PERSONAL BANKRUPTCY: A LITERATURE REVIEW. September 2000

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1 PERSONAL BANKRUPTCY: A LITERATURE REVIEW September 2000

2 NOTES Shaded areas in figures represent recessins as defined by the Natinal Bureau f Ecnmic Research. The areas extend frm the peak t the trugh f the recessins. Annual data n persnal bankruptcy filings end n June 30 f the year indicated. Other annual data refer t calendar years. Numbers in the text and tables may nt add up t ttals because f runding.

3 PREFACE The sharp rise in persnal bankruptcy filings between 1994 and 1998, a perid f ecnmic expansin, has renewed a lng-standing debate abut bankruptcy laws. One side f that debate ascribes a significant share f the rise in filings t the current law and t a lessening f the stigma assciated with filing fr bankruptcy. The ther side f the debate argues that the rise primarily reflects an increase in financial distress within the cnsumer sectr. This Cngressinal Budget Office (CBO) paper reviews the available data and evaluates the empirical research n persnal bankruptcy. It was prepared at the request f Jhn Cnyers Jr., Ranking Demcratic Member, Huse Cmmittee n the Judiciary; Jerrld Nadler, Ranking Demcratic Member, Subcmmittee n Cmmercial and Administrative Law f the Huse Cmmittee n the Judiciary; and Representatives William D. Delahunt and Martin T. Meehan. Kim Kwalewski f CBO s Macrecnmic Analysis Divisin prepared the paper under the supervisin f Rbert Dennis. At CBO, Cleman Bazeln, Dug Hamiltn, Arlene Hlen, Debbie Lucas, Angel Mascar, Jhn Petersn, David Trregrsa, and Christpher Williams ffered helpful cmments, and David Arnld, Ezra Finkin, Jhn McMurray, and Michael Simpsn prvided capable research assistance. Thanks are due t Ian Dmwitz f Pennsylvania State University, Stanley Lnghfer f Wichita State University, Dean Maki f the Bard f Gvernrs f the Federal Reserve System, Prestn Miller f the Federal Reserve Bank f Minneaplis, and Tim Muris and Tdd Zywicki f Gerge Masn University's Schl f Law fr their cmments n earlier drafts. Special thanks g t Melissa Jacby f the Beasley Schl f Law at Temple University fr sharing her expertise n cuntless ccasins regarding persnal bankruptcy and the law, and t Marilyn Miller f the Administrative Office f the U.S. Curts fr prmptly filling requests fr data n bankruptcy filings. Kevin Brwn f the Federal Depsit Insurance Crpratin kindly supplied and explained the data n cmmercial banks. Leah Mazade edited the paper, and Christine Bgusz prfread it. Verlinda Lewis-Harris typed the paper and prepared the manuscript fr final publicatin. Annette Kalicki prepared the electrnic versins fr CBO s Wrld Wide Web site (www.cb.gv). Questins abut the analysis may be addressed t Kim Kwalewski at (202) September 2000 Dan L. Crippen Directr

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5 CONTENTS SUMMARY vii THE FUNDAMENTALS OF PERSONAL BANKRUPTCY LAW 1 Debt Cllectin and Insurance Basic Prvisins f Chapter 7 Basic Prvisins f Chapter 13 TRENDS IN PERSONAL BANKRUPTCY FILINGS 4 The Persnal Filing Rate in the Pstwar Perid The Persnal Filing Rate and the Husehld Sectr s Risk f Default FACTORS LEADING TO PERSONAL BANKRUPTCY 11 Macrecnmic Factrs Legal Incentives t File fr Bankruptcy The Stigma f Bankruptcy THE ABILITY OF CHAPTER 7 FILERS TO REPAY THEIR DEBTS 23 Means-Testing Prpsals frm the 105th and 106th Cngresses Studies Estimating Debt-Repayment Capacity Under the Prpsals Implicatins f the Studies Estimates Uncertainties Surrunding the Estimates HOW PERSONAL BANKRUPTCY AFFECTS THE SUPPLY OF CREDIT 31 Creditrs Respnses t Persnal Bankruptcy Prvisins The Impact f Persnal Bankruptcy n Creditrs Lsses Explaining the Recent Decline in Persnal Filings

6 vi PERSONAL BANKRUPTCY: A LITERATURE REVIEW APPENDIXES A. Prblems with the Data n Persnal Bankruptcy Filings 41 B. The Stigma Variables Used by Fay, Hurst, and White 45 REFERENCES 47 TABLES 1. Parameters fr the Means-Testing Prpsals Examined by the Studies Dispsitin f Chapter 13 Cases, Average Lsses and Recveries per Bank n Bank Credit Cards 35 FIGURES 1. The Persnal Filing Rate fr Bankruptcy, The Persnal Filing Rate and the Debt-t-Incme Rati f the Husehld Sectr, Grwth in the Persnal Filing Rate and the Debt-Service Burden f the Husehld Sectr, Prfitability Measured as the Return n Assets and Net Lsses fr Cmmercial Banks Specializing in Credit Card Lending The Delinquency Rate n Credit Card Lans at Cmmercial Banks 38 A-1. Jint Persnal Bankruptcy Filings 43

7 SUMMARY During the ecnmic expansin f the 1990s, the rapid increase in the rate f filing fr persnal bankruptcy fcused attentin n the natin s bankruptcy law. Between 1994 and 1998, the persnal filing rate specifically, the number f nnbusiness bankruptcy cases filed annually per millin adults rse abut 75 percent t a histric high f 7,148 (r abut 0.7 percent f the United States adult ppulatin). Yet at the same time, the ecnmy was expanding at a healthy pace, and the civilian unemplyment rate was falling. That apparent cntradictin renewed a lng-standing debate abut hw big a rle bankruptcy law and ther factrs may have played in the persnal filing rate s climb. Persnal bankruptcy law is intended t help peple wh cannt pay their debts. By filing under Chapter 7 f the law, peple may generally avid repaying many kinds f debt in full. The law als allws them t keep specified amunts f certain assets (knwn as exempt assets) and all future incme fr a fresh start in life after bankruptcy. Cnsequently, bankruptcy law creates an incentive fr peple t increase their brrwing because they knw that they will nt be impverished if they have truble with debt. The magnitude f the incentive, as well as the chice f bankruptcy fr slving financial prblems, depends n the extent f the benefits that a persn receives frm bankruptcy. A law that allwed an ample fresh start wuld give peple a greater incentive t brrw than wuld a law with a smaller fresh start. Indeed, a lenient law creates a greater temptatin fr peple t brrw mre mney than they culd pssibly repay ver a reasnable perid f time. Such a law wuld als give peple a greater incentive t chse bankruptcy rather than ther ways f slving their prblems. In fact, a mre lenient law gives peple with few assets but the capacity t repay sme f their debts ut f future incme a strnger incentive t use bankruptcy t escape debt repayment altgether. Bankruptcy law als creates an incentive fr lenders t reduce the supply f credit and raise the cst f brrwing. Lsses stemming frm bankruptcy, like lsses frm ther defaults n lans, encurage lenders t bst their interest rates, tighten ther standards and terms fr lending, and reduce the availability f lans. Peple typically respnd t thse changes by brrwing less, which diminishes their expsure t debt-repayment prblems and makes them less likely t file fr bankruptcy. Advcates n ne side f the debate abut the effects f current bankruptcy law believe that its incentives explain a large part f the filing rate s upswing and its cntinued high level. They argue that Chapter 7 makes it t easy and t attractive fr peple t avid repaying their debts. Such advcates cntend that a significant number f debtrs file fr a Chapter 7 bankruptcy even thugh they are likely t have sufficient incme in the future t repay a sizable prtin, if nt all, f their debts.

8 viii PERSONAL BANKRUPTCY: A LITERATURE REVIEW Als cntributing t the higher rate f filing, say sme bservers, is a lessening f the stigma that sciety has traditinally assciated with bankruptcy. Many peple wh cnsider current law t lenient argue fr a means-testing prvisin that wuld restrict the way a persn culd file fr bankruptcy. The prvisin wuld prhibit peple wh exceeded certain threshlds fr incme and debt-repayment ability frm filing under Chapter 7 f the law; their ptins wuld be t withdraw their petitin r t file under Chapter 13 f the law, which encurages them t repay mre f their debts ut f future incme. (Under that prvisin, peple set up a curt-apprved plan t repay a specific amunt f debt ver three t five years, after which they may stp repaying the remaining debts cvered under the plan.) Advcates n the ther side f the debate abut current bankruptcy law see the higher persnal filing rate as largely reflecting an increase in financial distress within the husehld, r cnsumer, sectr f the ecnmy. They cntend that such distress stems frm adverse circumstances that batter peple s finances r frm hnest mistakes that peple make in managing their mney. Sme prpnents f that psitin attribute mst f the rise in the persnal filing rate t lenders, particularly bank credit card lenders, wh, they say, have verburdened peple by extending credit recklessly. Many bservers n this side f the debate argue against a meanstesting prvisin fr persnal bankruptcy law. The debate attests t the difficulty that plicymakers have in designing a bankruptcy law that prmtes the cmmn gd. Mst peple wuld prbably apprve in thery f a law that prevented cnsumers frm intentinally cheating creditrs by running up debt and then using bankruptcy t escape repayment. The challenge fr lawmakers is t develp prvisins that catch nly the cheaters, because the distinctin between them and peple wh, in sciety s view, deserve a fresh start is nt always clear-cut. A mre exacting law might lwer brrwing csts and increase the availability f credit, but it culd als deny a fresh start t deserving individuals. Cnversely, a mre lenient law that expanded the fresh start and allwed mre cheaters t walk away frm debts might raise the csts f brrwing and reduce the supply f credit. Evidence abut hw much brrwers and lenders respnd t the incentives in bankruptcy law wuld help plicymakers as they wrk t redesign it. Hw much d thse incentives affect peple s decisins t brrw mney and t declare bankruptcy? What percentage f debts discharged (r frgiven) in bankruptcy culd actually be repaid? Hw much d lenders adjust the cst and availability f credit n the basis f changes in their bankruptcy lsses? Answers t thse questins wuld give plicymakers vital clues abut the pssible inefficiency f current law. In its search fr thse answers, the Cngressinal Budget Office (CBO) reviewed the available data and evaluated existing studies n persnal bankruptcy.

9 PERSONAL BANKRUPTCY: A LITERATURE REVIEW ix Overall, CBO fund that thse surces generally ffered nly limited guidance. Althugh ecnmic reasning can identify the directin f brrwers and lenders respnses t incentives in bankruptcy law, empirical research has made nly a little prgress in estimating the magnitude, and hence the significance, f thse respnses. Estimates f ptential debt repayment by Chapter 7 filers under varius prpsals with a means-testing requirement suggest that sme filers might be using bankruptcy t escape frm their debts. The ptential repayments by thse filers are uncertain; they might amunt t as much as several billin dllars. Repayments f that magnitude wuld cntribute t a lwer cst and a greater availability f credit, but the exact changes are unclear. Many analysts wh have studied the current bankruptcy law agree that sme f its prvisins culd, indeed, be imprved. 1 Hwever, this paper des nt analyze alternative prpsals fr changing the law, nr des it indicate areas in which the law might be refrmed. Mrever, fllwing CBO s standard prcedures, it des nt present recmmendatins abut plicy. Available Data n Bankruptcy and Related Tpics A lack f data hinders any attempt t analyze the effect f bankruptcy law n brrwers and lenders. The fficial statistics cllected by the Administrative Office f the U.S. Curts are insufficient t determine hw well the bankruptcy system is wrking. Fr example, such basic infrmatin as the ttal amunt f debt discharged in persnal bankruptcy is lacking, and the data n persnal bankruptcy filings have several prblems that limit their usefulness (see Appendix A). 2 Data n individual filers are scanty as well, and fr gd reasn: cllecting such data wuld require nt nly a large sample f persnal bankruptcy petitins but als direct questins t the cnsumers themselves a cmplex, expensive undertaking. Data n related tpics, such as the stigma assciated with a bankruptcy filing, simply d nt exist. And public infrmatin n the cst and availability f credit fr cnsumers is fragmentary, which makes it difficult t estimate hw much lenders adjust the quantity and price f the credit they ffer in respnse t their bankruptcy lsses. What the available data d indicate is that, frm a histrical perspective, the rapid rise in the persnal filing rate frm 1994 t 1998 is unusual but nt unprecedented. The rate has als risen, in sme cases rapidly, in ther ecnmic expansins since the end f Wrld War II. In the bradest f terms, the persnal filing rate fllws the risk f default within the husehld sectr, measured as either the sectr's debt-t-incme rati r its debt-service burden (the rati f husehld debt payments t dispsable persnal incme). Indeed, increases in the risk f 1. See, fr example, the Natinal Bankruptcy Review Cmmissin (1997). 2. Bermant (1999) discusses ther gaps in the data abut peple wh file fr bankruptcy.

10 x PERSONAL BANKRUPTCY: A LITERATURE REVIEW default within the husehld sectr typically precede increases in the persnal filing rate, which suggests that at least sme f the majr factrs behind the rise in persnal bankruptcies during the 1990s are the same factrs that increased the husehld sectr s risk f default. Empirical Research n the Factrs Leading t Persnal Bankruptcy The empirical literature n persnal bankruptcy is vluminus, but researchers have made little prgress in judging the relative imprtance f the factrs that lead peple t file. Ecnmists wuld generally agree that the health f the ecnmy and f the husehld sectr and ther aspects f the demand fr and supply f credit are key macrecnmic factrs that underly the brad trends in the risk f default within the husehld sectr. Cnsequently, they might als be expected t significantly affect the persnal filing rate. Empirical studies d nt, hwever, cnsistently find such effects. Nt surprisingly, studies f individual filers indicate that a persn s financial health affects his r her chances f ging bankrupt. Such research has shwn that peple frm all walks f life experience financial difficulty fr a variety f ecnmic and persnal reasns, including large medical bills fllwing a serius illness r accident; divrce; lss f incme as a result f unemplyment r a drp in vertime hurs; and what is generally termed pr debt management, which may cver several underlying factrs. 3 Hwever, fr the mst part, the studies d nt examine the specific factrs that might mtivate a persn t file fr bankruptcy rather than reslve financial distress in sme ther way. (Fr example, ne impetus tward filing may be the desire t avid wage garnishment.) 4 Because the surces f financial difficulty shed little light n hw peple respnd t the incentives in bankruptcy law, thse studies are nt reviewed in this paper. Research t estimate hw the incentives in bankruptcy law affect persnal filings has had limited success. Perhaps the clearest finding frm such studies is that cnsumers generally file under the chapter f the law that best suits their financial circumstances. Anther result frm a study f cnsumers suggests that the prbability f filing fr bankruptcy generally increases with bankruptcy s financial benefits. Other studies have had less success in identifying the rle played by bankruptcy law incentives. Fr example, studies f the estimated impact f the Bankruptcy Refrm Act f 1978, which instituted majr changes in the law, fund effects ranging frm negligible t substantial. Research has als prduced mixed 3. Luckett (1988) briefly reviews sme f that research. 4. In general, studies shw that rates f filing fr bankruptcy tend t be higher in states with stricter laws fr wage garnishment. See, fr example, Stanley and Girth (1971) and Ellis (February 1998).

11 PERSONAL BANKRUPTCY: A LITERATURE REVIEW xi results abut hw prvisins fr exempt assets affect persnal filing rates measured at the state level. Several studies maintain that the scial stigma assciated with filing fr bankruptcy plays a significant rle in determining the filing rate, but at best, thse findings are merely suggestive. Because direct measures f stigma d nt exist, the studies used ther variables as prxies that is, t apprximate the effects f stigma. Hwever, the prxy variables did nt islate stigma s influence n the filing rate. Sme f thse variables were related t ecnmic factrs in additin t stigma, and sme prxies measured nly an unexplained change in filing rates ver time. Other prxies were pen t interpretatin. Cnsequently, the studies prbably verstated the effects f stigma. Studies Simulating Prpsals fr a Means-Testing Prvisin in Bankruptcy Law A clearer indicatin f hw peple respnd t the incentives in bankruptcy law cmes frm several studies that simulated recent legislative prpsals fr a meanstesting requirement. The requirement wuld prhibit Chapter 7 filings (but nt filings under Chapter 13) by peple whse incmes were abve certain threshlds and wh culd repay a minimum percentage r amunt f their nnpririty unsecured debt (fr example, credit card debt) ver a five-year perid. (Little nnpririty unsecured debt is repaid in bankruptcy.) As nted earlier, advcates f a meanstesting requirement argue that current law gives peple a strng incentive t file fr bankruptcy t avid debts that they culd affrd t repay. The studies' estimates f the number f filers whse incme and debt-repayment capacity wuld have exceeded the means-testing threshlds prvide ne indicatin f the pssible magnitude f the incentive s effect. The studies suggest that a small percentage f Chapter 7 filers culd repay a substantial prtin f their nnpririty unsecured debt. A very small percentage typically n mre than 5 percent f filers culd repay 100 percent r mre f that debt; larger percentages but typically n mre than 15 percent f filers had the means t repay at least 20 percent r 25 percent. (The results depended n the study and the specific prpsal being examined.) In particular, a study f H.R. 833, the Bankruptcy Refrm Act f 1999, estimated that 10 percent f Chapter 7 filers in 1997 culd repay at least 25 percent r $5,000 f their nnpririty unsecured debt ver a five-year perid. Anther general finding frm the studies was that the amunt f nnpririty unsecured debt repaid by peple exceeding the means-testing threshlds wuld amunt t n mre than a few billin dllars. (Researchers wh simulated the effects f H.R. 833 estimated repayment f $3 billin, r 8.6 percent, f the ttal amunt wed by Chapter 7 filers in 1997.) Althugh the studies agree in a brad sense that sme filers culd repay a substantial prtin f their debts, they differ in their estimates f the percentage f

12 xii PERSONAL BANKRUPTCY: A LITERATURE REVIEW filers wh wuld nt be allwed t file under Chapter 7 and the amunt f debt they might repay. The varying prvisins f the means-testing prpsals and researchers differing assumptins abut the amunt f incme that filers culd keep fr living expenses while repaying their debts accunted fr mst f the differences; the remaining variatin (prbably nly a small part verall) reflected differences in the samples f filers that the studies used. The prpsals adpt the standards fr living expenses that the Internal Revenue Service uses in tax cllectin cases. But researchers in the studies CBO examined interpreted thse standards and the expenses they cvered in varying ways, which raises the questin f hw different bankruptcy judges wuld rule n the allwances and cnsequently hw much debt culd actually be recvered. Anther area in which the studies differ is in their assumptins abut infrmatin that was unavailable t researchers, such as a filer s mnthly payments n secured debts like mrtgages. The amunt f debt repayment that a means-testing requirement might generate is uncertain fr ther reasns. Fr instance, the studies assume that filers wuld cmplete their Chapter 13 repayment plans. Yet the available data indicate that a significant fractin f cnsumers wh filed Chapter 13 plans in the past did nt make all f their scheduled payments. (Why thse plans fail is nt clear.) Anther unknwn factr cluding debt-repayment estimates is hw peple wuld respnd t a repayment plan that stretched ut fr five years and cmmitted a substantial prprtin f their incme t paying dwn debt. Sme filers might decide that repayment was t burdensme and s wrk less r hide incme t reduce their payments. Other filers might take n mre debt and find themselves back in financial truble. Alternatively, if a means test was in place, sme cnsumers might nt file at all and wuld make a greater effrt t repay their debts. Empirical Research n Hw Bankruptcy Affects the Supply f Credit In thery, a stricter bankruptcy law ught t lwer the average cst f credit and increase its availability (particularly in the case f unsecured credit). One study, in fact, fund that in states with lw asset exemptins, husehlds wning few assets faced lwer interest rates n aut lans and held mre debt than did similar husehlds in states with high asset exemptins. The same study als fund that the prbability f a husehld s being denied credit (f any kind) r being discuraged frm applying fr a lan was lwer in states with lwer asset exemptins. But there is little empirical evidence shwing hw the supply f credit has respnded t past changes in bankruptcy law prvisins. Sme data indicate that, at least fr credit card lenders, lsses related t bankruptcy are large enugh t affect their decisins abut lending. It is unclear, thugh, exactly hw the cst and availability f unsecured credit fr cnsumers wuld change as a result f a meanstesting requirement fr Chapter 7 filing.

13 THE FUNDAMENTALS OF PERSONAL BANKRUPTCY LAW Bankruptcy law is a debt-cllectin law that insures peple t sme extent against the inability t repay their debts as they fall due. The vast majrity f peple file fr bankruptcy under either Chapter 7 r Chapter 13 f the bankruptcy law (specifically, title 11 f the U.S. Cde). (Certain cnsumers can als file under Chapter 11 r Chapter 12.) Chapter 7 is used by abut 70 percent f filers; it prvides fr "straight bankruptcy," r the liquidatin f assets. Chapter 13, entitled "Adjustment f Debts f an Individual with Regular Incme," is a curt-spnsred debt-refinancing plan. Debt Cllectin and Insurance The prcedures by which creditrs can cllect debts are laid ut in state cmmercial law as well as in bankruptcy law. State cmmercial law utlines the prcess fr staking a claim t what is wed; it als ranks thse claims and details the remedies available t creditrs t satisfy r cllect them. State law fr debt cllectin is a "grab law," based n the ntin f first cme, first served. Accrdingly, the creditr that first stakes a claim t particular assets f a debtr is entitled t be paid first (Jacksn 1986). The legal remedies fr creditrs, such as freclsure n and the sale f prperty, allw them t cllect what they are cntractually wed, and frm the pint f view f state law, debtrs are required t repay debts in full, regardless f the circumstances. But debtrs smetimes default n their debts, and grab law makes n prvisin fr sharing the risk f such defaults either amng creditrs r between debtrs and creditrs. That results in an inefficiency; in ther wrds, sciety wuld be better ff with prvisins fr sharing default risk. The inability f brrwers t shift such risk als creates what is knwn as an adverse selectin prblem fr creditrs: risk-averse cnsumers will shy away frm brrwing, leaving creditrs with a grup f riskier brrwers. Bankruptcy law can better allcate the risk f default fr the ecnmy in cmparisn with the allcatin prvided by state cmmercial law. Mst imprtant, bankruptcy law spreads default risk amng brrwers and lenders by prviding brrwers with sme insurance against their inability t repay their debts. The insurance payff fr brrwers is the pprtunity t receive a discharge (r frgiveness) f their debts and t keep certain assets t start life afresh after bankruptcy. As a result, that insurance gives peple an incentive t increase their brrwing because they knw they will nt be impverished if they cannt repay their debts. Sciety benefits frm this aspect f greater risk spreading because it allws peple t better plan their cnsumptin they can finance it when they desire it mst rather than when they have the cash t pay fr it Bankruptcy law als helps creditrs by prviding a cllective frum fr debt cllectin that is based in large part n their rights and pririties under state law (Jacksn 1986).

14 2 PERSONAL BANKRUPTCY: A LITERATURE REVIEW In the lng run, brrwers pay the cst f the insurance prvided by bankruptcy law. T recup their lsses frm bankruptcy, creditrs will raise the cst f brrwing by using a cmbinatin f stricter standards and terms n their lans, such as higher interest rates, larger dwn payments, and restrictins n the supply f credit. Essentially, the premium brrwers pay fr the insurance cverage f bankruptcy is that additinal cst f brrwing. In the shrt run, creditrs will share sme f the risk f default if their lan lsses are greater than expected. Mrever, if the law is tightened, creditrs are likely t prfit at least temprarily (see the later discussin). The strength f the law s incentive t brrw and the cst f brrwing depend n the magnitude f the fresh start. The greater the fresh start, the greater are the incentive t brrw and the cst f brrwing. A larger fresh start als gives peple mre incentive t use bankruptcy, rather than ther means, t slve their financial prblems and escape debt repayment. Cnsequently, a bankruptcy law with a generus fresh start may prmte greater risk spreading, but it can als raise the cst f brrwing by expanding the fresh start and making it easier fr peple t walk away frm debts that they culd affrd t repay. The difficulty f achieving a desirable trade-ff between the benefit f risk sharing and its cst helps explain several changes t bankruptcy law since the late 1970s: The Bankruptcy Refrm Act f 1978 (BRA-78) was the first verhaul since 1898 and the first majr revisin since the Chandler Act f 1938 intrduced the wage-earner Chapter XIII plan, precursr t the current Chapter BRA-78 had several gals: t mdernize bankruptcy law fllwing the tremendus grwth f cnsumer credit in the pst-wrld War II perid, t imprve the fresh start fr persnal filers, and t refrm a bankruptcy curt system that many peple viewed as inefficient and unfair (Jeweler 1997). 7 The Bankruptcy Amendments and Federal Judgeship Act f 1984 sught in part t curtail alleged abuses f bankruptcy law by reducing bankruptcy s benefit fr cnsumers (Kwalewski 1985). The Bankruptcy Refrm Act f 1994 made a hst f changes in the bankruptcy cde; amng ther things, it dubled the dllar value f federal asset exemptins (which had nt been adjusted fr inflatin since 1978) and included prvisins t curtail bankruptcy fraud. 6. A brief summary f the changes made by BRA-78 appears in Dmwitz and Evaldi (1993). 7. The grwth f the market fr cnsumer credit in Eurpe during the 1980s, which was fllwed by recessin in the early 1990s, prmpted many Eurpean natins t mdify their cnsumer bankruptcy laws. See Niemi-Kiesilainen (1997).

15 PERSONAL BANKRUPTCY: A LITERATURE REVIEW 3 Basic Prvisins f Chapter 7 Under Chapter 7, the administratr f a bankruptcy case, wh is knwn as the trustee, versees the liquidatin, r sale, f a debtr s nnexempt assets and the distributin f the prceeds t creditrs. Only creditrs with allwable claims in the case receive a share f thse prceeds, which are distributed after the trustee's expenses, ther administrative csts, and pririty claims have been paid. 8 Unless the curt finds that the debtr was dishnest r engaged in wrngding, it discharges (frgives) all allwable claims n the persn and his r her assets except fr nndischargeable claims (fr example, many kinds f taxes) and any debts cvered under reaffirmatin agreements (in which the persn specifically agrees t repay ne r mre debts). The debtr keeps the value f the assets designated as exempt under the law (the fresh start discussed abve) and may nt receive anther discharge under Chapter 7 fr six years. Althugh bankruptcy law is federal in scpe, prvisins designating exempt assets appear in bth federal and state law. BRA-78 intrduced federal exemptins but allwed states t pt ut f using the federal limits and cntinue using their wn. Tday, 35 states d nt use the federal exemptins; in the remaining states, residents may use either the federal r the state exemptins. Bth federal and state exemptins cver brad categries f assets including primary residences; mtr vehicles; varius kinds f persnal prperty, such as husehld gds and clthing; and the tls f a persn s trade. Hwever, the particular types f assets that may be exempt and the dllar values f thse exemptins vary widely. The hmestead exemptin is a gd example f hw dllar values fr asset exemptins differ amng the states. Gergia allws bankrupt cnsumers t keep nly $5,000 f equity in real prperty used as a residence; Flrida, in cntrast, allws an unlimited amunt f equity in as much as ne-half acre in a municipality r 160 cntiguus acres elsewhere (King 1998). The federal dllar limit n the hmestead exemptin is currently $16,150 and is adjusted fr inflatin every three years. Basic Prvisins f Chapter 13 Chapter 13 helps peple avid liquidatin f their assets by requiring them t repay their debt ut f future incme. T qualify fr a Chapter 13 discharge, debtrs (with the exceptin f stckbrkers and cmmdity brkers, wh are cvered by separate prvisins) must have a regular incme, and their unsecured (such as credit card) and 8. The definitin f a claim is very brad under the bankruptcy cde. All pssible legal bligatins t banks, finance cmpanies, public utilities, hspitals, divrced spuses, and gvernments, fr example are within the purview f the bankruptcy curt, including claims that are unliquidated r cntingent. Thus, the term "creditr" cvers any entity with a legal claim n the debtr that arse befre the bankruptcy case began. It als cvers sme claims that arise afterward.

16 4 PERSONAL BANKRUPTCY: A LITERATURE REVIEW secured debts must ttal less than $269,250 and $807,750, respectively. The debt limits are adjusted fr inflatin every three years. Under Chapter 13, the debtr wrks with the trustee and submits a plan t the curt t repay utstanding debts ver three (r, in sme circumstances, five) years. The plan must satisfy three criteria: First, althugh the plan may call fr less than full repayment f certain debts, creditrs must receive at least as much as they wuld have received if the cnsumer had filed fr bankruptcy under Chapter 7 and liquidated his r her nnexempt assets. Secnd, the trustee and all unsecured creditrs must agree t the plan. If ne f them bjects, the debtr must use all f his r her incme in excess f reasnably necessary living and business-related expenses fr debt repayment. Third, the curt must determine that the plan has been filed in gd faith ; therwise, the plan may be dismissed. 9 When the payments are cmpleted, the cnsumer receives a discharge frm all debts that the plan cvered. A Chapter 13 filing has three advantages (relative t a Chapter 7 filing) that encurage peple t use it: debtrs retain all f their prperty, nt just their exempt assets; a greater variety f claims can be discharged; and cnsumers may be able t repay less than they we n certain secured debts. 10 TRENDS IN PERSONAL BANKRUPTCY FILINGS The rapid increase in the persnal filing rate between 1994 and 1998, despite the vigr f the natin s ecnmy, is unusual but nt unprecedented, given that the rate has risen during previus perids f relatively strng ecnmic grwth as well as recessin. In fact, fr the mst part, the rate has trended upward since the end f Wrld War II. What accunts fr the grwth in persnal bankruptcy filings, bth befre 1994 and, mre specifically, between 1994 and 1998? On the surface, the upswing in the filing rate mimics the trend in the risk f default fr the husehld sectr. Yet because husehlds have sme cntrl ver that risk, changes in its trend d nt cmpletely explain changes in the persnal filing rate. As discussed later, the current plicy debate is abut what underlies the ascending trends in bth measures. 9. Chapter 7 filings may be dismissed fr several reasns, including a judgment that discharging debts wuld be a substantial abuse f the law s prvisins. The antiabuse language has been interpreted by the curts t authrize dismissal if debtrs are able t pay part r all f their debts ut f future incme. 10. Jeweler (1997) discusses differences between Chapters 7 and 13 in the definitin f dischargeable debts.

17 PERSONAL BANKRUPTCY: A LITERATURE REVIEW 5 The Persnal Filing Rate in the Pstwar Perid The persnal filing rate has risen during all but ne ecnmic expansin f the pstwar perid (see Figure 1). Indeed, althugh the rate has ften increased especially sharply during recessins, much f its pstwar grwth has ccurred in gd ecnmic times, nt in slwdwns. Between 1948 and 1967, the rate climbed in every year except 1962, when it fell slightly after a jump in Between 1967 and 1979, the rate varied within a mdest range, fllwing a mre cyclical pattern rising during a recessin, falling immediately afterward, and then rising later in the expansin. The rate has trended strngly upward in the 1980s and 1990s, with mdest declines fllwing recessins. The rate fell in 1999, thugh it remains high. The break in the persnal filing rate displayed in Figure 1 shws that after 1979, the rate is nt strictly cmparable with the rate befre that year. The reasn is that the Bankruptcy Refrm Act f 1978 intrduced jint husband-and-wife bankruptcy petitins. (Befre the law was enacted, a husband and wife had t file separate petitins.) Cmparing the number f filings befre and after 1979 is difficult because analysts d nt knw hw t adjust the data t accunt fr the jint filings (see Appendix A). CBO chse t indicate the break when apprpriate and, after 1979, t use the number f nnbusiness bankruptcy filings t calculate the persnal filing rate. The Persnal Filing Rate and the Husehld Sectr's Risk f Default Changes in the persnal filing rate tend t mirrr changes in the risk f default in the husehld sectr. A husehld's risk f default generally rises when: It takes n additinal debt, Interest rates n its flating-rate debt rise, Its incme falls, r Its extrardinary r ther living expenses rise. Analysts typically use tw ratis t measure the husehld sectr's risk f default: the debt-t-incme rati and the debt-service burden. Yet neither f thse measures is a perfect indicatr f default risk. Bth fail t incrprate changes in extrardinary and ther living expenses, and the debt-t-incme rati des nt encmpass interest rate changes n flating-rate debt r the effects n mnthly payments f refinancing debt.

18 6 PERSONAL BANKRUPTCY: A LITERATURE REVIEW FIGURE 1. THE PERSONAL FILING RATE FOR BANKRUPTCY, SOURCES: Cngressinal Budget Office; Administrative Office f the U.S. Curts; Department f Cmmerce, Bureau f the Census. NOTES: The persnal filing rate is the number f nnbusiness bankruptcy cases filed per millin adults age 20 and lder. The data are pltted n a lgarithmic scale. A break ccurs in the persnal filing rate between 1979 and 1980 because the data are nt strictly cmparable. The break represents the intrductin f jint husband-and-wife filings allwed by the Bankruptcy Refrm Act f 1978.

19 PERSONAL BANKRUPTCY: A LITERATURE REVIEW 7 Debt-t-Incme Rati. This rati is measured as the sum f cnsumer credit plus hme mrtgage debt divided by dispsable, r after-tax, persnal incme. 11 It cmpares the level f the majr types f debt held by the husehld sectr with a measure f the sectr s ability t repay that debt. A larger amunt f debt relative t incme indicates a larger amunt f default risk; that is, as mre husehlds have mre debt relative t their repayment ability, mre f them are mre likely t face financial difficulties arising frm any surce. 12 The risk f default, accrding t this measure, can munt because husehlds take n mre debt relative t their incme r because their incme falls relative t their debt. In ecnmic expansins, husehlds generally take n debt at a greater rate than the rate at which their incme expands; mst analysts think the reasn is that husehlds feel cnfident abut their incme prspects and their debt-repayment ability. 13 At the same time, creditrs are mre willing t lend because they feel mre cnfident that they will be repaid. By cntrast, in recessins, creditrs are less willing t lend. Husehlds, fr their part, take n debt mre slwly, but the grwth rate f their incme drps ff even mre sharply. Just after recessins, the debt-tincme rati may fall fr a while because husehlds incmes pick up befre husehlds and creditrs becme cnfident enugh abut their financial futures t resume mre nrmal patterns f brrwing and lending. 14 Bth befre and after 1979, the brad trend in the persnal filing rate fllws the trend fr the debt-t-incme measure (see Figure 2). Given the break in the data fr the persnal filing rate, ne cannt cnclude that the relatinship remained the same in the tw perids. Nevertheless, the increase in the persnal filing rate between 1994 and 1998 is bradly cnsistent with the rise in the husehld sectr s default risk during that perid. Generally, an increase (r decrease) in the risk f default precedes an increase (r decrease) in the persnal filing rate. Fr the year ending June 30, 1998, fr example, the rise in the persnal filing rate reflects the rise in the risk f default at the end f calendar year The lag may ccur because lans typically d nt g int default immediately and because peple may try t reslve their financial prblems 11. The data n debt cme frm Bard f Gvernrs f the Federal Reserve System (2000). Cnsumer credit includes installment and nninstallment debt. Hme mrtgage debt includes hme-equity lans. 12. The clse crrelatin shuld nt be taken t mean that debt is the cause f bankruptcy. Of curse, debt is necessary fr bankruptcy, but saying that it causes bankruptcy begs the questin f what factrs explain the debt hldings f husehlds. Thse factrs are discussed later in this paper. 13. Cnsumers expectatins abut their incme prspects als affect their decisins abut saving, as discussed in Cngressinal Budget Office (1993). 14. The incentives in bankruptcy law and the stigma assciated with filing fr bankruptcy prbably d nt affect the risk f default acrss the business cycle.

20 8 PERSONAL BANKRUPTCY: A LITERATURE REVIEW FIGURE 2. THE PERSONAL FILING RATE AND THE DEBT-TO-INCOME RATIO OF THE HOUSEHOLD SECTOR, SOURCES: Cngressinal Budget Office; Department f Cmmerce, Bureau f Ecnmic Analysis and Bureau f the Census; Federal Reserve Bard. NOTES: The persnal filing rate is the number f nnbusiness bankruptcy cases filed per millin adults age 20 and lder. The data are pltted n a lgarithmic scale. The debt-t-incme rati, which is pltted with an 18-mnth lag, is the rati f the sum f cnsumer credit plus hme mrtgage debt t dispsable (after-tax) persnal incme. A break ccurs in the persnal filing rate between 1979 and 1980 because the data are nt strictly cmparable. The break represents the intrductin f jint husband-and-wife filings allwed by the Bankruptcy Refrm Act f 1978.

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