Liquidity Constraints and Imperfect Information in Subprime Lending

We present new evidence on consumer liquidity constraints and the credit market conditions that might give rise to them. We analyze unique data from a large auto sales company serving the subprime market. Short-term liquidity appears to be a key driver of consumer behavior. Demand increases sharply during tax rebate season and purchases are highly sensitive to down-payment requirements. Lenders also face substantial informational problems. Default rates rise significantly with loan size, providing a rationale for loan caps, and higher-risk borrowers demand larger loans. This adverse selection is mitigated, however, by risk-based pricing.