the first of many efforts that we at
the Federal Reserve Bank of Philadel-
phia plan to make to advance the con-
sumer credit research agenda. We hope
to shed light on the state of research and
to spotlight areas of potential future
contributions.
In my comments I will try to
put the current literature on consumer
finance into context and explain why
consumer credit should have a place in
academic research between standard
macro modeling and the valuation of
standard financial assets. I will also try to
set out a list of issues that must be
studied to further our knowledge and
understanding of one part of the
financial landscape that continues to
grow at double-digit rates.
CONSUMPTION THEORY AND
THE RESEARCH QUESTIONS
IN MACROECONOMICS
I’ll begin with the standard
view of consumer choice presented in
macroeconomic theory.  From the
traditions of classical macro theory to
the work of Keynes, standard macroeco-
nomic models involved the representa-
tive economic agent who maximizes an
expected utility function that summa-
rizes well-behaved preferences, in a
world with positive marginal productiv-
ity and a fixed discount rate.  The
agent’s choice is constrained by a
multiperiod budget or endowment
sequence. Nearly all of us as graduate
students could write down this problem’s
multiperiod first-order conditions and
the appropriate transversality conditions
associated with optimal behavior. The
representative agent maximizes ex-
pected utility by equating marginal
utility across periods, subject only to a
borrowing and lending condition that
bounds the problem. Such models yield
paths of consumption and savings over
time that achieve maximum expected
utility subject only to the aggregate
interest rate, which itself can be solved
for simultaneously in a general equilib-
rium setting.
Once consumption behavior
had been characterized, economists
turned to characterizing savings
behavior in a world where the agent’s
life span is uncertain. Here, the
profession’s attention centered on
models that featured various types of
risk aversion and their impact on both
wealth accumulation and decum-
ulation.  This work proved central to
understanding the role of pensions on
intertemporal consumption behavior and
remains an important part of our
understanding of life-cycle savings
behavior. The credit market imperfec-
tions leading to liquidity constraints and
the significance of the bequest motive in
driving savings decisions have been
studied.
On the public policy stage the
research offers important insights into
the debate over both Social Security
and the entire area of private pension
programs. Others have also used it to
relegated to macrofinance theorists, who
began where the monetary theorists left
off. In these macrofinance models the
representative consumer maximizes his
expected utility, which is represented by
a concave function of exogenously
given wealth.  The models are usually
single period. Multiperiod considerations
are sometimes addressed with some
intertemporal endogeneity, leading to
some of the rich models of asset choice
in a multiperiod consumption frame-
work.
Still, we are a long way from a
sophisticated model of households’
ultimately joint decisions about how
much to save, how to divide savings
among different types of assets, how
much to borrow, and what types of debt
to incur. The characteristics of the
specific assets are typically not modeled
beyond the first two moments of their
underlying distributions. Uncertainty is
characterized only in this most general
way, usually by reference to normality
and stationarity. Anything more specific
understand the effects of the private
sector’s evolution to defined contribu-
tion plans and their associated actuarial
risks to covered workers. Some have
even discussed and modeled the role of
inflation uncertainty in this multiperiod
asset-choice problem.
However, few researchers
studying this problem attempted to
explain the specific portfolio of risky
assets that should be selected by
economic agents over their life cycle or
the appropriate vehicles to use to
accumulate debt during periods of
excess consumption.  These issues were
is relegated to applied finance and its
interest in state-dependent payoffs and
their effect on valuation and time-series
dynamics.
In short, the detailed payoff
patterns associated with the debt
instruments issued by the agent were
entirely too mundane for the theorists’
consideration. So, a student of consumer
credit and consumer choice was sent to
the applied finance literature for the
modeling and valuation of real con-
sumer debt instruments.
To some extent, the underde-
velopment of this line of research
Today an increasing share of household
wealth is held in financial assets, and a smaller
share is invested in the household’s primary
residence.  Business Review  Q3 2001   3 www.phil.frb.org
probably reflects the relative simplicity of
most U.S. households’ portfolios before
the 1990s. But an explosive period of
financial innovation in the last two
decades and the rapid growth in
consumers’ wealth in the 1990s have
introduced many more households to
many more financial options. For
example, today an increasing share of
household wealth is held in financial
assets, and a smaller share is invested in
the household’s primary residence.
More households participate in equity
markets, with equity making up over
half of households’ financial holdings.
These changes in the structure
of household portfolios can be attributed
to the stock market boom of the 1990s,
the relatively slower growth in housing
prices during the same period, a highly
competitive mutual fund industry, and
demographic factors. While the shift in
household portfolios in the 1990s has
been dramatic, what might be more
surprising is that the shift hasn’t been
even larger.  Households still seemingly
prefer relatively simple and safe
portfolios.
Exactly why this is the case,
however, is unclear, for as noted above
little economic research has centered on
consumer asset choice. Still less has
investigated the characteristics unique
to each financial product available to
smooth consumption over a multiperiod
uncertain horizon. To learn more about
these issues the researcher is directed to
the field of finance.
FINANCE AND THE VALUE OF
CONSUMER FINANCIAL CLAIMS
Interestingly, applied finance is
up to the task of modeling consumer
assets. Its general theoretical construct
of stochastic behavior, using expected
present value in a state-contingent
framework, is well suited for the
underlying uncertainty associated with
consumer credit. With the rise of
discrete-time models and binomial tree
modeling techniques, the standard
financial valuation techniques can be
applied to consumer debt instruments
characterized by time-specific default
probabilities and multiperiod cash-flow
uncertainty.
But, as indicated earlier,
consumer assets do tend to have small
market values, and the field was
traditionally viewed as extraordinarily
“unsexy.” As a result, the new tech-
niques being applied to analyze
corporate finance instruments have only
rarely been applied to consumer debt,
and there has been little interest
expressed by the research community in
understanding the nuances of the
individual consumer markets. As a
result, the characteristics and time-series
price dynamics associated with different
types of consumer debt instruments
have never been seriously investigated.
This void in the literature is
important. Consumer debt of various
types exceeds total U.S. Treasury debt,
and it is likely to be the only liquid
market of the early 21st century. The
economics and finance profession has
been slow in concentrating on both the
theoretical and empirical issues sur-
rounding these instruments – with one
exception, the mortgage market.
Residential mortgages
currently account for the majority of
consumer debt, with an outstanding
value of over $5 trillion, and represent
the only area of consumer debt that has
received significant attention. Fostered
by the development of various types of
mortgage pass-through instruments, a
large literature developed about their
valuation.  The aggregation of indi-
vidual instruments added scale but also
complexity. Prepayment risk, default
modeling, and state-dependent cash
flows led to the development of a rich
literature.
Interestingly this literature has
not crossed over to other areas of
consumer debt, even as the percentage
of consumer debt represented by
mortgage assets continues to decline. In
fact, there is very little in the literature
on various types of asset-backed
securities, in spite of their growing
importance, and we know little about
the difference in yields across various
types of asset-backed securities.
ADDRESSING THE VOID
IN THE LITERATURE
How can this seemingly
important void in the literature be
addressed? The research plan is fairly
straightforward if one proceeds from first
principles. The securitization vehicle
can be understood as the aggregation of
individual economic decisions made by
a series of representative agents.  Using
consumption theory in a stochastic
environment, one could model cash-
flow dynamics, including default and
prepayment variation. Present value
valuation techniques could then be
applied to the underlying aggregation,
subject to the subtle but important
covenant constraints that differentiate
each instrument.
Collateral, recourse, and
seniority become key elements in the
distinction between repayment timing
and ultimate default probabilities
associated with different consumer debt
types. Issues of adverse selection,
switching costs, borrower heterogeneity,
and liquidity constraints also come into
play, making the pricing of consumer
debt instruments, such as credit cards,
not a trivial exercise. However, with
sufficient care, the techniques applied
to mortgage debt, which were derived
from multiperiod consumption behavior,
could be applied to CARs, CARDs, and
CLOs. Price dynamics would follow
directly.
Any such effort would
immerse the research in the public
policy debates that dictate terms and
conditions. Just as “due on sale” clauses
substantially altered mortgage dynamics
in the 1970s, and regulations surround-
ing adjustable rate mortgages altered the
valuation of these instruments substan-4   Q3 2001 Business Review www.phil.frb.org
B R
tially, consumer protection policies have
substantial implications for consumer
credit instruments. For example,
bankruptcy regulation alters repayment
probability and valuation, as do access to
collateral, privacy rules, and public
disclosure regulation. All of these
policies alter credit risks and credit
spreads.
The public debate surrounding
these consumer protection attributes
would be enhanced by both the
estimation and discussion of the implied
costs of such regulations. The beneficial
effect of the consumer rights acquired
through such legislation must be
weighed against the implied cost to the
lender and the derived increase in
credit spreads to the entire consumer
class.
THE UNFINISHED AGENDA
There is much to be gained
from the application of standard
economics and finance to the valuation
of consumer debt instruments. By
modeling the uncertain cash flows and
creditor rights associated with different
debt instruments, we can obtain proper
pricing and risk assessment. This will
also facilitate arbitrage across markets
and reaffirm the law of one price across
various types of instruments subject to
similar uncertainty.
Such research will also
illuminate the current policy debate
regarding debtor versus creditor rights at
the basis of various types of consumer
right proposals. Valuation techniques
can derive the costs of such legislation
against which the benefits can be
contrasted.
THE FEDERAL RESERVE BANK
OF PHILADELPHIA’S ROLE
This is a rich agenda that all of
us share as researchers. And the Fed has
a unique role to play, as both a center of
financial knowledge and a supporter of
various types of economic research. The
Fed has traditionally devoted significant
resources to banking and financial
market research, at a number of the
Reserve Banks.
We here in Philadelphia have a
particular interest in this area. The
Third District is the home of the credit
card industry, with approximately 40
percent of all consumer credit cards
emanating from the state of Delaware.
To underscore our interest in
this area and to address what we see as a
mandate to understand this industry, we
have established a Payment Cards
Center within the Bank to investigate
issues central to this part of the financial
services sector. The value of various
types of consumer debt instruments and
their relative values under different
the study of consumer transactions
media finds a historical precedent in the
traditional theory of money demand.
The traditional theories of money
demand — for example, the Baumol-
Tobin inventory model — weren’t
specific about the medium used for
transactions. And, as we know, financial
innovations and deregulation effectively
destroyed the empirical relationship
between money and income.
We need to develop new
theories if we hope to explain the
economic rationale for and the impact
of various transactions media, like credit
cards, debit cards, and smart cards,
which are much more complicated than
our traditional characterization of
money. Debit cards and smart cards are
relatively new developments, but there
is much we still do not know about
credit cards, which have been around
public policies, including but not limited
to bankruptcy rights, collateral access,
and various types of consumer protec-
tion legislation, are clearly crucial issues,
and they definitely belong on the
Payment Cards Center’s research
agenda.
Payments issues, as well, are on
the Center’s agenda. Clearly these too
are central to understanding the
payment cards industry and the
evolving financial services sector.  Just as
one can tie the study of consumer debt
instruments to a traditional literature,
for years: why do so many consumers,
even wealthy ones, borrow at the high
rates on credit cards? Given the large
number of credit card issuers, why are
credit card rates so high and sticky?
Why was there a large increase in
delinquencies and bankruptcies when
economic conditions were so favorable?
A well-developed theoretical framework
for solving these and related puzzles is a
pressing task, which promises an
interesting and rich research agenda.
By modeling the uncertain cash flows and
creditor rights associated with different debt
instruments, we can obtain proper pricing and
risk assessment.

Perspectives on research issues in consumer behavior

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Perspectives on research issues in consumer behavior

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