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Debt Causes Bankruptcy (But Sometimes in Counter-Intuitive Ways)

By Bob Lawless

I like NPR's Marketplace, but stories like this drive me nuts: "Why bankruptcy claims aren't as high as one would think." The story repeats a premise I often hear in media calls that I receive. The conversation usually starts something like this: "Foreclosures are up, unemployment is high, the economy is a wreck: why have bankruptcies stopped climbing?"

Wrong question. But fair enough. I get called because I am supposed to know something about bankruptcy filing rates, and my caller often has just picked up the assignment for the day. If that is the wrong question, what should we be taking away from trends in bankruptcy filing rates?

Bankruptcy is a legal act with legal consequences. Bankruptcy filings are not a bellwether indicator of the economy's health. Foreclosures, unemployment, and general economic conditions certainly play a role in determining the bankruptcy filing rate, but other factors are more important. At best, the bankruptcy filing rate is a weak and trailing economic indicator.

In trying to understand the bankruptcy filing rate, it is better to focus on the legal consequences and legal incentives for people who file bankruptcy. Specific legal rules mentioned in the NPR story--procedural requirements and rules on home mortgages--are also undoubtedly playing a part, but these rules are too specific to be playing a major role. The explanations are all trees and no forest.

People file bankruptcy to discharge debt (at least in the United States). No debt, no bankruptcy. In the long run, the overall bankruptcy filing rate will rise and fall with the amount of consumer debt. As people accumulate more debt, bankruptcy demand will grow. That is why we see countries often adopting American-style consumer bankruptcy laws featuring debt forgiveness as consumer debt in that country increases. Without lots of consumer debt, talking about bankruptcy filings rates is like talking about snow accumulations in Honolulu.

The long-term growth in U.S. consumer bankruptcies closely tracks the long-term growth in U.S. consumer debt. When the financial crisis hit, consumer credit dried up, and outstanding consumer debt experienced unprecedented declines. There are fewer reasons to file bankruptcy today because there was less borrowing two to three years ago.

Consumer debt also has a profound but perhaps counter-intuitive short-term effect on consumer bankruptcy rates. In the short-run, a decline in consumer credit will lead to a bump in consumer bankruptcy filings. As people run out of options--as they become less able to put this month's grocery or utility bills on a credit card--bankruptcy becomes a more attractive option. People can and will continue to borrow to stave off the day of reckoning. If a lender is willing to extend credit, further borrowing is a rational decision. After all, the consumer can become "none more broke" by borrowing further but might see things turn around tomorrow if they can get by just one more day on a credit card. Students of option pricing should quickly grasp the point.

The numbers bear out these effects. The graph to the right shows a close relationship between total consumer debt and bankruptcy filings. As consumer debt goes down in a particular month, bankruptcy filings tend to rise. Clicking on the graph should bring up a larger image in a pop-up box, and at the bottom of the post is some information about how the graph was constructed. The correlation is not perfect, but my claim is not that the correlation is perfect. A clear, negative relationship does exist. The takeaway message is that focusing on current foreclosure rates and unemployment to explain bankruptcy filing rates misses more important features of the story.

Right now, both the long-term and short-term effects of consumer credit are working in the same direction to tamp down the bankruptcy filing rate. There are lower levels of consumer debt because of decreased borrowing two or three years ago and hence less overall reasons for people to file bankruptcy. Also, with a reported easing of the consumer credit market, consumer who are at the brink have a slightly easier time borrowing to put off a bankruptcy filing. Given these dynamics, it is not surprising that bankruptcy filings are leveling off or declining and that a mathematical model predicts a decline in the bankruptcy filing rate for 2011.

The macrodata will fail to explain any individual case. A foreclosure, a job loss, a medical problem, and many other problems will be the primary impetus for many consumers will find themselves in bankruptcy court. These reasons explain why someone ends up filing bankruptcy, but they do not provide much help in explaining when they end up in bankruptcy court. Looking at trends in bankruptcy filing rates is all about the "when" question, and here macrodata are very helpful. The ups and downs of consumer debt levels tell us much--not everything, but much--about these trends.

Using data from Epiq Systems on bankruptcy filings and from the Fed for consumer debt, the graph compares monthly changes in the daily bankruptcy filing rate to monthly changes in the total amount of consumer debt outstanding. The graph begins in 2008 because of the anomalous effects the 2007 financial crisis had on outstanding consumer debt. Using 2007 data does not qualitatively change the results. The same phenomenon also can be observed historically, before the 2005 changes to the bankruptcy law. Bankruptcy filings are graphed against the left axis, and total consumer debt is graphed against the right axis. Both axes use different scales to make for easier comparisons. Also, the right axis for consumer credit has been inverted.

Full post as published by Credit Slips on January 07, 2011 (boomark / email).