This Has Been Fun

Thank you to Bob and the other folks at Credit Slips for letting us post here last week.  Thanks also to our readers -- it was fun to know that you exist.  This is a new form of writing for both of us, and we've enjoyed it tremendously.  Let us welcome David.  We hope he enjoys blogging as much as we did, and we look forward to his posts.  Ta ta.

The Myth of The Rational Borrower -- Pt. III

Okay, in our first post we suggested that a behavioral model of consumer lending that hypothesized a rational lender and a heuristic borrower would predict three effects from BAPCPA: 

• That the consumer bankruptcy filing rate would fall (no big surprise there).
• That the credit card charge-off rate would fall, but rebound.
• That consumers' ex ante borrowing decisions would not be altered by restricted availability of the bankruptcy discharge.

With regard to the first prediction, it is well known that bankruptcy filings spiked up in advance of the effective date of BAPCPA, and then plunged.  According to the Administrative Office of the United States Courts, the number remains depressed, but it has been rebounding -- quickly in the second quarter of 2006 and a little bit more slowly in the third quarter.

It is important to recognize that it is still way too early to tell how things will settle in. Bankruptcy lawyers and bankruptcy judges are still adjusting to practice under the new Act.  Over time, as practices stabilize in various districts, and lawyers regain an ability to handle cases efficiently, one might expect the filing rate to rebound.  In short, we have no idea what the ultimate equilibrium rate of filing will be.

More importantly, the bankruptcy filing rate has never been a particularly good measure of the number of families in financial distress.  A better indicator of how many families are having difficulty managing their debts is the percentage of credit card debt that is charged off each quarter (the lavender line below).  Here, too, BAPCPA has had an effect. The charge-off rate spiked in anticipation of October 17, 2005 as families that thought they might need bankruptcy filed (and thus charged off debt) in anticipation of the new law's effectiveness.  The difference here is that the rebound has been much more pronounced.  While chargeoffs are not yet back to the level of late 2005, they are getting close.

Moreover, delinquency rates are already above where they were in the third quarter of 2005.  Again, while we don't know where the new equilibrium will be, there is reason to think that even if the bankruptcy rate remains depressed, the effect on the level of consumer loan default rates will be much smaller.

What is most striking, however, and strongly suggestive of our behavioral model for consumer borrowing decisions is that, as far as we can tell, the massive changes in the bankruptcy law in late 2005 have not had any discernible effect on consumers' ex ante borrowing decisions.  For the two key measures of consumer indebtedness published by the Federal Reserve system, the consumer Financial Obligations Ratio and Debt Service Ratio, October 17, 2005 was a non-event.  Consumer debt loads showed no discernible change surrounding the effective date of BAPCPA.

Finally, the aggregate amount of consumer debt outstanding continues to grow as well.

Indeed, aggregate credit card debt has increased at rates that are higher (or at least as high) as the pre-BAPCPA rates of increase.

In short, a behavioral model of consumer lending suggests that tightening up on the bankruptcy discharge will do very little to change ex ante consumer borrowing decisions, and hence it will do little to change either the underlying level of credit card default or the number of families in financial distress.  We see little in the above data to contradict this intuition.

The Myth of the Rational Borrower -- Pt. II

We're back on the topic of consumer mythology.  Here, we address in greater detail the inferences raised by the experimental work of cognitive psychologists and other behavioral decision researchers (BDR to the cognoscenti) regarding consumers' borrowing and default behavior.  (We say inferences because few of these experiments directly tackle the psychology of debt).  Our primary insight in The Myth of the Rational Borrower was that the decision whether to pay with cash or to borrow (by using a credit card or some other means) is a complex one -- so complex that a law degree, a calculator, a present value table and a crystal ball would come in handy when resolving it.   

The shortcomings of consumer borrowers come in three flavors: (1) cognitive limitations; (2) heuristic biases; and (3) anomalous preferences. 

Cognitive Limitations.  First, we think that most (OK, OK nearly all) consumers simplify borrowing decisions by reducing the many comparisons at stake to one simple question: Can I afford the minimum monthly payment?  While normally heuristics -- aka rules of thumb -- get us successfully through the day, this one (and a few others) may create problems.

Heuristic Bias.  Shortcuts are fine, but the psychological literature on framing suggests that some of these heuristics may hide biases in decisionmaking that render consumers easy marks.  For example, the availability heuristic (focusing on an easy or "available" measure) leads many consumer to anchor their consumption and borrowing decisions around the minimum payment.  Optimism bias may cause consumers to overestimate their income in the next period, or underestimate their need for borrowed money in future periods.  Cognitive dissonance may cause consumers to underestimate credit card use so far this month, or to ignore the amount being spent on finance charges.

Anomalous Preferences. The most interesting to us, or at least the concept that produced the biggest "aha" when we learned of it, is time inconsistent preferences.  Consumer borrowing decisions involve a choice between present and future consumption. This intertemporal choice depends on the relative weight attached to future consumption versus present consumption – the consumer’s discount rate. Economists assume that the discount rate is consistent over different time periods.  Apparently, however, individuals do not apply a single discount rate over their lifetime. Richard Thaler asked respondents to specify the amount of money they would require in {one month/one year/ten years} to make them indifferent to receiving $15 now.  The responses {$20/$50/$100} imply a wildly divergent, indeed paradoxical range of average annual discount rates over the three periods {345 percent/120 percent/9 percent}.  This effect may cause consumers to ignore very high lending costs on small amounts or for short time periods.  For real world examples think of pay day lending (or health club membership).

What's the implication?  The biases identified by BDR consistently suggest that flesh-and-blood consumers will borrow more than a rational actor would.  It also suggests that less than rational consumers may make borrowing and consumption decisions that do not accurately reflect their true (whatever that might mean) preferences.

In our view the possibility that consumers are less than rational, when married to the changes in lending technology described in our previous post, provides a plausible explanation for the confluence of highly profitable consumer lending and a skyrocketing bankruptcy filing rate between 1980-2005.

(Okay, we've promised some empiricism.  We're getting there.)

It's All Up to You

National Consumer Protection Awareness Week (Feb. 4-11)

http://www.consumer.gov/ncpw/toolkit.htm

If you see a scam, say something....

This is a federal website!?

Healthcare Privacy and Bankruptcy

Yesterday I (Ted) was invited to testify at an HHS advisory committee hearing on healthcare privacy.  My assigned topic was to describe the effect of bankruptcy on the privacy protection afforded medical information held by entities that are not covered by the HIPAA Privacy Rule. 

The hearing raised the problem of transfers of patient medical information in two contexts:

1. B2B, when health care providers give patient information to other non-covered "Business Associates" for purposes such as billing or data analysis; and
2. B2C, when patients either provide medical information to non-covered entities, or authorize their doctors to do so.  An example is the emerging concept of a portable electronic healthcare record.

The short answer used to be that confidentiality promises are contracts and that breach of contract claims end up getting paid in bankruptcy dollars.  The chair of the committee presumably knew that I would say this because I'd already said it once before in a slightly different context.  Edward J. Janger, Genetic Information, Privacy and Insolvency, 33 J. L. Med. & Ethics 79 (2005).

He probably didn't expect that he'd be giving me my first chance to think about the effect on my answer of the so-called Leahy Amendment, contained in BAPCPA. The Leahy Amendment amends section 363 and adds a new section 332 to the Code.  These provisions prohibit the sale of customer data in violation of a published privacy policy unless a "consumer privacy ombudsman" is appointed and the court approves the sale.

So, does the Leahy Amendment enhance the security and protection of your medical records?  Bottom line, a qualified "No."

Coalition for Debtor Education

Ted and I share more than having co-authored the Texas piece. We also both sit on the board of directors for a non-profit corporation, the Coalition for Debtor Education. The Coalition, the brain-child of Karen Gross (formerly a professor of law at New York Law School and now president of Southern Vermont College), was established in 1998 to improve consumers' understanding and management of their own financial affairs. Over the years, the Coalition has:

• Produced, published and evaluated a financial literacy curriculum.
• Designed, implemented, and empirically assessed a pilot financial literacy program that education more than 600 consumer debtors pre-BAPCPA.
• Licensed our financial education curriculum as a means of assisting the low-cost, high-quality provision of financial literacy education post-BAPCPA; our licensed curriculum has reached more than 18,000 bankruptcy filers nationwide to date.
• Trained more than 175 debtor educators from around the New York metropolitan area, around the country and abroad.
• Created and administered a pilot pro se assistance program in the U.S. Bankruptcy Court for the Eastern District on New York that streamlined bankruptcy procedures for approximately 1,700 individual filers. This program was adopted into the Court’s FY’07 annual budget.

Currently the Coalition is undertaking a number of new initiatives, including a pilot program to bring financial education workshops to unbanked (or underbanked) populations in New York City. The pilot combines training the staff of various financial institutions to conduct financial literacy workshops at New York City Housing Authority Community Centers. The initial workshops will be held in the South Bronx and will target seniors and teens.

What have we learned from these experiences?  A couple of things: First, we find an enormous satisfaction in helping real people with their real-life problems. Both of us have advised in litigation in big reorganization cases, but this is completely different. Yes, it's exhausting and there are never enough hours in the day...but it's all about how you allocate your time. Second, it has been incredibly important to focus on institutionalizing the non-profit. People float on and off the board and other positions, but the Coalition has continued to do good work. Third, BAPCPA has complicated our ability to provide financial literacy courses to debtors.  We're confused about the interraction between pre-filing counseling (which we hate), and pre-discharge counseling which might, in a different form (more about that later) hold some promise.  We haven't figured out how to become "approved providers" and still retain our day jobs, so we have had to back into a behind-the-scenes training role.  For now, this suits us, but we wonder if debtors are well served by the mandate and all this regulation.  Finally, we can always use help. Look us up at www.debtoreducation.org or shoot us an email.....

The Myth of the Rational Borrower -- Pt. 1

Six Months ago (in Law Journal time), we published an article entitled The Myth of the Rational Borrower, 84 Texas L. Rev. 1481 (2006).  In that article we looked at macro-data, the economic literature on consumer credit that informed BAPCPA, and the oh so hip literature on behavioral economics to explore the argument -- familiar to readers of this blog -- that rational lenders use sophisticated marketing techniques to exploit consumers' lack of information and imperfect decisionmaking processes and encourage excessive consumer borrowing.   We further sought to consider whether this, and not consumer opportunism, might be the engine behind the bankruptcy filing rates observed prior to 2005.

One of the few good things about BAPCPA is that it has offered us a found empirical experiment with which to test our hypothesis.  One of our projects this week is to lay out a short form version of the argument we made in "Myth", and to publicly evaluate our predictions in light of the three quarters of data that are now available following BAPCPA's enactment. 

So first the short form argument . . .

Introduction

Hello to the readers of Credit Slips.  Thank you to John Pottow for that generous introduction, and to Bob Lawless and the regular Credit Slips authors for loaning us their bully pulpit.  To keep things simple we will both be posting from the same account.  So, if we understand the technology properly, all posts will look like they are coming from both of us.  We're comfortable with that.  That's why we teamed up.  In many cases the jointness will be accurate.  Where it's not, we'll  decide whether we wish to be clear about which one of us is posting.

We expect to post on a variety of topics over the course of the week from consumer credit and bankruptcy reform, to data privacy in bankruptcy, to debtor education and financial literacy, to international bankruptcy, but we're new at this, so who knows where it will lead. 

We look forward to your comments and to a lively, thoughtful discussion.

Ted and Susan