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. 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

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

Chapter 7 Filing Rate

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

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 Total Unsecured Debt Revolving Unsecured Debt

Credit Cards and Bankruptcy Filings 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 Population with a bank card56%71% Population with positive balance29%39% Average credit limit relative to income20%46%

Credit Cards in the Data: Solicitations

Credit Card Penetration

YearAll Lowest %2%9%14%23%33% %11%23%37%51%69% %11%27%41%57%79% %17%37%62%76%89% %28%55%71%83%95% %28%58%72%86%95% %38%65%79%87%95% %37%61%76%87%96%

Credit Cards in the Data: Interest Rates

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?