Household Borrowing after Personal Bankruptcy

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  • 1. Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary Aairs Federal Reserve Board, Washington, D.C.Household Borrowing after Personal Bankruptcy Song Han and Geng Li 2009-17 NOTE: Sta working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research sta or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

2. Household Borrowing after Personal BankruptcySong Han Geng LiFederal Reserve BoardFederal Reserve BoardMarch 26, 2009 AbstractA large literature has examined factors leading to ling for personal bankruptcy,but little is known about household borrowing after bankruptcy. Using data from theSurvey of Consumer Finances, we nd that relative to comparable nonlers, bankruptcylers generally have more limited access to unsecured credit but borrow more secureddebt post bankruptcy, and they pay higher interest rates on all types of debt. Wealso nd that credit access and borrowing costs improve as more time passed sinceling. However, lers experience renewed debt payment diculties and accumulate lesswealth, even many years after ling, suggesting that for many bankrupt households,debt discharges fail to generate an eective fresh start as intended by the law. Ourestimate also provides empirical guidance for calibrating the equilibrium models ofhousehold credit. JEL Classications: J22, K35 Key words: Personal bankruptcy, credit constraints, household nance The views expressed herein are those of the authors and do not necessarily reect the views of the Board of Governors or the sta of the Federal Reserve System. We thank Karen E. Dynan, Johnathan Fisher, Elizabeth R. Perlman, and seminar participants at the Federal Reserve Board for their helpful comments.Capital Markets Section, Federal Reserve Board, Mail Stop 89, Washington, DC 20551 USA. E-mail: Song.Han@frb.gov; phone: 202-736-1971; fax: 202-728-5887.Household and Real Estate Finance Section, Federal Reserve Board, Mail Stop 93, Washington, DC 20551 USA. E-mail: Geng.Li@frb.gov; phone: 202-452-2995; fax: 202-728-5887. 3. Household Borrowing after Personal BankruptcyAbstractA large literature has examined factors leading to ling for personal bankruptcy,but little is known about household borrowing after bankruptcy. Using data from theSurvey of Consumer Finances, we nd that relative to comparable nonlers, bankruptcylers generally have more limited access to unsecured credit but borrow more secureddebt post bankruptcy, and they pay higher interest rates on all types of debt. Wealso nd that credit access and borrowing costs improve as more time passed sinceling. However, lers experience renewed debt payment diculties and accumulate lesswealth, even many years after ling, suggesting that for many bankrupt households,debt discharges fail to generate an eective fresh start as intended by the law. Ourestimate also provides empirical guidance for calibrating the equilibrium models ofhousehold credit. JEL Classications: J22, K35 Key words: Personal bankruptcy, credit constraints, household nance 4. 1 IntroductionA cornerstone of the U.S. consumer credit markets is the personal bankruptcy law, whichaims to provide a fresh start to distressed debtors through debt discharge.1 Amid the fast growth of consumer credit in the past two decades, the number of households that have sought bankruptcy protection has also increased dramatically in the United States, with theannual rate of personal bankruptcy lings rising from 3.6 lings per thousand households in 1980 to nearly 14 in 2004. Such a rapid rise has motivated an extensive literature searchingfor the causes of personal bankruptcy ling. Most of the existing literature, however, fo- cuses squarely on the prepetition conditions and nancial market evolutions and pays littleattention to household nancial conditions post bankruptcy. This is somewhat surprising because what happens to postbankruptcy borrowing should aect the ling decision in the rst place. In addition, studying postbankruptcy nancial well being is critical to evaluatingthe eectiveness of the law. Moreover, with little empirical evidence documented as guid- ance, the existing dynamic equilibrium models with bankruptcy features may not have beenrealistically calibrated. In this paper, we seek to address this void by providing a comprehensive analysis on house-hold borrowing after personal bankruptcy ling. Using data from the Survey of Consumer Finances (SCF), we examine the dierences in the use of credit between those households who have ever led for bankruptcy and those who have never led, hereafter lers andnonlers, respectively. In addition, we study how the eects of bankruptcy ling vary with time passed since the last ling, hereafter time since ling. Specically, for eachof the three major debt categoriescredit card debt, rst lien home mortgages, and vehicle loanswe try to answer the following questions: Is it less likely for lers to take on such debtthan comparable nonlers? Conditional on having the access, do lers borrow less or pay a 1 The best-known elaboration of the fresh start idea is by the U.S. Supreme Court in its inuential ruling in Local Loan Co. v. Hunt, 292 U.S. 234 (1934), which stated that the bankruptcy discharge gives to the honest but unfortunate debtor...a new opportunity in life and a clear eld for future eort, unhampered by the pressure and discouragement of pre-existing debt. 1 5. higher interest rate? Are lers more likely to experience renewed debt payment diculties?How do these eects change with the staleness and the removal of a bankruptcy record from credit reports? We nd that without controlling for time since ling, lers generally have less access to unsecured revolving credit than comparable nonlers but borrow more on mortgages and vehicle loans. Relative to comparable nonlers, an average ler is about 50 percent less likelyto obtain a credit card and, conditional on having a card, has a credit limit that is almost $8000 lower. In contrast, lers have a similar likelihood of obtaining a mortgage, and theirmortgages have only slightly higher loan-to-value ratios at the origination. Filers are also 28 percent more likely to obtain a vehicle loan, but they have similar size of loans relativeto their income. Finally, lers generally pay signicantly higher interest rates on all three types of loans than comparable nonlers.The eects of bankruptcy ling also depend on whether the bankruptcy ling recordappears on credit reports. The Fair Credit Reporting Act requires that credit bureaus remove a bankruptcy record from credit reports ten years after a ling. We nd that, forhouseholds who led for bankruptcy fewer than nine years previouslythose whose ling records remain on their credit reportsthe eects of ling on credit card debt and vehicleloans are similar to the general results stated above, but the eects on rst lien mortgages vary considerably with time since ling. Relative to comparable nonlers, households who led more than nine years earlierthose whose ling records no longer appear on their creditreportshave similar or higher likelihood of having each of the three types of loans, carry higher balances or leverages, but do not necessarily pay higher interest rates. Despite the reduced form nature of our estimations, we attempt to infer through which channel, demand or supply of credit, the bankruptcy ling aects postbankruptcy borrowing.We make such inference based on the joint predictions of standard price theory on the changes in both equilibrium debt quantity and interest rate. This approach allows us to make the following claims: First, households who led for bankruptcy fewer than nine years earlier face2 6. a lower supply of credit card credit than comparable nonlers, but they have stronger demandfor vehicle loans. Second, relative to comparable nonlers, households who led more than nine years earlier have stronger demand for all three types of credit. This stronger demandis possibly due to the fact that lers may have deliberately deferred their loan requests until the tenth anniversary, because after that they can get better deals when their credit scores articially improved with the removal of the bankruptcy ag. Our analysis also reveals that lers continued to experience debt payment diculties and accumulate less wealth post bankruptcy. Relative to comparable nonlers, lers are generallyabout 30 percent more likely to have fallen behind on their debt payment schedules, and they have substantially lower net worth, even many years after their last lings. The persistentnancial distress and low wealth accumulation among lers suggest that, for many bankrupt households, debt discharge fails to generate an eective fresh start as intended by the law.This paper contributes to three strands of literature. First, our comprehensive analysisextends signicantly the limited studies on household borrowing and nancial well being post bankruptcy. Previous studies suggest that households may still be able to borrow, inpart because advances informational technology and nancial innovations allow lenders to better screen, monitor, and price loans. Our analysis goes beyond these studies by providingquantitative evidence on both quantity and prices of postbankruptcy borrowing in major consumer debt categories. Second, our ndings provide a benchmark for the calibration of theoretical models of personal bankruptcy and credit constraints. In recent years, a grow-ing literature has used dynamic equilibrium models to study various positive and normative aspects of personal bankruptcy. With little empirical guidance from the existing literature,these theoretical models impose various assumptions about postbankruptcy credit access, instead of calibrating the models directly using data on actual credit use. Third, our papercontributes to the growing literature on the impact of ling for personal bankruptcy on con- sumer behavior. Existing empirical studies have looked into the eects of lings for personal bankruptcy on homeownership, consumption, and labor supply. Our paper complements3 7. these studies and provides further evidence about the costs of ling for personal bankruptcy.The rest of the paper is organized as follows. Section 2 reviews the relevant legislation, theory, and literature; Section 3 describes our data and discusses methodological issues;Sections 4 and 5 present, respectively, descriptive and regression results on postbankruptcy borrowing; Section 6 examines debt delinquency and wealth accumulation after bankruptcy ling; and Section 7 concludes and discusses directions for future research.2 Background: Legislation, Theory, and LiteratureIn this section, we briey review the areas of legislation relevant to household postbankruptcy borrowing, theoretical hypotheses about the eects of bankruptcy, our strategy to infer demand and supply eects, and the related literature. 2.1Relevant LegislationHousehold postbankruptcy borrowing is aected by two areas of legislation: the BankruptcyAct which governs the personal bankruptcy ling, and the Fair Credit Reporting Act (FCRA) which regulates how a ling is reported by credit bureaus.2 The key aspect of the Bankruptcy Act is the provision of debt discharge. A debtor can leunder Chapter 7 of the Bankruptcy Act to obtain a discharge of unsecured debts (with some debts, such as student loans and unpaid tax liabilities, not dischargeable). Alternatively,the debtor can le under Chapter 13, where he obtains a debt discharge after paying o a portion of his debt through a 3-to-5 year debt repayment plan.3 In this study we are unableto distinguish the dierent eects of the two Chapters because our data do not have any 2Because we use the SCF waves from 1998 to 2004, the applicable bankruptcy law is the Bankruptcy Reform Act of 1994 (Public Law 103-394, October 22, 1994). The latest amendment, which became eective on October 17, 2005, was the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA) of 2005. The Fair Credit Reporting Act (FCRA) is a federal law (codied at 15 U.S.C. 1681 et seq.) that regulates the collection, dissemination, and use of consumer credit information. Enforced by the US Federal Trade Commission, it was originally passed in 1970 and the latest amendment was in 2008.3For a detailed description of the dierent options under the current Bankruptcy Act, see Bankruptcy Basics available at http://www.uscourts.gov/bankruptcycourts/bankruptcybasics.html.4 8. information on the Chapter choice.Pooling the two chapters, however, is standard in theliterature, mostly because of the small number of Chapter 13 lings. Historically, before the 2005 amendment of the Bankruptcy Act, Chapter 7 lings account for about two-thirdsof total initial personal bankruptcy lings, and many of the Chapter 13 lings eventually convert to Chapter 7. In addition, both chapters share the key feature of the U.S. personal bankruptcy law, that is, debt discharge. The second aspect of the Bankruptcy Act that can aect postbankruptcy borrowing is that it restricts repeated discharges. Specically, the law prohibits a debtor from obtaininga bankruptcy discharge until six years after being discharged from a previous bankruptcy ling.4 Thus, a ler diers from nonlers in his delayed access to bankruptcy discharge andfrom other lers in the length of the delay. As argued below, this temporary removal of the option of obtaining bankruptcy discharges may aect both the decision of ling in the rst place and the postbankruptcy credit demand and supply. The FCRA is also important to studying postbankruptcy borrowing because it regulates how a bankruptcy ling is reported by credit bureaus. The most important rule is thetime limit on reporting a bankruptcy ling and the associated defaults leading to the ling. Specically, the FCRA requires that a bankruptcy ling can only stay on credit reportsfurnished by the credit bureaus for at most 10 years from the date of relief or the date of adjudicationthe date when the court decrees that the ler is bankrupt (FCRA 605 (a)(1)). In addition, all other non-bankruptcy defaults can only stay on a credit report forseven years (FCRA 605 (a)(5)).5The potential channels through which a bankruptcy ling and the above regulations can4This limit has been extended to eight years in the Bankruptcy Abuse Prevention and Consumer Protec- tion Act of 2005.5The exact texts are the following: 605 (a) Information excluded from consumer reports. (1) Cases under title 11 [United States Code] or under the Bankruptcy Act that, from the date of entry of the order for relief or the date of adjudication, as the case may b...