Bankruptcy and delinquency in a model of unsecured debt
AbstractThe two channels of default on unsecured consumer debt are (i) bankruptcy, which legally grants partial or complete removal of unsecured debt under certain circumstances, and (ii) delinquency, which is informal default via nonpayment. In the United States, both channels are used routinely. This paper introduces a model of unsecured consumer credit in the presence of both bankruptcy and delinquency. Our model yields three new findings: First, with respect to the choice between bankruptcy and delinquency, labor income shocks matter. Specifically, we find delinquency is readily used by borrowers with the worst labor market outcomes, even those with relatively minor levels of debt. In contrast, bankruptcy is used by households with relatively high debts, but whose long-run earnings prospects are high enough to make interest rate penalties from delinquency too large. Second, financial distress is persistent: households in poor financial conditions stay in that state for several quarters. Third, in broad terms, bankruptcy and delinquency are “substitutes,” with bankruptcy increasing as delinquency costs rise.
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Bibliographic InfoPaper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2012-042.
Length: 52 pages
Date of creation: 2012
Date of revision: 30 Jan 2014
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-11-11 (All new papers)
- NEP-BAN-2012-11-11 (Banking)
- NEP-DGE-2012-11-11 (Dynamic General Equilibrium)
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