Personal Bankruptcy
Michelle J. White UCSD and NBER
Some US Bankruptcy Facts
In 2004, Americans were more likely to file for bankruptcy than to:
– – – graduate from college get divorced be diagnosed with cancer.
What I’ll talk about:
• • • • • How personal bankruptcy law works. Bankruptcy and social insurance. Characteristics of an efficient bankruptcy law. Research on the effects of bankruptcy. Bankruptcy, homeowning and the financial crisis.
How bankruptcy law works
• Debtors file when they can’t pay their debts. • Creditors’ collection efforts are stopped during the bankruptcy process. • What are debtors obliged to repay?
– All assets above a fixed asset exemption, and – Future income above an income exemption. – Obligation to repay from income lasts for a fixed number of years.
How bankruptcy law works
• Remaining unsecured debt is discharged:
– Credit card debt, – Medical debt, – Installment loans. (Discharge may depend on debtors’ making a good faith effort to repay.)
• Secured debts (mortgages and car loans) are discharged only if the debtor gives up the house or car.
How bankruptcy law works
• Equal proportional payment to all unsecured creditors (but any repayment is rare). • Debtors can’t give up their right to file for bankruptcy. • Bankrupts may be punished:
– Social stigma, – Public notice of bankruptcy filing, – Disbarment from some jobs. – Prison, slavery, death, exile (not anymore!).
Bankruptcy is privately-provided consumption insurance for debtors
• Borrowing increases the riskiness of consumption, since income may fall when debts are due. • Bankruptcy reduces downside risk by discharging some debt when income falls. • This makes risk-averse debtors better off and raises demand for loans.
Characteristics of an efficient bankruptcy law
• The optimal asset exemption depends on the tradeoff between:
– Risk-averse debtors’ gain from additional consumption insurance when the asset exemption is higher versus – Debtors’ loss from reduced credit availability.
The optimal asset exemption is zero if all debtors are risk neutral and rises as debtors become more risk averse.
Characteristics of an efficient bankruptcy law—cont.
• The optimal earnings exemption depends on:
– The same tradeoff between the gain from additional consumption insurance versus reduced the cost of reduced credit availability, plus – The additional cost of reduced labor supply by debtors when there is a “bankruptcy tax” on future earnings.
Inverse relationship between bankruptcy and social insurance?
• Countries with generous social safety nets have less generous bankruptcy exemptions. • Suggests that governments mandate private provision of consumption insurance when they don’t provide a high level of social insurance. • But many poor countries have neither type of insurance.
Cross-Country Differences in Bankruptcy Law
Income exemption
No bankruptcy law (many countries) France Germany England/Wales none $15,000/year $38,000/year “reasonable domestic needs”
Repayment Period
until death 8-10 years 6 years up to 3 years
Cross-Country Differences in Bankruptcy Law (cont.)
• None of these countries have appreciable asset exemptions. • But the relationship doesn’t cover poor countries—they often have no social insurance programs and no bankruptcy law.
US Bankruptcy Law
• The US has the most debtor-friendly bankruptcy law. • Two separate personal bankruptcy procedures
– Chapter 7:
• Debtors repay only from non-exempt assets. (All future income is exempt.) • States set the asset exemptions and they vary widely. • Homestead exemption for home equity is the most important. Unlimited in Florida and Texas; zero in some states. It shelters all types of assets.
US Bankruptcy Law, cont.
– Ch 13:
• Debtors repay only from non-exempt future income. • Repayment period is 5 years.
• Debtors have the right to choose between Chs. 7 and 13 (restricted a little in 2005). • Because Ch 7 is so favorable, 70% choose it. 96% of Ch 7 filers repay nothing.
Research on effects of bankruptcy
• Most research uses US data. • Research makes use of variation in asset exemption levels across US states—higher asset exemptions mean bankruptcy provides more complete consumption insurance for debtors. • Other aspects of bankruptcy law are uniform across US states.
Effect of bankruptcy on credit markets
• When exemptions are higher, demand for credit rises and supply of credit falls. • Net effect is higher interest rates and reduced credit availability for:
– Consumer credit, – Home equity loans, – Small business credit, – Credit to small corporations. (Exception is credit to high-income borrowers.)
Effect of bankruptcy on entrepreneurial behavior
• Starting/running a business is risky; bankruptcy law encourages entrepreneurship by reducing the cost of failure. – Owners of failed businesses can file for bankruptcy, where both their business and personal debts are discharged. – In the US, failed entrepreneurs keep all of their future income after bankruptcy; they also keep their homes if their state has a high homestead exemption. – In other countries, a shorter repayment period encourages entrepreneurs.
Effect of bankruptcy on entrepreneurship, cont.
• Pro-debtor bankruptcy law also encourages entrepreneurs to start a second business if the first fails (Henry Ford, Walt Disney,…). • Similar effect on proprietorships and small corps. • Research shows that US states with higher asset exemptions and European countries with shorter repayment periods have more entrepreneurs.
Bankruptcy reduces aggregate consumption risk
• Recent paper shows that across US states, those with higher exemptions have less variation in aggregate consumption levels.
Bankruptcy encourages opportunistic behavior by debtors
• In US states with high asset exemptions, debtors gain from filing even if they have high incomes, high assets and no fall in income. (May require advance planning to convert assets from non-exempt to exempt.) • Up to 1/3 of US households can gain by filing. • Research shows that more debtors file for bankruptcy as their financial gain rises.
Bankruptcy and Housing
How does US bankruptcy law help homeowners in financial distress to save their homes?
Homeowners and Ch 7
• Filing under Ch 7 helps homeowners pay their mortgages by discharging credit card debt. • It also discharges recourse claims against debtors who have given up their homes. • But:
– Ch 7 doesn’t stop foreclosure. – Since 2005, a new means test prevents some highincome debtors from filing under Ch 7. – Debtors in Ch 7 must sell their homes if home equity > homestead exemption.
Homeowners and Ch 13
• Filing under Ch 13 stops foreclosure. • Debtors can repay mortgage arrears over 5 years under a repayment plan. • Most unsecured debt is discharged b/c mortgage is paid first. • But no mortgage debt forgiveness in bankruptcy.
How do debtors use Chapter 13?
Repay unsecured debt or save their homes?
Debtors use Chapter 13 to save their homes and cars
• In a sample of Ch 13 bankruptcy filers in 2006, 96% were homeowners. • 78% could have filed under Ch 7 (they passed the new means test). • What debtors repaid in Ch 13 plans: -- 78% repaid mortgages. -- 45% repaid car loans. -- only 9% repaid just unsecured debt. • But using Ch 13 to save your home is less attractive now, since housing values have fallen.
Bankruptcy and The US Mortgage Crisis
• 2.7 million foreclosures occurred in 2007 and 2008; 2 million more are projected. • Foreclosures have very high costs:
Owners lose since they must move; Some become homeless; Lenders lose 1/2 of loan value; Neighborhoods harmed because vacancies cause blight/disease; – Cities lose property tax revenue. – – – –
• Foreclosures lead to yet more foreclosures…
Solutions 1: renegotiate mortgage contracts
• Avoiding foreclosure is in both sides’ interest. • But little renegotiation has occurred—why?
– Most mortgages are in securities that limit or prohibit changes in financial terms. – Mortgage servicers are paid for foreclosing, not for renegotiating. – Second mortgage-holders can block refinancing of first mortgages unless they are paid off. – Private mortgage holders often prefer foreclosure.
Solutions 2: government programs
• “Hope Now” – program to encourage voluntary renegotiation. It did little. • “Hope for Homeowners” passed July 2008.
– – – Government will issue new mortgages. Program requires old lenders to consent. This means adverse selection (large losses for government) and tough bargaining by lenders (some worthwhile refinancings won’t occur).
Solutions 3: Bankruptcy approach
• Allow bankruptcy judges to “strip-down” mortgages in bankruptcy. • Divide mortgage into:
– secured part = current market value and – unsecured part = the remainder.
The unsecured part would be discharged or partially repaid, like other unsecured debt.
Solutions 3: cont.
• Judges could also:
– Reduce the principle or interest rate. – Discharge excessive fees.
• Lenders’ consent not required, so no renegotiation problem and no adverse selection. • Bankruptcy trustees could spot opportunism since bankruptcy requires extensive documentation (?).
Solutions 3: cont.
Possible drawbacks: • • Mortgage interest rates might rise? Reduced supply of credit card loans because more would be discharged.
Bankruptcy approach complements other approaches by providing an alternate route for debtors.