Personal bankruptcy and consumption smoothing

The welfare effects of bankruptcy legislation are not correctly understood. Policymakers and the general public think, for the most part, that laws that protect borrowers in the event of default are beneficial to consumers. In practice, however, those laws have negative effects on the households that need credit most — and, ironically, those whom the legislation was intended to protect.

Traditionally, Chapter 7 has been the most popular type of bankruptcy filing. Under that section of the Bankruptcy Code, a filer relinquishes her assets, minus a certain exempted amount, and in return is discharged from her unsecured debt (credit card debt, personal loans, student loans, etc.).

State law sets those exempted amounts. In Illinois, for instance, exemptions are: $7,500 for home equity, $1,200 for motor vehicles, $750 for tools of the trade, and $2,000 for any other generic property. So suppose that you file for bankruptcy in the “Land of Lincoln,” and that you have $20,000 worth of home equity, and a car with a market value of $600. Then you can sell the house and keep $7,500 of the proceeds, and sell your car and keep the $600 (since that’s below the $1,200 limit).

Since 1978, with the passage of the Bankruptcy Reform Act (BRA), there’s also a federal exemption. Some states allow filers to choose between the state and the federal amounts. Obviously, if given the opportunity, filers use whichever is highest.

There is an enormous disparity of bankruptcy exemptions across states, even after accounting for the existence of the federal limits. For example, in 2006 the states of Texas, Florida, Oklahoma, Iowa, Kansas, South Dakota, and the District of Columbia, all allowed for an unlimited homestead exemption. In the states of Ohio and Virginia, at the other extreme, the limit is set at $5,000 (and those states don’t allow for the application of the federal exemption). The map below shows the maximum exemption that a married homeowner could claim in 2003, after combining homestead and non-homestead amounts, and taking the highest of the state and federal limit (where the federal limit is available). The limits also vary over time, although high-exemption states tend to remain the same over the years.

Bankruptcy exemptions under Chapter 7 of the Bankruptcy Code
(in 2003, for a home owner)
Click to enlarge

The amount of the exemption provides insurance for the debtor’s consumption. Suppose that a debtor suffers a setback, such as illness or unemployment, and that she is forced to default on her credit card debt and student loans. In the absence of any exemption, creditors would take a blanket security interest in all of the debtor’s possessions. The existence of an exemption means that she is left with at least a small amount of assets after filing for bankruptcy. Legislators see it as a way to provide a “fresh start.” An alternative view is that a certain amount of assets, and hence consumption, are insured against negative events.

On the other side of the coin, lenders are hurt by this form of consumer protection. Higher exemptions reduce the payments received by the lender in the event of default, and increase the probability of bankruptcy, since the borrower’s punishment for doing so becomes smaller. Creditors rationally respond to higher exemptions by raising interest rates and rationing credit. This rationing may take the form of fewer households with access to debt, smaller loans, or both. Fewer and smaller loans reduce the amount of consumption that households can finance with debt in times of low income.

In theory, then, bankruptcy exemptions have an ambiguous effect on consumption smoothing. Higher exemptions allow bankrupt households to keep more assets; but those same higher exemptions reduce the supply of credit. It is, therefore, an empirical matter whether higher limits enhance or detract from the role of debt as a consumption insurance mechanism.

To answer that question, I put together data on consumption and lay-offs of American households (from the Panel Study of Income Dynamics), as well as bankruptcy exemptions, for as many years as I could get consistent data for. (In practice, that is 1976 through 2003, with the exception of 1994-1997.) The idea is to estimate by how much a family’s consumption is reduced when its main income earner gets laid off, and see how much the hit to consumption changes with the bankruptcy exemption.

As a warm-up and point of reference, I estimate that, without taking into account the exemptions, a household whose breadwinner gets laid off reduces its consumption by five to six percent. Once I include bankruptcy laws in the econometric analysis, I find that households that live in states with unlimited exemptions reduce their consumption by 16 to 18 percent. Households in the top third of the distribution of (limited) exemptions reduce their consumption by nine to ten percent. For households with lower exemptions the effect of unemployment on consumption is low and statistically insignificant. (See chart.)

Click to enlarge

My interpretation of the results is that consumer debt is an important mechanism of consumption insurance. People use loans and credit card debt not only to finance big-ticket items, but also to make ends meet when disaster strikes. Legislation that makes it harder to obtain debt, such as bankruptcy exemptions or interest rate caps, ends up punishing the weakest: people with low wealth, who could make the most use of credit as an insurance device.


Don’t get me wrong: this is not a call to eliminate bankruptcy exemptions. There is a place for them as a means to provide safety to people who have been struck by unexpected events. A zero-exemption policy would probably expand credit supply — at the cost of leaving thousands of families destitute and without a chance to recover. But exorbitant homestead exemptions go way beyond providing a chance for a “fresh start.” Likewise, there’s no reason why people should be allowed to keep $60,000 worth of personal property, as they can do in Texas.

Surely, medical expenses can easily run into the hundreds of thousands of dollars. But that’s a reason to reform health insurance. Limiting the enforceability of credit contracts is a bad way to lay out safety nets.

This post was based on my own research. The write-up of the paper is still in the making. It will be available on my website by January 28. In the meantime, you can have a look at the slides I prepared for a presentation this Friday.

Technorati tags: economics, personal bankruptcy, consumption, bankruptcy exemption, consumption smoothing

The ugly consequences of consumer protection

Millions of homeowners won’t be able to make their mortgage payments in the next five years, leading to a surge in defaults and foreclosures. It all started with the home-buying frenzy of 2003-2006. Many borrowers didn’t understand the contracts they were signing. Many others did know what they were doing, but thought that refinancing would always be an option. Congress now works on legislation that will let more Americans keep their homes – at the expense of increasing the cost of borrowing in the future and reducing the amount of credit available.

Four congressmen have introduced bills that would amend Chapter 13 of the Bankruptcy Code. All four share two features. First, they allow courts to cap the debtor’s obligations at the market value of the property. This provision is relevant because home prices have fallen since 2006, making it likely that in the near future the debts of a bankrupt consumer are worth more than his house. It is also relevant for homeowners who initially follow a “negative amortization” scheme, under which mortgage payments are less than accrued interest, so total debt increases over time, possibly above the value of the property.

The second feature allows courts to set interest rates below those in the original loan contracts – current legislation prohibits the modification of a mortgage on the principal residence (§1322(b)(2) of Chapter 13).

The bills therefore potentially reduce the obligations of homeowners who file for Chapter 13. This increases the interest rate that borrowers are willing to pay on their mortgages, as well as the fraction of borrowers who file for bankruptcy – because the legislation protects them from foreclosure. From the lenders’ point of view, receivables decrease and the proportion of loans in default rises, both of which increase the interest rate that lenders are willing to offer for any given loan – because the expected losses from defaults increase. Both the demand and the supply shifts make the cost of mortgages go up – their combination makes them go up even more. (A wealth of academic research, most of it by professor Michelle White, supports my analysis. Read this paper and this one.)

The New York Times says that it doesn’t make sense to claim that increasing consumers’ protection raises borrowers’ cost. Lenders – the newspaper correctly points out – would rather deal with a bankruptcy filing than with a foreclosure, because the losses from the latter are larger.

The NYT’s error comes from two places. First, it confounds the effects of the legislation on the amount of losses from defaults with its effects on the probability of default. The bills increase the fraction of borrowers that try a debt renegotiation (file for Chapter 13 bankruptcy) instead of letting the bank foreclose. This reduces the cost of default for the bank, because a foreclosure is costlier than a debt renegotiation. On the other hand, the proposed legislation increases the fraction of borrowers that default -- and banks always incur a loss when a mortgage goes bad. Total losses – the product of the average loss from default times the fraction of bad loans – may thus well increase.

The second error of the NYT is to confuse the banks’ losses from bankruptcy under the current legislation with those under the new one. Under the 2005 Bankruptcy Code, banks almost always incur a bigger loss from a foreclosure than from a debt renegotiation. If the proposed amendments lower the banks’ receivables from bankrupt consumers, it’s not clear that lenders prefer renegotiation to foreclosure any more.

And what’s wrong with foreclosures anyway?

Consumers with weak credit histories would be affected the most, because they are the most likely to default. Lenders would turn down applicants with the worst credit scores – the same ones who were getting risky mortgages not long ago, no questions asked. People shouldn't get loans they can’t afford in the first place, and Congress should certainly not provide the incentives to do so.

The proposed legislation encourages consumers to file for bankruptcy under Chapter 13. Under that section of the Code, the borrower proposes a repayment plan that pays off the arrears over five years. If the court approves of (i.e. confirms) the plan, the borrower gets to keep the house. Confirmation of the plan depends on whether the borrower has enough disposable income – after all expected expenses – to pay off her debt.

Chapter 13 is the right option for people who fall behind their payments because of a temporary financial setback. But everyone else would be better off filing for Chapter 7. Under this alternative, the borrower forfeits some home equity to pay off her debt. In many cases, banks foreclose and the mortgagees become renters. These are people who have neither enough equity to pay off their arrears nor enough income to afford the mortgage.

The sensible thing to do

So what should Congress rather do? First of all, settle on a bankruptcy text and stick to it. The latest overhaul of the Bankruptcy Code took place as recently as 2005. Regulatory uncertainty inhibits lenders.

Second, lawmakers should give the two parties in a contract more leeway to renegotiate their loans. I applaud the congressmen’s proposals to allow modifications of the terms of the original loans, but they could go further. For example, they should allow converting 30-year adjustable rate mortgages (ARM) into 50-year fixed-rate mortgages.

The modifications could be proposed by the court, but then they should require consent from both mortgagee and lender. Two of the bills under consideration -- the ones by Senator Durbin (D-IL) and Representative Miller (D-NC) -- allow the bankruptcy court to modify the terms of the loan without restrictions, not even agreement in writing between the parties. Giving such power to the court has at least two effects. First, it tilts the balance towards the consumer -- in a free negotiation between mortgagee and bank, the latter would have the upper hand. Second, it increases the uncertainty of the bank's payoffs. Both effects reduce the supply of debt.

Congress should also modify the Code so that the least creditworthy borrowers have more incentives to file for Chapter 7 instead of Chapter 13.

Going beyond the current problems, better ex ante disclosure would be welcome. Most borrowers don’t understand 95 percent of the legal mumbo jumbo on their contracts. Mortgage applicants should be given worst-case scenario simulations of their monthly payments.

We could also set a floor on “teaser” introductory mortgage payments. Hybrid ARM's, for example, start out carrying a low, fixed rate. Two to five years later the interest rate resets to a higher, floating level. Option ARM's let the borrower initially make interest-only payments, minimum payments (often below the interest accrued), or fixed, low-rate payments, also until the first reset date. Any of those schemes make mortgages affordable, but only for the first few years. Legislation could provide, for example, that initial monthly payments never be below 80 percent of the expected payment after the first reset date.

So here's a sensible policy on consumer protection: NO to protecting Americans who want to keep homes they can't afford; YES to protecting them from getting unaffordable mortgages in the first place.

Technorati tags:
economics, bankruptcy, mortgage, mortgage crisis, real estate

Apparent "oops"

In my previous post I wrote "For borrowers in a pinch, mortgage payments probably take priority over credit card payments." Somebody called my attention to a study by Experian that seems to contradict my assertion. The credit-reporting agency finds that people with bad credit are less likely to skip a credit card payment than a mortgage payment. I couldn't find the study online, but here's a review.

But if you interpret the finding by Experian carefully, you'll see that the contradiction is only apparent, and I already touched on this argument in my post. Borrowers have the option to make small payments on their credit card debt. Because minimum payments are minute and late payment fees hefty, borrowers have the incentive and the ability to "not skip" card payments. In a way, however, making just the minimum payment is skipping your card payment. Mortgage amortization schemes, on the other hand, are seldom flexible, so people either make their monthly payments in full, or not at all.

The other sub-prime debt

Pop quiz: What am I? Banks give me to people with weak credit histories. I get securitized off the lender’s balance sheet. And I carry a variable interest rate. Nope, I’m not a sub-prime mortgage.

Credit card companies wrote off 4.58 percent of distressed debt balances in the first half of 2007, 30 percent more than in the same part of 2006. Outstanding revolving debt –the lion’s share of which consists of credit card debt- amounted to about $915 billion at the end of August. With a default rate of, say, 4.5 percent, we’re talking about $41.2 billion worth of non-performing credit lines. Could credit card debt bring about another liquidity crisis?

The current level of credit card balances in distress is relatively small. The default rate for sub-prime mortgages is about 20 percent, and aggregate outstanding balances of that type of loans come to about $1.2 trillion. The level of non-performing sub-prime mortgage balances is thus $240 billion, or about 6 times as large as its credit card counterpart. This is the end of the good news.

The relative low rate of credit card defaults is a bit misleading. Mortgages are classified as bad as soon as the borrower is late for a few monthly payments in a row. On the other hand, the 4.58 percent of bad revolving credit I mentioned above does not include the balances that borrowers roll over indefinitely by making only the minimum payment. Many of those balances will eventually be in default, but that may take months or years.


Moreover, the fortunes of credit card balances and mortgages may go hand in hand. For borrowers in a pinch, mortgage payments probably take priority over credit card payments. Debtors can always postpone the latter by rolling them over. If enough people do that, cash flows from credit card balances will fall too far below projections and a liquidity problem may ensue. The investors who buy securitized pools of receivables will have a problem too as the value of their bonds drops.

Credit card debt is also more or less linked to the value of real estate. Part of the reason why the sub-prime mortgage market got out of hand is that the size of loans was implicitly linked not to the current value of housing but to its expected future value -both borrowers and lenders were expecting the price of housing to go up, and were planning to refinance the loans before higher interest rates kicked in. Alas, the real estate soufflé collapsed and borrowers got stranded with outsized mortgages that they could neither pay off nor roll over.

Likewise, credit card issuers probably extended generous credit lines to homeowners in the expectation that, if need be, borrowers would tap into their home equity to finance their card balances. In the face of falling real estate prices, credit card issuers will become stingier.

The Wall Street Journal reported in August that some lenders are tightening credit standards for auto loans, credit cards and personal loans. “We used to offer frequent, automatic line increases, and now, we’ve pulled back a little bit,” Barbara Johnson of the USAA Federal Savings Bank told the Journal. The growth of revolving consumer debt has stopped accelerating since the spring (see chart, from the same article in the WSJ).


By some accounts, the economy is tiptoeing around a recession. Reining in credit would bring consumption growth to a halt, as well as Gross Domestic Product to a large extent. Is there anything we can do?

The simplest thing that state and federal governments should do is lower or eliminate bankruptcy limits. The bankruptcy limit is the amount of wealth that a borrower is allowed to keep when she files for bankruptcy. More than one academic study (see this one and this one, for example) show that higher bankruptcy limits make lenders decrease the amount of credit they give, especially to low-wealth borrowers. And those are precisely the debtors who are most likely to be caught in sub-prime debt with adjustable rates. Lower limits would increase the amount of credit available, lower its cost, and foster responsible borrowing.

Here’s a more difficult quiz: who is going to convince the government and consumer associations that less consumer protection is better for borrowers?

How likely is a credit card meltdown? Could it set off a recession? Who is to blame for the high default rates in the sub-prime and credit card markets? Leave your answers in the comments.

Technorati tags:
economics, credit card debt, subprime mortgages, revolving debt, mortgage crisis