Less Lending to Consumers Could Mean More Bankruptcies

Conventional wisdom currently holds that the implosion of the subprime lending market already has led consumer lenders to tighten lending standards. Although I have not seen it expressly stated, a corollary must be that we should expect a retreat in the amount of consumer debt outstanding. Will a decline in outstanding consumer debt lead to a decline in bankruptcies? Probably not. In fact, a decline in outstanding consumer debt will lead to a short-term increase in bankruptcy filings.

Historically, the United States bankruptcy filing rate has tracked the amount of consumer debt outstanding. As consumer debt increases, the bankruptcy filing rate increases. But that effect is long-term, in the two- to three-year window. In the short term, decreases in consumer debt lead to increases in the bankruptcy filing rate. I crunched the numbers in a piece published earlier this, "The Paradox of Consumer Credit" (available at p. 347 of volume 2007 of the University of Illinois Law Review; a prepublication SSRN draft is available here).

The intuition here is that the tightening of consumer credit makes liquidity unavailable for consumers on the edge of bankruptcy. With short-term liquidity more difficult to obtain, more consumers are pushed into bankruptcy. In the long-run, however, the increased debt increases bankruptcy risk, and bankruptcy filing rates go up. Thus, the paradox here is that more consumer debt actually can mean fewer consumer bankruptcies but only in the short-term. Interestingly, the same pattern does not hold for mortgage debt, The pattern only holds for consumer debt (credit cards, car loans, and such), exactly the type of debt to which we would expect consumers to incur so as to stave off the day of financial reckoning.

Although I think the above analysis is correct, does that mean we will see more bankruptcies in the short term. Certainly? Probably? Maybe? What should consumers do? Like most issues in the public policy arena, the answers require subtlety and complexity.

First, all we have are media reports about tightening credit standards. The most current Federal Reserve data for consumer credit are available only through June and thus do not yet capture most recent events. The data through June show consumer credit was still on the rise. It could be that, despite the anecdotal reports, systematic data will show that consumer credit has not declined. Also, it may take a while for the effects of the subprime crisis to work through the system such that we won't see the effects in the Federal Reserve data until much later in the year.

Second, analysis of past historical patterns is no guarantee that any particular future event will follow that pattern. Quantitative analysis tells me that bankruptcy filings only tend to go up in the short-term when outstanding consumer credit declines. It's not a certainty.

Third and finally, because bankruptcy filings go up in the long run with consumer debt, do the data suggest that consumers are foolish to borrow in an attempt to get past a short-term liquidity problem? The data are a collection of general patterns in the economy and do not necessarily provide advice for specific individuals. Some consumers are able to borrow, avoid a short-term liquidity crunch, and never file bankruptcy. Others do not. The data are an aggregate analysis of the effects across the entire economy. Different people will have different experiences, which is another way of saying "Your mileage may vary." Consumers should make these decisions based on the usual factors that do or do not make borrowing a good financial decision. The only thought I would add is that I think these data add is that over the long-term increased debt leads to more bankruptcies across the economy. In making a decision
to borrow his or her way past a short-term liquidity crunch, a consumer might ask what's different about their circumstances that they will not add to these statistics.

Comments

[Ken Houghton]

"In making a decision to borrow his or her way past a short-term liquidity crunch, a consumer might ask what's different about their circumstances that they will not add to these statistics."

One of the differences is, of course, that things could get better. Remember that the majority of declared bankruptcies follow negative system shocks--job loss, major medical bills.

It seems reasonable to assume that marginal bankrupts who avoid filing do so due to positive shocks: new job, better health, sudden infusion of cash.

For the past several years, the Sudden Infusion of Cash has been a MEW, caused in no small part by economists such as David Malpass arguing that people are "wealthier" due to increased home values.

It's not coincident that the places with the most foreclosures were, until recently, not places where people tend to owe very little on their house and that could be described as having a real estate "bubble." (Cleveland? Detroit??)

They already threw the "hail mary" pass, taking money out of their home in an attempt to keep it. The local economy didn't recover.

So the tighter credit might actually have a smaller effect than usual, since the traditional sources had been fully tapped out long before the standards were tightened.

[Lurker]

Isn't this just a way of saying what matters isn't balance sheet solvency, but equity insolvency? I might be balance sheet insolvent today because of my new mortgage and car loan, but what really matters is when that debt comes due; as long as I can pay my debts as they come due, there is no reason to file for bankruptcy.