Financial innovations are a common explanation for the rise in credit card debt and bankruptcies. To evaluate this story, the authors develop a simple model that incorporates two key frictions: asymmetric information about borrowers’ risk of default and a fixed cost of developing each contract lenders offer.

The authors propose a parsimonious model with adverse selection where delinquency, renegotiation, and bankruptcy all occur in equilibrium as a result of a simple screening mechanism.