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Bankruptcy and delinquency in a model of unsecured debt

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  • Kartik Athreya
  • Juan M. Sánchez
  • Xuan S. Tam
  • Eric R. Young

Abstract

Limited commitment for the repayment of consumer debt originates from two places: (i) formal bankruptcy laws granting a partial or complete legal removal of debts under certain circumstances, and (ii) informal default and renegotiation, “delinquency.” In the US, both channels are used routinely. The usefulness of each of these routes as a way out of debt depends on the costs and benefits available through the other: delinquency exposes a household to collections processes initiated by lenders, while formal bankruptcy appears to carry more visible consequences for future transactions, including restrictions to even secured forms of credit. This paper introduces a model of unsecured consumer credit markets in the presence of both bankruptcy and delinquency. A key feature of our model is to allow lenders to deal with debtors in delinquency by choosing the (implicit) interest rate on debt owed by delinquent borrowers to maximize the market value of these obligations. We show that these two options to default on unsecured debt indeed interact in important ways. We first show that households with a large amount of debt who have received negative income shocks prefer delinquency. As long as their income does not improve, they remain there. This behavior occurs as lenders’ optimal behavior is to offer write-offs to households in delinquency, but only when they have very low incomes. As income improves, lenders can extract more from the households that stay delinquent, so the households look to reorganize their financial situation by either repaying the debt or filing for bankruptcy. We also show that stricter control of delinquency, defined by a relatively high ability to garnish wages, increases the risk of bankruptcy and lowers equilibrium credit use, in line with cross-state comparisons in the U.S. From a normative perspective, such policies lower welfare, in part because they encourage excessive use of bankruptcy.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2012-042.

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Date of creation: 2012
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Handle: RePEc:fip:fedlwp:2012-042

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Related research

Keywords: Debt ; Bankruptcy ; Finance; Personal;

This paper has been announced in the following NEP Reports:

References

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  1. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
  2. Juan Carlos Hatchondo & Leonardo Martinez & Juan M. Sánchez, 2011. "Mortgage defaults," Working Papers 2011-019, Federal Reserve Bank of St. Louis.
  3. Satyajit Chatterjee & Burcu Eyigungor, 2009. "Maturity, indebtedness, and default risk," Working Papers 09-2, Federal Reserve Bank of Philadelphia.
  4. Kartik B. Athreya & Xuan S. Tam & Eric R. Young, 2009. "Are harsh penalties for default really better?," Working Paper 09-11, Federal Reserve Bank of Richmond.
  5. Julio Davila & Jay H. Hong & Per Krusell & Jose-Victor Rios-Rull, 2005. "Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks," PIER Working Paper Archive 05-023, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
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