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Debt Causes Bankruptcy (But Sometimes in Counter-Intuitive Ways)

posted by Bob Lawless

I like NPR's Marketplace, but stories like this drive me nuts: "Why bankruptcy claims aren't as high as one would think." The story repeats a premise I often hear in media calls that I receive. The conversation usually starts something like this: "Foreclosures are up, unemployment is high, the economy is a wreck: why have bankruptcies stopped climbing?"

Wrong question. But fair enough. I get called because I am supposed to know something about bankruptcy filing rates, and my caller often has just picked up the assignment for the day. If that is the wrong question, what should we be taking away from trends in bankruptcy filing rates?

Bankruptcy is a legal act with legal consequences. Bankruptcy filings are not a bellwether indicator of the economy's health. Foreclosures, unemployment, and general economic conditions certainly play a role in determining the bankruptcy filing rate, but other factors are more important. At best, the bankruptcy filing rate is a weak and trailing economic indicator.

In trying to understand the bankruptcy filing rate, it is better to focus on the legal consequences and legal incentives for people who file bankruptcy. Specific legal rules mentioned in the NPR story--procedural requirements and rules on home mortgages--are also undoubtedly playing a part, but these rules are too specific to be playing a major role. The explanations are all trees and no forest.

Consumer Credit & Bankruptcy FilingsPeople file bankruptcy to discharge debt (at least in the United States). No debt, no bankruptcy. In the long run, the overall bankruptcy filing rate will rise and fall with the amount of consumer debt. As people accumulate more debt, bankruptcy demand will grow. That is why we see countries often adopting American-style consumer bankruptcy laws featuring debt forgiveness as consumer debt in that country increases. Without lots of consumer debt, talking about bankruptcy filings rates is like talking about snow accumulations in Honolulu.

The long-term growth in U.S. consumer bankruptcies closely tracks the long-term growth in U.S. consumer debt. When the financial crisis hit, consumer credit dried up, and outstanding consumer debt experienced unprecedented declines. There are fewer reasons to file bankruptcy today because there was less borrowing two to three years ago.

Consumer debt also has a profound but perhaps counter-intuitive short-term effect on consumer bankruptcy rates. In the short-run, a decline in consumer credit will lead to a bump in consumer bankruptcy filings. As people run out of options--as they become less able to put this month's grocery or utility bills on a credit card--bankruptcy becomes a more attractive option. People can and will continue to borrow to stave off the day of reckoning. If a lender is willing to extend credit, further borrowing is a rational decision. After all, the consumer can become "none more broke" by borrowing further but might see things turn around tomorrow if they can get by just one more day on a credit card. Students of option pricing should quickly grasp the point.

The numbers bear out these effects. The graph to the right shows a close relationship between total consumer debt and bankruptcy filings. As consumer debt goes down in a particular month, bankruptcy filings tend to rise. Clicking on the graph should bring up a larger image in a pop-up box, and at the bottom of the post is some information about how the graph was constructed. The correlation is not perfect, but my claim is not that the correlation is perfect. A clear, negative relationship does exist. The takeaway message is that focusing on current foreclosure rates and unemployment to explain bankruptcy filing rates misses more important features of the story.

Right now, both the long-term and short-term effects of consumer credit are working in the same direction to tamp down the bankruptcy filing rate. There are lower levels of consumer debt because of decreased borrowing two or three years ago and hence less overall reasons for people to file bankruptcy. Also, with a reported easing of the consumer credit market, consumer who are at the brink have a slightly easier time borrowing to put off a bankruptcy filing. Given these dynamics, it is not surprising that bankruptcy filings are leveling off or declining and that a mathematical model predicts a decline in the bankruptcy filing rate for 2011.

The macrodata will fail to explain any individual case. A foreclosure, a job loss, a medical problem, and many other problems will be the primary impetus for why many consumers will find themselves in bankruptcy court. These reasons explain why someone ends up filing bankruptcy, but they do not provide much help in explaining when they end up in bankruptcy court. Looking at trends in bankruptcy filing rates is all about the "when" question, and here macrodata are very helpful. The ups and downs of consumer debt levels tell us much--not everything, but much--about these trends.

Using data from Epiq Systems on bankruptcy filings and from the Fed for consumer debt, the graph compares monthly changes in the daily bankruptcy filing rate to monthly changes in the total amount of consumer debt outstanding. The graph begins in 2008 because of the anomalous effects the 2007 financial crisis had on outstanding consumer debt. Using 2007 data does not qualitatively change the results. The same phenomenon also can be observed historically, before the 2005 changes to the bankruptcy law. Bankruptcy filings are graphed against the left axis, and total consumer debt is graphed against the right axis. Both axes use different scales to make for easier comparisons. Also, the right axis for consumer credit has been inverted.

Comments

Marketplace isn't owned or produced by N.P.R. It's produced by American Public Media which was formed by a merger of Minnesota Public Radio and Southern California Public Radio a few years ago.

I try not to argue with data because data usually wins. However, I think it will be interesting to see if "this time is different," This recession and this housing bubble are unprecedented (so they tell us) since the enactment of the Bankruptcy Code in 1978. Even with the 2005 amendments, the Code as it is now is substantially more debtor friendly than was the Bankruptcy Act during the Depression.

My hypothesis is that at least in jurisdictions where mortgage holders can get deficiency judgments, former homeowners will be filing bankruptcy to protect their income from garnishment once they get jobs. But my ground level view is pretty skewed, and this probably won't be true on a macro level

David, your prediction is not necessarily contradictory with what I am saying. Consumer debt explains a lot but not all of the variation in bankruptcy filings. My unexplained variation may very well due to things like foreclosure rates.

That's a pretty cool graph. I am surprised that the bankruptcy filing numbers were not time lagged, that they moved more or less simultaneously with the consumer debt numbers.

To what extent do the consumer debt numbers reflect the effect of chargeoffs? If they do, that would diminish the odds that the consumer debt change is driving bankruptcy filings. Rather they might both be driven by an extrinsic factor. Or to some extent the bankruptcy filings might be increasing the chargeoffs and thus partly driving the consumer debt swings.

I found this article interesting. It makes total sense that consumer debt would go down due to the unavailability of credit and that, in turn, bankruptcies would rise.

I filed a chapter 7 bankruptcy late in 2008, while it was still being denied that we were in a recession and right about the time that credit started drying up. This article pretty much sums up the situation I was in, unfortunately.

A note on the previous comment: I don't believe that charge-offs would diminish the odds that consumer debt numbers are driving bankruptcy filings. A charge-off prior to bankruptcy does not relieve the debtor of the debt. Rather, the debt is usually sold to some junk debt buyer who is often more agressive about collecting, maybe even providing further incentive to the debtor to file.

However, I might buy the fact that bankruptcy filings might be increasing the chargeoffs and partly driving consumer debt swings. Gotta think about that one.

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  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.

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