Consumer Bankruptcy

Jaromir Nosal

Columbia University

Consumer Bankruptcy

What it is: Individuals filing for protection against creditors

Role: Option of bankruptcy is society’s way of insuring individuals against financial disasters Job loss Illness Unexpected expenses

Should We Allow For Bankruptcy? Pros

A form of social insurance

Protects individuals from effects of adverse events

Can give a second chance to individuals that made bad financial decisions in past

Cons Can induce irresponsible

behavior Potential for abuse High cost to society

Policy Debate

What rules should we set? Want to restrict access to bankruptcy so that it is

difficult to abuse the system Want to restrict access for repeat defaulters to

induce responsible behavior Want to have the option accessible to individuals

who really need it

Consumer Bankruptcy: Two Options Chapter 7: ‘liquidation’

Seizure of assets above an exemption level Full discharge ‘Fresh start’ Inability to file again for 8 years Bankruptcy flag on the record

Chapter 13: ‘repayment plan’ Three- or five- year repayment plan No assets seized – payments from current income Partial discharge

Consumer Bankruptcy:Dischargeable Debt What kind of debt can be discharged?

Unsecured debt: no collateral There are exceptions

Taxes Student loans Divorce obligations Certain insurance settlements

Unsecured Debt

What is unsecured debt? Debt that is not collateralized by any items that

would secure payments Examples

Personal loans Credit card debt Medical bills Certain forms of store credit

Unsecured Debt

What is unsecured debt? Debt that is not collateralized by any items that

would secure payments What is left: secured debt

Mortgage debt Car loans Big-ticket items loans

Unsecured Debt in the U.S.

Look at total debt relative to disposable income Indebtedness of U.S. households relative to what

they earn

Debt of the U.S. HouseholdsTotal Consumer Credit Relative To Disposable

Income

0%

5%

10%

15%

20%

25%

30%

1968Q1 1973Q1 1978Q1 1983Q1 1988Q1 1993Q1 1998Q1 2003Q1 2008Q1

Debt of the U.S. Households

Total credit includes car loans and student loans We want to look only at the unsecured component

Unsecured Debt of the U.S. Households

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Consumer Bankruptcy: Data

At the same time Huge increases in Chapter 7 filings Filings per household increased by a factor of 5 In 2005, over 1.5 million households in the U.S.

filed for Chapter 7

Chapter 7 Filings

0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

1800000

1980 1985 1990 1995 2000 2005

Chapter 7 Filing Rate

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

1980 1985 1990 1995 2000 2005

Charge-off Rate

Bankruptcy may be on the rise, but how big an item is it in banks’ portfolios

Charge-off rates

Charge-off rate = Debt written off banks balance sheets / Total Debt

Charge-off Rate

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1985 1990 1995 2000 2005

Credit Cards

New product Access to a line of credit that you access only

when you need it Pay interest only on the amount borrowed

First cards – 1950 Diners Club check cards Really took off in 1970s

Unsecured Debt: Credit Cards Take Over

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Total Unsecured Debt

Revolving Unsecured Debt

Credit Cards and Bankruptcy Filings

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

0

1

2

3

4

5

6

Revolving Unsecured Debt

Bankruptcy Filings

Supply side of the credit market What happened to the supply of unsecured

credit Huge changes in credit cards

Lower interest rates More generous credit limits Huge increase in credit card solicitations

At the same time, profitability fairly stable

Credit Cards in the Data

Year 1989 2004

Population with a bank card 56% 71%

Population with positive balance 29% 39%

Average credit limit relative to income 20% 46%

Credit Cards in the Data: SolicitationsCredit Card Mail Solicitations (billions)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Credit Card Penetration

0%

10%

20%

30%

40%

50%

60%

70%

80%

1970 1977 1983 1989 1995 1998 2001 2004

Credit Card Penetration

Year AllLowest

20 20-40 40-60 60-80 80-

1970 16% 2% 9% 14% 23% 33%

1977 38% 11% 23% 37% 51% 69%

1983 43% 11% 27% 41% 57% 79%

1989 56% 17% 37% 62% 76% 89%

1995 66% 28% 55% 71% 83% 95%

1998 68% 28% 58% 72% 86% 95%

2001 73% 38% 65% 79% 87% 95%

2004 71% 37% 61% 76% 87% 96%

Credit Cards in the Data: Interest RatesCredit Card Interest Rate vs. Personal Loans 1985-2005

0

2

4

6

8

10

12

14

16

18

20

1985 1990 1995 2000 2005

Pe

rce

nt

(%)

Notes: *, ** Credit card interest rate is annualized quarterly FRS series; Source: FRB Board of Governors.

Credit Card Interest Rate*

Personal Loan Interest Rate**

Major Issues

What accounts for the rise? In particular, should we worry about it? Should we change the law to make bankruptcy less attractive?

George W. Bush: The old system ‘made credit less affordable and less accessible, especially for low income workers’

Several competing stories More income uncertainty Bigger expense shocks (especially medical bills) Lower cost of bankruptcy Lower ‘stigma’ of bankruptcy:

We observe huge increases in bankruptcy because ‘Americans lost their sense of shame’, A. Greenspan

Lower cost of giving credit: expansion to lower income, ‘riskier’ customers

Major Issues

Need theory to evaluate the potential of these stories

Deeper question: what is the best way to think about this market? How are new credit card accounts established? Are there big asymmetric information problems? What happens to bankrupts?

Major Issues: Debt Puzzle

Why do people pay interest on their credit cards and at the same time hold money in the bank?