Bankruptcy law is a debt-collection law that insures people to some extent against the inability to repay their debts as they fall due. The vast majority of people file for bankruptcy under either Chapter 7 or Chapter 13 of the bankruptcy law (specifically, title 11 of the U.S. Code). (Certain consumers can also file under Chapter 11 or Chapter 12.) Chapter 7 is used by about 70 percent of filers; it provides for "straight bankruptcy," or the liquidation of assets. Chapter 13, entitled "Adjustment of Debts of an Individual with Regular Income," is a court-sponsored debt-refinancing plan.
Debt Collection and Insurance
The procedures by which creditors can collect debts are laid out in state commercial law as well as in bankruptcy law. State commercial law outlines the process for staking a claim to what is owed; it also ranks those claims and details the "remedies" available to creditors to satisfy or collect them. State law for debt collection is a "grab law," based on the notion of first come, first served. Accordingly, the creditor that first stakes a claim to particular assets of a debtor is entitled to be paid first (Jackson 1986). The legal remedies for creditors, such as foreclosure on and the sale of property, allow them to collect what they are contractually owed, and from the point of view of state law, debtors are required to repay debts in full, regardless of the circumstances. But debtors sometimes default on their debts, and grab law makes no provision for sharing the risk of such defaults--either among creditors or between debtors and creditors. That results in an inefficiency; in other words, society would be better off with provisions for sharing default risk. The inability of borrowers to shift such risk also creates what is known as an adverse selection problem for creditors: risk-averse consumers will shy away from borrowing, leaving creditors with a group of riskier borrowers.
Bankruptcy law can better allocate the risk of default for the economy in comparison with the allocation provided by state commercial law. Most important, bankruptcy law spreads default risk among borrowers and lenders by providing borrowers with some insurance against their inability to repay their debts. The insurance "payoff" for borrowers is the opportunity to receive a discharge (or forgiveness) of their debts and to keep certain assets to start life afresh after bankruptcy. As a result, that insurance gives people an incentive to increase their borrowing because they know they will not be impoverished if they cannot repay their debts. Society benefits from this aspect of greater risk spreading because it allows people to better plan their consumption--they can finance it when they desire it most rather than when they have the cash to pay for it.
In the long run, borrowers pay the cost of the insurance provided by bankruptcy law. To recoup their losses from bankruptcy, creditors will raise the cost of borrowing by using a combination of stricter standards and terms on their loans, such as higher interest rates, larger down payments, and restrictions on the supply of credit. Essentially, the premium borrowers pay for the insurance coverage of bankruptcy is that additional cost of borrowing. In the short run, creditors will share some of the risk of default if their loan losses are greater than expected. Moreover, if the law is tightened, creditors are likely to profit--at least temporarily (see the later discussion).
The strength of the law's incentive to borrow and the cost of borrowing depend on the magnitude of the fresh start. The greater the fresh start, the greater are the incentive to borrow and the cost of borrowing. A larger fresh start also gives people more incentive to use bankruptcy, rather than other means, to solve their financial problems and escape debt repayment. Consequently, a bankruptcy law with a generous fresh start may promote greater risk spreading, but it can also raise the cost of borrowing by expanding the fresh start and making it easier for people to walk away from debts that they could afford to repay.
The difficulty of achieving a desirable trade-off between the benefit of risk sharing and its cost helps explain several changes to bankruptcy law since the late 1970s:
Under Chapter 7, the administrator of a bankruptcy case, who is known as the trustee, oversees the liquidation, or sale, of a debtor's nonexempt assets and the distribution of the proceeds to creditors. Only creditors with "allowable" claims in the case receive a share of those proceeds, which are distributed after the trustee's expenses, other administrative costs, and priority claims have been paid. Unless the court finds that the debtor was dishonest or engaged in wrongdoing, it discharges (forgives) all allowable claims on the person and his or her assets except for nondischargeable claims (for example, many kinds of taxes) and any debts covered under reaffirmation agreements (in which the person specifically agrees to repay one or more debts). The debtor keeps the value of the assets designated as exempt under the law (the fresh start discussed above) and may not receive another discharge under Chapter 7 for six years.
Although bankruptcy law is federal in scope, provisions designating exempt assets appear in both federal and state law. BRA-78 introduced federal exemptions but allowed states to "opt out" of using the federal limits and continue using their own. Today, 35 states do not use the federal exemptions; in the remaining states, residents may use either the federal or the state exemptions. Both federal and state exemptions cover broad categories of assets including primary residences; motor vehicles; various kinds of personal property, such as household goods and clothing; and the tools of a person's trade. However, the particular types of assets that may be exempt and the dollar values of those exemptions vary widely.
The homestead exemption is a good example of how dollar values for asset exemptions differ among the states. Georgia allows bankrupt consumers to keep only $5,000 of equity in real property used as a residence; Florida, in contrast, allows an unlimited amount of equity in as much as one-half acre in a municipality or 160 contiguous acres elsewhere (King 1998). The federal dollar limit on the homestead exemption is currently $16,150 and is adjusted for inflation every three years.
Basic Provisions of Chapter 13
Chapter 13 helps people avoid liquidation of their assets by requiring them to repay their debt out of future income. To qualify for a Chapter 13 discharge, debtors (with the exception of stockbrokers and commodity brokers, who are covered by separate provisions) must have a regular income, and their unsecured (such as credit card) and secured debts must total less than $269,250 and $807,750, respectively. The debt limits are adjusted for inflation every three years.
Under Chapter 13, the debtor works with the trustee and submits a plan to the court to repay outstanding debts over three (or, in some circumstances, five) years. The plan must satisfy three criteria:
When the payments are completed, the consumer receives a discharge from all debts that the plan covered. A Chapter 13 filing has three advantages (relative to a Chapter 7 filing) that encourage people to use it: debtors retain all of their property, not just their exempt assets; a greater variety of claims can be discharged; and consumers may be able to repay less than they owe on certain secured debts.
The rapid increase in the personal filing rate between 1994 and 1998, despite the vigor of the nation's economy, is unusual but not unprecedented, given that the rate has risen during previous periods of relatively strong economic growth as well as recession. In fact, for the most part, the rate has trended upward since the end of World War II. What accounts for the growth in personal bankruptcy filings, both before 1994 and, more specifically, between 1994 and 1998? On the surface, the upswing in the filing rate mimics the trend in the risk of default for the household sector. Yet because households have some control over that risk, changes in its trend do not completely explain changes in the personal filing rate. As discussed later, the current policy debate is about what underlies the ascending trends in both measures.
The Personal Filing Rate in the Postwar Period
The personal filing rate has risen during all but one economic expansion of the postwar period (see Figure 1). Indeed, although the rate has often increased especially sharply during recessions, much of its postwar growth has occurred in good economic times, not in slowdowns. Between 1948 and 1967, the rate climbed in every year except 1962, when it fell slightly after a jump in 1961. Between 1967 and 1979, the rate varied within a modest range, following a more cyclical pattern--rising during a recession, falling immediately afterward, and then rising later in the expansion. The rate has trended strongly upward in the 1980s and 1990s, with modest declines following recessions. The rate fell in 1999, though it remains high.
The break in the personal filing rate displayed in Figure 1 shows that after 1979, the rate is not strictly comparable with the rate before that year. The reason is that the Bankruptcy Reform Act of 1978 introduced joint husband-and-wife bankruptcy petitions. (Before the law was enacted, a husband and wife had to file separate petitions.) Comparing the number of filings before and after 1979 is difficult because analysts do not know how to adjust the data to account for the joint filings . CBO chose to indicate the break when appropriate and, after 1979, to use the number of nonbusiness bankruptcy filings to calculate the personal filing rate.
The Personal Filing Rate and the Household Sector's Risk of Default
Changes in the personal filing rate tend to mirror changes in the risk of default in the household sector. A household's risk of default generally rises when:
- It takes on additional debt,
- Interest rates on its floating-rate debt rise,
- Its income falls, or
- Its extraordinary or other living expenses rise.
Analysts typically use two ratios to measure the household sector's risk of default: the debt-to-income ratio and the debt-service burden. Yet neither of those measures is a perfect indicator of default risk. Both fail to incorporate changes in extraordinary and other living expenses, and the debt-to-income ratio does not encompass interest rate changes on floating-rate debt or the effects on monthly payments of refinancing debt.
Debt-to-Income Ratio. This ratio is measured as the sum of consumer credit plus home mortgage debt divided by disposable, or after-tax, personal income. It compares the level of the major types of debt held by the household sector with a measure of the sector's ability to repay that debt. A larger amount of debt relative to income indicates a larger amount of default risk; that is, as more households have more debt relative to their repayment ability, more of them are more likely to face financial difficulties arising from any source.
The risk of default, according to this measure, can mount because households take on more debt relative to their income or because their income falls relative to their debt. In economic expansions, households generally take on debt at a greater rate than the rate at which their income expands; most analysts think the reason is that households feel confident about their income prospects and their debt-repayment ability. At the same time, creditors are more willing to lend because they feel more confident that they will be repaid. By contrast, in recessions, creditors are less willing to lend. Households, for their part, take on debt more slowly, but the growth rate of their income drops off even more sharply. Just after recessions, the debt-to-income ratio may fall for a while because households' incomes pick up before households and creditors become confident enough about their financial futures to resume more normal patterns of borrowing and lending.
Both before and after 1979, the broad trend in the personal filing rate follows the trend for the debt-to-income measure (see Figure 2). Given the break in the data for the personal filing rate, one cannot conclude that the relationship remained the same in the two periods. Nevertheless, the increase in the personal filing rate between 1994 and 1998 is broadly consistent with the rise in the household sector's default risk during that period.
Generally, an increase (or decrease) in the risk of default precedes an increase (or decrease) in the personal filing rate. For the year ending June 30, 1998, for example, the rise in the personal filing rate reflects the rise in the risk of default at the end of calendar year 1996. The lag may occur because loans typically do not go into default immediately and because people may try to resolve their financial problems before filing for bankruptcy. The lag appears to be the same both before and after 1979.
Some analysts dispute the correlation between the personal filing rate and debt-related measures of the household sector's default risk. Their arguments, however, are based on less useful measures of that risk. Chimerine (1996) and Feldstein (1998), for instance, do not believe that the rise in personal bankruptcy filings during the mid-1990s is related to growth in the debt holdings of the household sector. However, the measure Chimerine uses covers only consumer credit; it excludes home mortgages and home-equity loans, which are substantial components of household debt. Indeed, many people have taken equity out of their homes to support their consumption, using such loans as a substitute for consumer credit (Canner, Durkin, and Luckett 1998). One of Feldstein's arguments against the idea that debt contributed to the surge in filings is that the nominal-dollar value of debt is not closely related to personal bankruptcy filings. That finding is not surprising because the amount of outstanding debt presumably rises when creditors believe that they will be repaid. Thus, the ratio of debt to income, rather than the nominal-dollar amount of debt, better measures the household sector's vulnerability to financial problems.
Debt-Service Burden. This measure is the ratio of the household sector's debt-service payments to disposable personal income, as computed by the staff of the Board of Governors of the Federal Reserve System. Debt-service payments are the principal and interest payments on consumer credit and home mortgages (the two debt variables used in the debt-to-income ratio). According to that measure, the risk of default increases as debt-service payments rise relative to income. Because no comprehensive statistics exist on actual debt-service payments by households, the Board of Governors' staff estimate the payments using data on the average terms for new loans and a variety of assumptions for the period since 1980. The staff consider their estimates to be a "rough approximation" that is useful for indicating changes in (rather than levels of) the household debt-service burden.
The relationship between growth in the personal filing rate and the change in the household debt-service burden, plotted with a one-year lag, is shown in Figure 3. Growth in the filing rate tends to increase (or decrease) in the year following a greater (or smaller) increase in the debt-service burden. In particular, the slowdown in the rate's growth during the past few years corresponds to smaller increases in the debt-service burden.
FACTORS LEADING TO PERSONAL BANKRUPTCY
The current debate over revising personal bankruptcy law centers on the reasons for the personal filing rate's jump between 1994 and 1998 and its continued high level since then. Some observers believe that the high rate, occurring in a strong economy, indicates that many consumers are filing for bankruptcy even though they could repay a substantial portion of their debt. Those observers argue that a significant proportion of recent filings stem from various legal and social factors--in particular, an overly lenient personal bankruptcy law and a weakening of the stigma that has traditionally been associated with bankruptcy. Other observers maintain that growth in the filing rate largely reflects a household sector that has become heavily indebted and unable to manage its debt burden, as a result of financial troubles brought on by bad judgment or bad luck. The debate comes down to the empirical question, What is the relative importance of the various factors leading to personal bankruptcy?
Empirical research has made only limited progress in supplying an answer. The close correlation during the postwar period between the default risk of the household sector and the personal filing rate suggests that macroeconomic factors underlying the risk of default play a large role in what happens to the rate nationally. Economists would generally agree that those factors include measures of the financial health of the household sector and other aspects of the demand for and supply of credit. Because of possible methodological problems, however, empirical studies do not consistently find that macroeconomic factors significantly affected the filing rate.
Mixed success also characterizes attempts to estimate how much the incentives in bankruptcy-related federal and state law, as well as various social factors, influence the personal filing rate. Those elements complement the macroeconomic factors by providing additional explanations of credit demand and supply. But measuring such elements accurately has proved difficult, if not impossible. The clearest finding on how consumers respond to the incentives in bankruptcy law comes from research comparing filers under Chapter 7 with those under Chapter 13. Those studies suggest that consumers file for bankruptcy under the chapter that best suits their circumstances. Moreover, some evidence suggests that the probability of filing for bankruptcy rises with the financial benefits of filing. Research using the personal filing rate measured at the national, state, and circuit court levels is split, however--some studies found that bankruptcy law affected the filing rate, and others did not. Several studies attempted to analyze whether changes in the stigma associated with bankruptcy had affected people's propensity to file. But those studies were hampered by the use of proxy variables (discussed below) that do not isolate stigma's effects.
Broadly speaking, the trends in the risk of default and indebtedness in the household sector reflect trends in the sector's economic health and in the supply of credit available to households. The 1946-1967 period, which encompassed the baby-boom years (1946 to 1964), was a time of rapid family formation. Consumers were optimistic about the future because of low unemployment, low inflation, strong household balance sheets, and the rapid growth of real (adjusted for inflation) disposable personal income per capita. Consequently, lenders accommodated consumers' robust demands for credit, and indebtedness rose rapidly to finance spending for housing and consumer durable goods. With greater indebtedness (and, presumably, larger debt-service payments) relative to income, personal bankruptcies rose as well.
In contrast, overall household finances generally deteriorated from about 1968 through 1982. The period was marked by economic turbulence as a consequence of food and energy price "shocks" and rising inflation, two deep recessions on top of a slowdown in the trend growth of real disposable personal income per capita, and postwar highs in short- and long-term interest rates. Consumers lowered their expectations about future economic conditions and grew cautious about accumulating debt. Debt-financed purchases of houses and consumer durable goods slowed, possibly also because the surge in family formation and the baby boom were over. The personal filing rate was strongly correlated with the business cycle during this period, as external forces dominated changes in family finances.
After 1982, the financial picture of the household sector brightened. A strong economic recovery, rising stock market, and sharp drops in energy prices, inflation, and interest rates bolstered the sector's general financial health. Consumers' expectations about their future prospects soared. With the baby-boom generation entering its own family-formation phase, spending for housing, furniture, and other consumer goods expanded, as did home mortgage and consumer debt. At the same time, consumers increasingly used general-purpose credit cards as a substitute for cash. As the indebtedness and default risk of the household sector increased, so did personal bankruptcies.
The recession at the beginning of the 1990s and the slow recovery from it kept a lid on the demand for credit by consumers and potential home buyers for several years. But economic conditions in the household sector had improved again by the second half of the decade. Employment gains came quickly as the economy began to grow more rapidly; by the late 1990s, the civilian unemployment rate had fallen to levels not seen in over two decades. Interest rates also fell while inflation remained under control, and household wealth was boosted by impressive gains in the stock market. That confluence of favorable developments bolstered consumer confidence and expectations about the future and probably contributed to the rise that occurred in household indebtedness and default risk.
The preceding explanation of the broad trends in the demand for credit by households and in the risk of default in the household sector is based on a widely accepted theory of consumer spending behavior, the life-cycle model. Accounting for variations in the household sector's debt holdings more precisely is difficult, however, because the literature offers few models of total household indebtedness. That limited understanding of indebtedness mirrors economists' lack of knowledge about the factors that influence the rate of personal saving in the United States.
The saving rate fell in the mid-1980s and dropped considerably in the 1990s--at the same time that household indebtedness and personal bankruptcies were rapidly rising.
Home mortgage and consumer lenders, of course, share responsibility for the rise in the household sector's risk of default. Lenders affect that risk through their terms and standards of lending: lenient terms and standards encourage borrowing, which raises default risk. Indeed, lenders have made credit more widely available, particularly in the past two decades--a period encompassing changes in bankruptcy law and alleged reductions in the stigma attached to bankruptcy. That wider availability stemmed from deregulation of credit markets, technical innovations, tax policy, and competition among lenders. For example:
- The Supreme Court's 1978 decision in Marquette National Bank of Minneapolis v. First of Omaha Service Corporation allowed a nationally chartered bank to extend credit at the maximum interest rate of the state in which it was chartered rather than at the maximum rate allowed by the borrower's state. That decision spurred many states during the early 1980s to raise or eliminate the maximum rates of interest (usury ceilings) that lenders could charge consumers, which contributed to the rapid growth of credit card lending in the 1980s.
- The elimination of ceilings on interest rates for deposits in banks and thrift institutions ended the flow of funds out of those institutions when market interest rates rose above the ceilings. The change helped to stabilize the availability of funds for borrowers.
- The Tax Reform Act of 1986 eliminated the tax deductibility of interest payments on consumer loans, which spurred growth in the market for home-equity loans. Those loans cost less than consumer loans because their interest rates are lower and interest payments are tax-deductible.
- Advances in information processing and in financial management techniques have reduced the costs of marketing and servicing a large portfolio of loans. They have also allowed lenders to price and manage risk better by using "credit-scoring" models (to evaluate prospective borrowers) and loan securitization (to sell some of their loans to others). For example, high loan-to-value home-equity loans (for up to 125 percent of a homeowner's equity) have become widely available.
The increased availability of credit has made individuals and homeowners better off. By increasing the risk of default in the household sector, however, it has also contributed to a higher incidence of personal bankruptcy. Consumers who formerly could not get the credit they wanted have found it much easier to obtain in the past 20 years. Indeed, evidence compiled by the Board of Governors of the Federal Reserve System indicates that borrowing increased broadly throughout the population during the 1980s and the first half of the 1990s. To the extent that the increase in indebtedness of the household sector reflects borrowing by consumers who previously found credit difficult to obtain, that indebtedness would be more the result of the greater supply of credit than of changes in attitudes toward debt and bankruptcy. (That would be true even if more marketing of credit had changed consumers' attitudes.) Evaluating that possibility, however, requires additional research.
Legal Incentives to File for Bankruptcy
A considerable amount of research has examined whether the incentives contained in federal and state law have driven up bankruptcy filings. Many studies have investigated BRA-78's effect on the personal filing rate; others have developed simple measures of the value of asset exemptions to judge how those exemptions affect personal filing rates among the states and the probability of filing among individual consumers. Still other studies have looked at whether incentives affect a person's choice of a Chapter 7 or Chapter 13 filing.
Such research has encountered considerable difficulty in identifying the incentives' effects, in part because many of them are extremely difficult to quantify. The results of studies of how BRA-78 affected the personal filing rate range from no effect to a substantial one; studies that searched for a relationship between asset exemptions and personal filing rates among the states also have mixed findings. Nevertheless, there is some evidence that the probability of filing for bankruptcy and the choice of the bankruptcy chapter under which to file depend on the benefits of filing. Moreover, simple comparisons of the characteristics of people who file for bankruptcy suggest that they respond to the law's incentives by filing under the chapter that best suits their circumstances.
How Differences in the Benefits of Bankruptcy Affect the Probability of Filing. Fay, Hurst, and White (1998) found evidence suggesting that people do respond to the incentives in bankruptcy law, although their results are weakened by the small number of filers in their sample. Their study used data from households participating in the University of Michigan's Panel Study on Income Dynamics from 1984 to 1996; the 1996 "wave" of the study asked respondents if they had ever filed for bankruptcy and if so, when. The researchers found that the probability of filing increased as the value of bankruptcy's benefits rose to $9,000; thereafter, the estimated probability did not change. (Fay, Hurst, and White defined "benefits" as the difference between respondents' unsecured debt and their wealth after subtracting the value of exempt assets allowed by their state.) However, only 254 of the thousands of households in the study had ever filed for bankruptcy. Gross and Souleles (1998) note that estimating probabilities from models with such small samples can give misleading results.
Indeed, the small number of filers in the sample may be responsible for several puzzles in Fay, Hurst, and White's results. For example, the researchers divided the variable for benefits into five separate variables representing different ranges of benefits. Yet only two of the five coefficients for the variables were statistically significant. Furthermore, the estimated overall effect of the benefit variables was different over time. The researchers found the expected positive effect on the probability of filing in the first half of their sample (1984 to 1989) but only a small and negative effect in the latter half (1990 to 1995). Those results, if taken at face value, would imply that the incentives in bankruptcy law were encouraging personal filings in the second half of the 1980s but discouraging them in the first half of the 1990s. Alternatively, they may simply indicate that such a small sample of filers is unlikely to yield stable results.
How Incentives Affect the Choice of Bankruptcy Chapter for Filing. Another way researchers have looked for the effects of the incentives to file for bankruptcy is by examining whether people choose the chapter under which they file on the basis of available asset exemptions. The general hypothesis of such studies is that a high level of asset exemptions creates an incentive for people to file under Chapter 7 rather than under Chapter 13.
Domowitz and Sartain (1998) examined a very small sample of personal filers in the early 1980s and found that bankruptcy asset exemptions affected people's choice of chapter. They estimated that, all else remaining constant, a 50 percent drop in exemption levels would increase the probability of a person's choosing Chapter 13 over Chapter 7 by between 18 percent and 25 percent.
Other studies exploring the impact of asset exemptions on chapter choice yield mixed results. For example:
- The General Accounting Office (1983) found that as a group, states that opted out of the federal exemptions in the early 1980s experienced slower growth in Chapter 7 filings than the group of states that permitted use of the federal exemptions. However, the GAO researchers also found considerable variation in filings by state, which led them to conclude that they could not make a "definitive assessment of the impact of Federal exemptions on decisions to file bankruptcy" (p. 34).
- White (1987-1988) used a model based on county-level data in 1981 and found that asset exemptions significantly affected chapter choice. According to the model, higher exemptions raised Chapter 7 filings and lowered Chapter 13 filings.