The National Bureau of Economic Research has just published a new paper, “Bankruptcy Reform and Credit Cards” by Michelle J. White, which has a pretty distressing set of findings.
Readers may recall that that the bankruptcy law changes put into effect in October 2005 had been sought by the banking industry for years. They increased the cost of filing for bankruptcy, and considerably restricted access to Chapter 7 bankruptcies, in which debts in excess of non-retirement assets are wiped out and forced most borrowers into Chapter 13 (in which the borrower has to enter into a plan of repayment. Note that the law also made the assumptions for budgeting under Chapter 13 much tougher. This isn’t a trivial issue. A cousin who is a bankruptcy lawyer describes the standard of living that the new law allows for to punitive and unrealistic (for example, most people could not eat on the amount allowed for food).
Not surprisingly, bankruptcy filings dropped sharply, from around 2 million in 2005 (a peak as many filed to get in under the old law) to 600,000 in 2006.
However, White found that the banks benefitted in another way:
….by making it harder for consumers to escape their debts, the new law dramatically reduced lenders’ losses from default and bankruptcy. As a result, they started lending more, even to consumers with bad credit. Credit card debt increased more quickly during the past two years than at any time during the previous five years.
Consumers should have responded to the new harsher bankruptcy law by borrowing less, which would have lowered their risk of getting into financial distress. But not all consumers behaved in this rational way. Instead, many behaved shortsightedly and took advantage of the greater availability of credit to borrow more than they could easily handle — ignoring the risk of financial distress. (Economists refer to this shortsighted behavior as “hyperbolic discounting” – consumers who are hyperbolic discounters intend to start paying off their debts immediately, but each month they consume too much and end up postponing repayment until the following month. So their debts steadily increase.)
The new bankruptcy law exacerbated the problem of shortsighted consumers borrowing too much, because it prevented many of them from using bankruptcy to limit their financial distress. Many consumers in financial distress are unable to file for bankruptcy under the new law, because they cannot afford the costs of filing, cannot meet the new paperwork requirements, or are ineligible. This means that their debts will not be discharged and they will remain vulnerable to creditors’ collection calls and to wage garnishment that may take funds they need for basic necessities. Because of the new bankruptcy law, consumers can end up in deeper financial distress than would have been possible before 2005.
Survey evidence presented by White supports the idea that most debtors get into financial distress because of shortsighted behavior, rather than because they behave rationally but experience adverse events. In one survey of bankruptcy filers, 43 percent pointed to “high debt/misuse of credit cards” as their primary or secondary reason for filing. Another survey in 2006 found that two-thirds of those who sought credit counseling before filing for bankruptcy cited “poor money management/excessive spending” as the reason for their predicament, compared to only 31 percent who pointed to loss of income or medical bills.
White argues that lowering the costs of filing for bankruptcy would help debtors who are in the worst financial distress by making it easier for them to file. But changes in bankruptcy law cannot solve the basic problem of shortsighted consumers borrowing too much, since these consumers generally ignore the provisions of bankruptcy law until after they are in financial distress. Instead, White argues that changes in credit market and truth-in-lending regulation are more likely to work because they motivate lenders to lend less to the most vulnerable consumers.