Even as total household debt in the U.S. rose to a record $14.3 trillion in the first quarter of this year, the number of personal bankruptcy filings is at a 15-year low, according to a recent New York Times report. The economic stimulus payments of $1,200 for each individual and higher unemployment insurance payments cushioned the impact of the pandemic — but once the federal benefits dry up, those who are highly indebted would begin filing for bankruptcy, the report predicted.
Households filing for bankruptcy tend not to take undue advantage of the debt relief it brings; a bigger attraction is the increase in cash in their hands, according to recent paper by Wharton finance professor Sasha Indarte. Her paper, “Moral Hazard versus Liquidity in Household Bankruptcy,” argues that “increases in potential debt forgiveness have a positive, but small, effect on filing [and that] filing is five times more responsive to cash-on-hand than relief generosity.” She concludes that 83% of the effect of the debt burden (that bankruptcy alleviates) on filing 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 cash, that alleviates their financial distress and can give them a strong incentive to not file,” she noted during 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 that they’re able to get in bankruptcy much more generous has a much smaller impact on that decision.”
Moral Hazard Not a Big Factor
“One of the main arguments against making debt relief generous in bankruptcy is that it can create moral hazard,” said Indarte. “If a household anticipates that they can run up a large tab and they’re able to just wipe it all out in bankruptcy, that might make households much more willing to file in the first place.”
Such expectations that bankruptcy filings will banish debt loads come at a cost. “The reason that’s costly is that creditors are going to anticipate that households are more tempted to file for bankruptcy, and they’re going to be more reluctant to lend if they expect not to be paid back,” said Indarte. “If debt forgiveness is a lot more generous, the idea is that more people will be tempted to file [for bankruptcy].”
However, Indarte’s research found that “although people do respond to this financial incentive, they’re not responding very strongly.” A $1,000 increase in relief generosity increases annual filing by 0.02 percentage points, Indarte wrote in her paper. “The small moral hazard effect implies that a key component of the social cost of generous bankruptcy is small.”
People are reluctant to file because they perceive other costs of bankruptcy as being large, she said. Filers incur court fees around $300 and, if they hire a lawyer, legal fees are typically $1,000 to $2,000, her paper noted.
There could also be “nonmonetary costs like stigma coming from a moral aversion to defaulting,” or difficulty in finding a job, she continued. She pointed out that research by other experts has found that “having a bankruptcy flag on your credit report makes it more likely that you’ll be rejected for jobs in the future, and it might also make future credit access more challenging.”
She said her research indicated that “people are reluctant to go through bankruptcy unless they’ve exhausted their other options.”
The weak moral hazard effect implies that “moral hazard is not a strong driver of household bankruptcy,” Indarte wrote in her paper. Instead of increased “generosity of bankruptcy,” a more powerful driver of bankruptcy filings is the lack of liquidity, she added.
In terms of social welfare, the estimates in the study point towards lower costs and higher benefits of generous bankruptcy. “Together, these suggest significant scope for generous bankruptcy to improve welfare,” she wrote.
Protecting Home Equity in Bankruptcies
The main contribution of the research is to estimate and compare the causal effect on filing of increases in debt relief generosity and cash-on-hand, according to the paper. Indarte analyzed data on millions of U.S. households, including mortgage payments data for 7 million homeowners and 200,000 home sales.
“If you give people more cash, that alleviates their financial distress and can give them a strong incentive to not file [for bankruptcy].”
That data was required for a new approach she used to study the relationship between state-level homestead exemption laws and the debt relief households receive in bankruptcy. The homestead exemption caps the amount of home equity that those filing for bankruptcy can retain – creditors get the value of the home equity in excess of the exemption. Those exemptions varied widely across states in 2017, from $0 in New Jersey, to $550,000 in Nevada, to an unlimited amount in Texas, the paper noted.
Every year, about a million U.S. households seek debt relief by filing for personal bankruptcy, and one in 10 households have filed for bankruptcy at some point, Indarte wrote. In a typical year, bankruptcy offers U.S. households $189 billion in debt forgiveness, exceeding transfers from unemployment insurance at its 2010 peak ($139 billion), she added.
“With the current public health and economic crises, we’re seeing some very unusual patterns in bankruptcy,” said Indarte. She pointed to a recent working paper that found a 27% year-over-year drop in bankruptcy filings by consumers and small businesses between January and August this year, despite the effects of the pandemic. But Chapter 11 filings by large corporations jumped 200% during the same period year-over-year.
The takeaways from the research for policymakers are twofold. One is “we shouldn’t be as concerned about the cost associated with providing households generous debt relief and bankruptcy,” said Indarte. But her study also suggests that strengthening the social safety net in the U.S. could be valuable by eliminating some of the reasons households have for using bankruptcy, she added.