Overcoming information asymmetries in low-income lending: lessons from the 'Working Wheels' program.

• Author: Holmes, Jessica

1. Introduction

   "Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The great difficulty is to get that little."

   Adam Smith, Wealth of Nations, 1776

   Welfare reform in the 1990s marked an important transition from income maintenance programs toward welfare-to-work policies. The crucial role of transportation is often overlooked, yet without access to reliable transportation, the welfare-to-work transition is nearly impossible. In fact, recent evaluations of the welfare-to-work reforms have cited lack of transportation as a major barrier to job search, employment, self-sufficiency, and the transition off welfare (Danziger et al. 1999; Goldberg 2001; Ong 2002; Cervero, Sandival, and Landis 2003). In particular, lack of access to an automobile has been associated with a difficult transition from welfare to financial autonomy. Car ownership reduces commuting time, widens the geographic area for job search, improves job attendance, and expands childcare options; not surprisingly, it is positively associated with the probability of being employed, hours worked, and earnings among the poor (Polit and O'Hara 1989; Holzer, Ihlanfeldt, and Sjoquist 1994; Ong 1996, 2002; O'Regan and Quigley 1997; Danziger et al. 1999; Raphael and Rice 2002). The Raphael and Rice (2002) and Ong (2002) studies are particularly important because they both account for the dual causality of employment and car ownership and still find a strong effect of car ownership on labor supply. Another recent study by Lucas and Nicholson (2003) finds that vehicle acquisition through a car "donation-and-sales" program in Vermont has significant positive effects on both the level of earned income and the probability of paid employment. Yet despite the proven benefits of car ownership, Murakami and Young (1997) find that 36% of low-income single parents have no vehicle, compared to only 4% of middle- and upper-income households.

   Access to a car is particularly important in rural and selected suburban areas, where public transportation, car-pooling, and other ride share opportunities are not well established. (1) Nearly 40% of rural counties in the United States have no public transportation (Rucker 1994); thus, many rural employers expect or require that employees have access to reliable private transportation. However, many welfare recipients and other low-income individuals, especially those who are jobless, lack the savings or income necessary to purchase a car. Even those with enough income or savings to purchase a car still face high registration, insurance, and maintenance costs; Reichart (1998) estimates that a family earning minimum wage may spend as much as 14 percent of its income on annual car ownership costs (excluding purchase price and major repairs).

   It is clear that income cannot be attained without transportation, and transportation cannot be attained without income. This cycle is intensified when one considers that most welfare-to-work recipients are subject to strict work or job training mandates that often require transportation. In some states, recipients of "Temporary Assistance for Needy Families" (TANF) who cannot secure mandated employment or job training are penalized through either partial or total loss of welfare benefits (Goldberg 2001).

   Many states and counties, recognizing the importance of access to transportation in the welfare-to-work transition, use TANF and state maintenance-of-effort (MOE) funds to assist low-income families purchase, insure, or repair cars. For example, Kansas, Nebraska, Pennsylvania, and Florida provide grants directly to low-income families for car purchases; California, Virginia, and Ohio donate or resell government surplus vehicles; and Arizona, Georgia, Vermont, Maine, Michigan, New York, Tennessee, and Wisconsin fund programs that provide affordable car loans (Reichert 1998; Goldberg 2001; National Economic Development and Law Center 2004).

   Since 1998, Vermont's TANF funds have been used to provide automobile loans to low-income residents through the "Working Wheels" program of the Vermont Development Credit Union (VDCU), a nonprofit credit union that caters to traditionally "unlendable" clients. Very little is known about how welfare-to-work programs such as Working Wheels improve the access to credit for traditionally disenfranchised individuals. In this paper, we take advantage of unique microlevel data on Working Wheels loan applications and loan performance to explore how such programs can cost-effectively provide car loans to those who are unable to obtain affordable loans elsewhere (particularly low-income clients without documented credit histories). Specifically, by stratifying a large sample of Working Wheels loan applications by the presence of a credit score, we first test the hypothesis that a strong lender/borrower relationship ("relationship lending") can overcome the information asymmetry that would otherwise impede the flow of credit to those who are perceived as "unlendable." We then examine whether relationship lending can mitigate the risk of loan default among this high-risk population.

   Our results verify the importance of relationship lending, particularly among those without documented credit histories. In the presence of pronounced information asymmetries about credit history, our results justify a loan officer's increased trust in a client with whom the bank has had a stronger relationship; such clients, ceteris paribus, are less likely to default. We conclude that in the current climate of welfare reform, policymakers should consider progi-ams that encourage welfare recipients to establish and maintain relationships with financial institutions in order to facilitate access to affordable credit and to minimize the risk of loan default.

   The remainder of this paper is organized as follows. Section 2 provides a brief background and overview of the related literature, and Section 3 provides more detailed information on the VDCU and the Working Wheels program. Section 4 outlines our empirical strategy and describes the data. Section 5 presents the empirical results, and Section 6 concludes.

2. Background and Literature Review

   In a world of certainty and perfect information, low-income households might overcome the transportation barrier through the automobile credit market. However, an extensive theoretical literature confirms that asymmetric information between borrower and lender can lead to excess demand in traditional credit markets (Jaffee and Russell 1976; Stiglitz and Weiss 1981; Williamson 1987; Jaffee and Stiglitz 1990). Under conditions of asymmetric information, rationing by price may lead to adverse selection because rising interest rates increase the average "riskiness" of the borrower, thereby potentially increasing the probability of borrower default and reducing profit per dollar lent. Thus, a "bank-optimal" interest rate can emerge at a rate lower than is necessary to clear the market but above which expected profit per dollar lent falls. Not surprisingly, many poor households report an inability to secure an affordable car loan through traditional financial institutions, particularly because these institutions are often legally prohibited from raising interest rates above state-established ceilings. Empirical evidence verifies that low-income households are more likely to be credit rationed than their high-income counterparts (Attanasio, Goldberg, and Kyriazidon 2000). (2)

   Low-income households face costly consequences of this form of credit rationing. Those who are denied credit by mainstream financial institutions are often forced to rely on payday lending, title loans, rent-to-own, pawn-broking and tax refund anticipation loans with typical annualized interest rates over 100 percent (but often as high as 500 percent) and stiff pre-payment penalties (Caskey 2002; Barr 2004). Reliance on this largely unregulated alternative financial sector not only undermines the financial stability of the poor but also imposes negative externalities on the rest of society (Barr 2004).

   In order to distinguish borrowers with higher probabilities of repayment from potentially less capable borrowers, traditional lenders employ a number of screening devices to predict loan default. Recent improvements in methodology, computer power, and data access have enhanced the predictive power of credit scoring and thus increased the reliance on credit bureau scores as a tool to overcome many of the informational asymmetries in the credit market. (3) Some lenders rely almost exclusively on credit score to determine loan approval (Mester 1997). However, because low-income individuals may have difficulty establishing credit and therefore credit scores, they are more likely to be rationed out of the market. (4) In fact, "insufficient or no credit history" is a cited reason for loan denial at many traditional banks. Because credit score is increasingly relied on as a predictor of loan repayment, lenders must rely on other applicant characteristics when credit score is unavailable. In particular, the relationship between borrower and lender can reduce information asymmetries, lower the cost of financial capital, and thereby decrease the probability of being credit rationed (Ferrary 2003).

   Relatively little is known about the role of relationship lending in the consumer loan market (5) despite the fact that household borrowing constitutes a larger fraction of the overall loan market than business loans. (6) Using the Federal Reserve Board's Survey of Consumer Finances, Chakravarty and Scott (1999) show that both the length of the relationship with the lender and the number of asset accounts/loans with the creditor significantly decrease the likelihood that a consumer is credit-rationed. Using the same data, Chakravarty and Yilmazer (2004) find that the relationship between the borrower and lender affects the borrower's decision to apply...