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Cheaper credit, more bankruptcies
Personal bankruptcies in the United States have increased dramatically, rising from 1.4 per thousand working age population in 1970 to 8.5 in 2002. We use a heterogeneous agent life-cycle model with competitive financial intermediaries who can observe households' earnings, age and current asset holdings to evaluate several commonly offered explanations. We find that increased uncertainty (income shocks, expense uncertainty) cannot quantitatively account for the rise in bankruptcies. Instead, the rise in filings appears to mainly reflect changes in the credit market environment. We find that credit market innovations which cause a decrease in the transactions cost of lending and a decline in the cost of bankruptcy can largely accounting for the rise in consumer bankruptcy. We also argue that the abolition of usury laws and other legal changes are unimportant.
Here is the paper. Here are non-gated versions.
Posted by Tyler Cowen on September 7, 2007 at 06:41 AM in Economics | Permalink
Comments
You can argue that a low failure rate in anything is proof that not enough people are trying things. If no business ever failed, the implication is no business ever takes a risk, and the economy as a whole isn't performing as well as it could. Similarly, though many sub-prime borrowers who are now going through forclosure, there are many more who are enjoying the benefits their initial sub-prime gave them, and thriving in ways they wouldn't have otherwise.
To summarize, the problem isn't that bankruptcies are now too high. The problem was that in the past they were too low.
Posted by: pawnking at Sep 7, 2007 8:20:06 AM
Being a credit snob is not a one way street.
pawnking -- of course you have data on how many are enjoying the benefits of easier credit compared to how many are being bankrupt. Since this process is not complete how can you make that statement without any knowledge of how many will benefit and how many will be harmed?
Generally I agree with the point you are making, but I like to see some data before I evaluate a specific situation.
Posted by: spencer at Sep 7, 2007 9:05:45 AM
pawnking -- I'm not sure if someone *able* to make the mortgage payments on 10% interest loan is enjoying
much of a "benefit" to begin with :-P
Re: usury laws: Aren't they necessarily irrlevant as per the put-call parity theorem? (You linked a neat
paper a while back explaining all the ways to circumvent usury laws by equivalently expressing them
as option exchanges.)
Posted by: Person at Sep 7, 2007 9:17:26 AM
When my wife and I bought our first house together in the early 1980's the rate on our mortgage was 14.5%, 10% would have been a bargain.
Another factor, although I have no data to back this up, is the removal of the stigma of bankruptcy. As recently as the early 1990s a bankruptcy filing showing on a credit report was reason for decline for almost all types of consumer credit from a bank (I've worked in bank lending since 1978). With the rise of bankruptcies and risk based credit scoring models this paradigm has changed over the last decade and a half.
When I lived in Baltimore during the mid 1970s the local Merchant’s Association would have advertising placards placed on the side of the MTA busses that said “Bankruptcy—a 7 year mistake” (seven years being how long the credit reporting bureaus used to report filings). Now you see advertising from lenders saying “Past bankruptcy—No Problem!”
Posted by: Dave Richardson at Sep 7, 2007 12:28:54 PM
More rope = more hangings. Caveat emptor.
Posted by: anne at Sep 7, 2007 12:45:46 PM
How much of the "past bankruptcy -- no problem" attitude is the result of changes in the ways the primary lenders can resell loans? If I were getting a bunch more money up front at the risk of (maybe, but probably not) getting bitten down the line, that would be an attractive proposition. Much like the teaser rates on mortgages...
A true conservative would also point out that accepting higher risks is a good way to move product that would otherwise sit on the lot, thus increasing the current valuation of one's equity interest in a business.
Posted by: paul at Sep 7, 2007 1:06:59 PM
On what basis do you claim that prior bankruptcies were too low? Buying a house has historically been a form of long-term investing, and for many, their primary form. A failure had sever effects.
Anne has it exactly right.
Posted by: Nathan Zook at Sep 7, 2007 2:52:02 PM
The fact that bankruptcies increase with credit availability certainly casts into question that new liberal factoid that the majority of bankruptcies are medically induced. In fact it supports an assertion that the extra bankruptcies flow from voluntary borrowing. Those bankruptcies that flow from genuine duress represent borrowing that would happen no matter what the rate.
-dk
Posted by: Dick King at Sep 7, 2007 5:49:21 PM
King,
Both factoids can be true. A person with a lot of debt due to voluntairy borrowing is in bad financial
state to withstand a genuine unexpected crisis. It might be genuine duress that finally sends someone
into bankrupcy. However had they had more savings and less borrowing to begin with, a simillar unexpected
medical problem would not lead to bankrupcy.
Posted by: Sun at Sep 7, 2007 8:00:44 PM
A Harvard study that was quoted by Krugman in one of his column suggests that medical emergency (faced mostly by the uninsured) explains close to half of the bankruptcy. I have not read the paper. I do not understand how innovations in credit market will help people from the vagaries of medical emergency. Medical savings account? Daniel Gross has an interesting article in Slate on Tony Snow
http://www.slate.com/id/2173288/ and why he is leaving government.
Posted by: Asif Dowla at Sep 7, 2007 11:04:08 PM
Asif, that Harvard study is a poster child for, shall we say, advocacy scholarship. It was written by Elizabeth Warren and others to oppose the new bankruptcy law by portraying the majority of the bankrupt as completely innocent victoms of happenstance. The fact that Krugman quoted it uncritically speaks volumes about how shrill and unscholarly _he_ has become, but that's another story.
Don't take my word for anything. Read the study. http://tinyurl.com/4e2bm .
How do we get even close to 1/2? Let me count the ways...
1: If you bankruptcy appears to have been caused by problem gambling, it is medically induced.
2: If your bankruptcy appears to have been caused by birth of a child, it is medically induced.
3: If your bankruptcy appears to have been caused by addiction to alcohol or another [illicit, street] drug, it is medically induced.
4: Everything is self-reported. Despite the fact that these documents are public records, she made no attempt to verify anything.
5: If you had $1000 in uncovered medical bills over the past two years, _no matter what other bills you had and how many plasma TVs you bought over the same two years and what taxes you had to pay_, your bankruptcy was classified as medically induced.
For this report to have come close to being scholarship there would have needed to be a control group. She should have taken a thousand people from the general population, ascertained that none of the control group had filed for bankruptcy, and asked them the sat many of them had lost two weeks or more from work over the last couple of years -- that's one good case of influenza and a cold -- or had $1000 of co-pays and the like over the past few years or had had children. I may travel in the right circles but about 15% of my friends have borne or have had their wives bear or have adopted children recently, and none of my friends has gone bankrupt.
Sun, it's probably true that "something happens" to most people who go bankrupt. Some number of people would go bankrupt even if unsecured credit were not available. However, the excess rates in times of easier credit can only be explained by people embrittling their financial picture by voluntary borrowing.
-dk
Posted by: Dick King at Sep 8, 2007 11:20:40 AM
Easy credit means easy bankruptcy.
Posted by: jtoour at Sep 11, 2007 8:41:05 PM
