Even though total household debt in the United States hit a record high of $ 14.3 trillion in the first quarter of this year, the number of personal bankruptcy filings is at its lowest in 15 years, according to a recent report. New York Times report. Economic stimulus payments of $ 1,200 for each individual and higher unemployment insurance payments cushioned the impact of the pandemic – but once federal benefits dried up, those heavily in debt would start filing the balance sheet, the report predicts.
Households that file for bankruptcy tend not to take unfair advantage of the debt relief it provides; greater attraction is the increase in money in their hands, according to a recent article by finance professor Wharton Sacha Indarte. His paper, “Moral risk versus liquidity in household bankruptcy“States that” the increase in potential debt forgiveness has a positive, but small, effect on the deposit [and that] the deposit is five times more sensitive to the cash in hand than to the generosity of relief. She concludes that 83% of the effect of the debt burden (which bankruptcy alleviates) on deposit is due to liquidity rather than moral hazard. “In other words, people file for bankruptcy not because of what they can get, but because of what they don’t have,” she said.
“If you give people more money, it alleviates their financial distress and can be a strong incentive for them not to deposit,” she noted in a recent interview with the Wharton Business Daily Radio Show on SiriusXM (listen to the podcast at the top of this page). “Making the debt relief they can get in bankruptcy much more generous has a much smaller impact on that decision. “
Moral hazard is not an important factor
“One of the main arguments against generous debt relief in bankruptcy is that it can create moral hazard,” said Indarte. “If a household anticipates that they can rack up a big bill and are able to wipe everything off in bankruptcy, that could make households much more willing to file in the first place.”
Such expectations that bankruptcy filings will banish debt come at a cost. “The reason this is expensive is that creditors will anticipate that households are more inclined to file for bankruptcy, and they are going to be more reluctant to lend if they expect it will not be repaid,” Indarte said. “If the debt forgiveness is much more generous, the idea is that more people will be tempted to deposit [for bankruptcy]. “
However, Indarte’s research found that “although people react to this financial incentive, they do not react very strongly”. A $ 1,000 increase in relief generosity increases the annual deposit by 0.02 percentage point, Indarte wrote in his article. “The low moral hazard effect implies that a key component of the social cost of a generous bankruptcy is low. “
People are reluctant to file because they perceive the other costs of bankruptcy to be significant, she said. Filers incur legal costs of around $ 300 and, if they hire a lawyer, legal costs are typically $ 1,000 to $ 2,000, his article noted.
There could also be “non-monetary costs such as stigma resulting from a moral aversion to failure,” or difficulties in finding a job, she continued. She pointed out that research from other experts found that “having a bankruptcy indicator on your credit report makes it more likely that you will be rejected for jobs in the future, and it could also make access to the bank more likely. more difficult credit in the future ”.
She said her research indicated that “people are reluctant to go bankrupt unless they have exhausted their other options.”
The weak moral hazard effect implies that “moral hazard is not a powerful driver of household bankruptcy,” Indarte wrote in his article. Instead of increased “bankruptcy generosity”, lack of liquidity is a more powerful driver of bankruptcy filings, she added.
In terms of social welfare, the study’s estimates point to lower costs and higher benefits from a generous bankruptcy. “Together, these suggest important possibilities for generous bankruptcy to improve well-being,” she wrote.
Protect Home Equity In Bankruptcy
The main research contribution is to estimate and compare the causal effect on deposit of increases in the generosity of debt relief and cash on hand, according to the paper. Indarte analyzed data on millions of US households, including data on mortgage payments from 7 million homeowners and 200,000 home sales.
“If you give people more money, it alleviates their financial distress and can be a strong incentive for them not to report. [for bankruptcy]. “
These data were needed for a new approach she used to study the relationship between state-level family property exemption laws and the debt relief households receive in bankruptcy. The homestead exemption caps the amount of home equity that people filing for bankruptcy can keep – creditors get the home equity value that exceeds the exemption. These exemptions varied widely from state to state in 2017, ranging from $ 0 in New Jersey to $ 550,000 in Nevada, to an unlimited amount in Texas, the newspaper notes.
Each year, about one million American households seek debt relief by filing for personal bankruptcy, and one in ten households has filed for bankruptcy at some point, Indarte wrote. In a typical year, bankruptcy offers US households $ 189 billion in debt cancellation, surpassing UI transfers at its 2010 peak ($ 139 billion), she said. added.
“With the current health and economic crises, we are seeing very unusual bankruptcy patterns,” said Indarte. She highlighted recent work paper which saw a 27% year-over-year drop in bankruptcy filings by consumers and small businesses between January and August of this year, despite the effects of the pandemic. But Chapter 11 filings by large companies jumped 200% in the same period year over year.
The research findings for policy makers are twofold. One is “we shouldn’t be so concerned about the cost associated with providing generous household debt relief and going bankrupt,” said Indarte. But her study also suggests that strengthening the social safety net in the United States could be helpful in eliminating some of the reasons households resort to bankruptcy, she added.