Moral Hazard versus Liquidity in Household Bankruptcy

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Sasha Indarte reveals the crucial role of moral hazard and liquidity in driving household bankruptcy. Implications for consumption-smoothing are significant.

Image courtesy of interviewee. December 6, 2023

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This video video discusses the significance of consumer bankruptcy as a crucial element of the social safety net in the U.S., serving as a mechanism for individuals to reduce their debt burden during tough times. It likens bankruptcy to insurance, suggesting that it helps mitigate the financial impacts of adverse events such as job loss or illness.

Key points include:

1. **Consumer Bankruptcy Statistics**: Approximately 1 million people in the U.S. file for bankruptcy annually, and one in ten people will do so in their lifetime. The financial relief provided through bankruptcy surpasses that of unemployment insurance in many years.

2. **Debate Over Accessibility**: There are discussions on the balance between making bankruptcy easily accessible with generous relief versus potential moral hazards, where individuals might be tempted to file for bankruptcy even when they could repay their debts.

3. **Research Focus**: The author aims to quantify the trade-offs of generous bankruptcy policies by examining the reasons for filing and evaluating the influences of moral hazard versus insurance motives. They note that previous studies have highlighted different aspects of strategic default, particularly concerning mortgages and credit card debts.

4. **Findings**: The research reveals that the insurance motive (liquidity) is substantially stronger than the moral hazard motive. A small increase in bankruptcy costs leads to a slight decrease in filings, suggesting that the fear of bankruptcy is a strong deterrent for many. The results imply that generous bankruptcy policies could be supported due to the limited moral hazard and significant insurance benefits.

5. **Implications**: The study suggests a careful consideration of bankruptcy accessibility policies since the costs associated with moral hazard are relatively low, yet the insurance value of bankruptcy is significant. Factors such as the stigma of bankruptcy and potential future credit access issues also play a role in individuals' reluctance to file.

In summary, the author argues that consumer bankruptcy serves as an essential support mechanism for those facing financial hardships, with a strong emphasis on the need for balanced policies that provide adequate relief while minimizing moral hazard.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

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The reason I was interested in studying consumer

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bankruptcy is

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that consumer bankruptcy is actually an important part

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of the social safety net in the US by allowing people

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to lessen the burden

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of debt payments when they fall on hard times.

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Bankruptcy acts like a form of insurance similar

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to health insurance, unemployment insurance,

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bankruptcy can make adverse events like job loss

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or illness less costly.

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You can essentially think of it as a source of an,

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as a insurance for your wealth.

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Now, in terms of the importance of bankruptcy,

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there's about a million people on average in the US

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that seek debt relief through bankruptcy.

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In a typical year, one in 10 people in the US file

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for bankruptcy at some point in their life.

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And if we wanna compare bankruptcy to other parts

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of the social safety net, it's quite large overall.

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Uh, the size of the wealth transfer in the form

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of debt forgiveness

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that people receive in bankruptcy is bigger than

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what people receive through unemployment

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insurance in most years.

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Now, it's not obvious how easily accessible

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and generous the, debt relief

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that bankruptcy provides people should be.

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And that's because there are trade-offs

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to providing easily available generous debt relief.

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On the one hand, making bankruptcy easy to do

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and generous could create moral hazard.

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If, people stand to gain more from filing

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for bankruptcy, this makes for more temptation to file.

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But then creditors, the lenders,

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lenders are gonna expect bigger losses if more people

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file for bankruptcy.

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And the broader social cost of that is that,

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lenders are gonna be more reluctant

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to lend if they expect bigger losses.

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So fewer people might be approved for loans,

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and even when they get approved, the interest rates

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that they pay will be higher.

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Now, that's the main cost,

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but in terms of benefits, it really comes down

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to this insurance like property of bankruptcy

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and the insurance that bankruptcy provides is going

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to be especially valuable when people are not well insured

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against adverse events like job loss, illness, the loss

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of a partner, things like that.

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Now in my study, what I aim to investigate is,

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I wanna quantify the trade-offs of,

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providing generous bankruptcy.

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And what I do is I use data

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to investigate the reasons why people file

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and quantify the importance

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of this moral hazard motive versus this insurance motive.

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So my research builds on a literature that studies

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strategic default, which means default, that's driven

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by unwillingness

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to repay debt rather than the inability to repay debt.

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Most of this prior work focuses on mortgage delinquency

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that is missing mortgage

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payments defaulting on your mortgage.

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Uh, one big example in this literature would be work

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by Peter Ganong

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and Pascal Noel, who study mortgage debt relief,

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that was administered through the ham program

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during the Great Recession.

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In that setting, they find very limited evidence

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of strategic default, specifically when people have their,

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when people have their mortgage payments unchanged,

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the required monthly payments are unchanged,

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but the total, amount that they have to repay creditors,

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their mortgage lender is lowered.

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That is very little effect on the

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likelihood that someone defaults.

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But instead, if you reduce people's required monthly

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payments, even if they have to repay the, the total amount,

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the same, the total amount that they have to repay is,

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is the same, the reduction in those monthly payments

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that make it easier and makes people more able

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to afford their mortgage, that has a sizable

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reduction in the likelihood

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of people defaulting on the mortgage.

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Now, there's other work

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that finds the opposite in different settings.

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So there's work by Will Doby

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and Jsong who studied debt relief

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provided to credit card borrowers,

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and they use a randomized control trial, that,

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reduces, that does a mixture

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of reducing people's minimum monthly payments

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and writing down some of the total amount

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of credit card debt that people owe.

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Now, what they find is the opposite.

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Uh, what they see is that writing down

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that credit card debt is much more likely

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to make people avoid defaulting on their credit cards,

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whereas lowering that monthly payment

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for credit cards has very little effect

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on the likelihood of default.

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So together, this suggests that credit card,

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default on credit cards might be more strategic,

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that is more driven by, unwillingness

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to repay rather than inability

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to repay compared to mortgages.

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One possible reason for this is

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that default on mortgages is very costly.

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That's because mortgages are secured.

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Unlike credit card debts, they're secured on your home.

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And if you default on your mortgage,

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and if you don't make up those payments quickly enough,

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this could result in foreclosure in losing your home.

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Now, bankruptcy, it's also used

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to write down unsecured debts.

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So for that reason, we might expect that strategic

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and moral hazard motives would be an important driver

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of the bankruptcy decision.

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Uh, that would be the case

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unless people, face large costs

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of filing for bankruptcy.

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Now, another reason we might expect bankruptcy

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to also be different from delinquency on credit cards

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and mortgages is that the inability

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to be paid might force someone to miss a credit card payment

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or force them to miss a mortgage payment,

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whereas missing payments does not automatically mean

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that you're going bankrupt.

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So someone could still hold out if they really didn't

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wanna file for bankruptcy.

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So for these reasons, we might have expected

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that moral hazard

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and strategic default would be a big driver

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of the bankruptcy decision,

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but I end up finding the opposite.

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So what is consumer bankruptcy?

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Consumer bankruptcy is a legal process

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that allows households to discharge,

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that is erase the obligation to repay unsecured debt.

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And, and specifically the kind

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of debt people can discharge

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through bankruptcy is unsecured.

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So that would be things like credit card debt, medical debt,

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personal loans, not things like mortgages.

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Now, in order order to receive debt relief,

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bankruptcy filers have to make partial payments

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to their creditors based on the amount of income

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and assets that they have.

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One of the main policies that we have that governs how much,

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or one of the main policies that we have that governs

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how generous bankruptcy is a net of the payments

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to creditors are state's asset exemption laws.

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And these differ significantly across states.

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One of the most important exemptions is

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the homestead exemption.

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The homestead exemption. It protects people's home equity.

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For example, if you live in a state

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with a $15,000 bankruptcy homestead exemption,

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if you had $20,000 in home equity, you would have to pay

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that $5,000 difference in order

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to access the debt relief in bankruptcy.

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The farther above the exemption limit is your home equity,

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the more you're gonna have to pay creditors,

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when you file for bankruptcy.

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The data I use in my study,

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it comes from a large database of mortgages.

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So one caveat for the study is

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that I'm only gonna be studying homeowners who,

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contribute to about 40% of bankruptcy.

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So we should be cautious about extrapolating my

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results to renters.

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The data that I have, it covers about half

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of us mortgage borrowers over, the period

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of 2000 to 2016.

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So there's millions of people in this sample.

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The data, it has monthly information on whether

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or not people file for bankruptcy, the,

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the balance on their mortgage,

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and also the original sale price of the home.

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That's important because it's gonna make it possible

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to exactly track how people's home equity evolves over time.

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Now, with this data, I do two analyses.

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One is to estimate the moral hazard motive,

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and the other is to estimate the insurance

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or what economists would also call the liquidity

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motive for bankruptcy.

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The first analysis, it quantifies the moral hazard motive.

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Now, the ideal experiment for learning about moral hazard

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and bankruptcy would be one

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where you could hold fixed the wealth people have available

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outside of bankruptcy,

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but vary the financial gain

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that they would get from filing for bankruptcy.

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Now, I approximate that ideal experiment

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by using a natural experiment.

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And the natural experiment I use is related to

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how the homestead exemption works in bankruptcy.

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In essence, what I do is measure how the relationship

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between the likelihood of filing for bankruptcy varies

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with home equity, around the exemption limit.

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Now, visually, if we plot this data, what we see is

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that once people cross the homestead exemption limit

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and home equity is starting to make bankruptcy, more

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and more expensive, people become increasingly less likely

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to file for bankruptcy.

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So we do see that that cost

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of bankruptcy is deterring people's willingness to file.

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Now, the idea is that as long as the only thing

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that's sharply changing, right at that exemption limit

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is the cost of bankruptcy, we're able

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to learn about the causal effect of the cost

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of bankruptcy on people's decision to file.

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The second analysis estimates the insurance motive.

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This is also known as the liquidity motive.

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Now, the ideal experiment,

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for estimating this would be one that does the opposite

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of the first one specifically, we want a setting

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where we can hold fixed the financial gain of filing

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for bankruptcy, but very cash on hand that is available

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to people whether or not they file for bankruptcy.

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Now, for this analysis exploit another natural

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experiment related to the design

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of adjustable rate mortgages, also known as arms.

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Now, this experiment led to

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as if random variation in the size

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of mortgage payment reductions that people

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with arms received.

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To understand how this works, I need

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to describe a little bit about how arms work.

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So arms, they typically have a low fixed rate initially,

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and the idea is that that rate typically

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after a period of about five

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or 10 years, will later on reset to a higher rate.

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And that new rate

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after the reset is generally going

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to be some major interest rate plus something like

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half a percentage point.

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Now, two popular interest rates in the period

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that I study were the treasury rate and the L-I-B-O-R rate.

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Now, prior to the global financial crisis, L-I-B-O-R

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and Treasury, they basically moved in lockstep

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with each other, and it wouldn't matter which one you were

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indexed to if you had an arm.

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But after the global financial crisis, people

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that were resetting in that period, they were surprised

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by very different sized,

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changes in their mortgage interest rates.

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What happened was, during, in response

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to the global financial crisis,

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fed lowered the treasury rate.

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Now L-I-B-O-R, it's a linked to the health

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of the interbank lending market.

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That is the market where banks are lending to each other.

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That market was not doing

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so well in the global financial crisis.

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So even though L-I-B-O-R did fall,

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it didn't fall nearly as much as treasury.

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What this meant for people with arms is you could have an

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otherwise identical mortgage,

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but if you're indexed to L-I-B-O-R rather than treasury,

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you would've been paying a couple thousand dollars more each

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year, because of, the more limited

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decrease in your mortgage payment.

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In the first analysis, I find

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that while there is a moral hazard motive, it's small, using

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that variation from the homestead exemption.

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What I find is that when bankruptcy is $1,000 more

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expensive, this leads

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to only a 0.02 percentage point decrease in the likelihood

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that people file for bankruptcy.

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In relative terms, this is about a two

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and a half percent decrease relative

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to the average filing rate.

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Now, in the second analysis, I find a much stronger response

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to mortgage payments.

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Under the most conservative assumptions, I estimate

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that a $1,000 one-time reduction in one year's worth

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of mortgage payments leads

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to at least a 0.09 percentage point decrease in the

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likelihood of filing for bankruptcy.

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In relative terms, this is about a 12.5% decrease relative

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to the average filing rate.

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To sum up, I find

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that the insurance motive is about five times stronger

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than the moral hazard motive for filing for bankruptcy.

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These results have several important implications.

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The first is that the small moral hazard response indicates

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that one of the major determinants of the cost

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of providing generous debt relief

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through bankruptcy is small.

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Now, this doesn't give us a complete picture of the cost.

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The total cost is gonna depend on

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how strongly creditors react to that additional filing

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and to the additional debt

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that's being discharged through bankruptcy.

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Uh, second,

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together these estimates tell us something about the

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insurance value of bankruptcy.

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So they also speak to the benefits

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of providing generous bankruptcy In the paper,

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I use economic theory to show how these behavioral

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responses reveal how much people value bankruptcy.

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Intuitively, the stronger response

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to liquidity versus the moral hazard incentive tells us

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that people have a strong aversion to bankruptcy.

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It takes just a little bit of cash on hand to make people

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avoid bankruptcy, but increasing the payoff, even

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by a large amount, is not gonna attempt a lot more people

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to file for bankruptcy quantitatively.

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What I show through the lens of economic theory is

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that in order to rationalize these responses,

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it must be the case that the marginal bankruptcy filer

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that is someone who is on the brink of bankruptcy,

13:32.555 --> 13:36.525
they anticipate their consumption increasing by 50%

13:36.895 --> 13:38.445
after filing for bankruptcy.

13:38.905 --> 13:42.205
So this means that the person who's just right on the brink

13:42.225 --> 13:43.365
in different between filing

13:43.365 --> 13:46.085
and not filing for bankruptcy expects

13:46.085 --> 13:48.965
to get a huge increase in their wellbeing from filing.

13:49.865 --> 13:52.325
Now, on the one hand, this means that the insurance value

13:52.325 --> 13:53.325
of bankruptcy is high,

13:53.665 --> 13:56.805
but at the same time, this means that the,

13:56.805 --> 14:00.285
that people are holding out, avoiding bankruptcy

14:00.655 --> 14:04.405
until they stand to gain a really sizable,

14:04.925 --> 14:07.125
relative increase in their wellbeing from filing.

14:08.435 --> 14:11.865
Third, this reluctance to file in turn also indicates

14:11.865 --> 14:14.865
that people perceive a high cost of bankruptcy.

14:15.605 --> 14:17.865
Uh, this could come from a couple different factors.

14:17.965 --> 14:20.185
So one is that when you file for bankruptcy,

14:20.185 --> 14:22.545
you get a flag on your credit report.

14:22.815 --> 14:25.385
Creditors can see that for up to 10 years,

14:25.845 --> 14:28.945
and they're gonna, they can be less likely, to,

14:28.965 --> 14:30.145
to then give you credit knowing

14:30.145 --> 14:31.465
that you filed for bankruptcy.

14:31.725 --> 14:34.385
So one of the costs could be limited future credit access.

14:34.875 --> 14:36.665
There could also be an earnings cost.

14:36.775 --> 14:40.145
Sometimes employers, they gather, they,

14:40.175 --> 14:42.225
they solicit people's, credit reports

14:42.525 --> 14:43.945
and they can use that information.

14:43.945 --> 14:45.425
Things like whether or not you file

14:45.425 --> 14:47.425
for bankruptcy when considering whether

14:47.425 --> 14:48.705
or not to hire someone.

14:49.085 --> 14:50.305
So it's possible that,

14:50.725 --> 14:53.725
Uh, there may be lost earnings as a result

14:53.725 --> 14:54.845
of filing for bankruptcy.

14:55.425 --> 14:58.125
Uh, finally, there could also be non-monetary costs

14:58.145 --> 15:00.365
of filing for bankruptcy like stigma.

15:01.025 --> 15:03.205
Now, one reason we might think that would be the case is

15:03.205 --> 15:06.165
that there's a survey evidence that shows people,

15:07.045 --> 15:09.805
indicate a strong moral aversion to defaulting.

15:09.905 --> 15:13.325
For example, a survey survey, by Iza, ZA

15:13.325 --> 15:17.125
and NG finds that 83% of people say

15:17.125 --> 15:18.325
that it would be morally wrong

15:18.425 --> 15:20.485
to default on a mortgage when they are

15:20.485 --> 15:22.165
capable of repaying it.

15:23.005 --> 15:26.505
So just to, to sum up, people file for bankruptcy not

15:26.505 --> 15:29.745
because of what they can get, but because of what they lack.

15:30.325 --> 15:31.585
And through the lens of economic

15:31.725 --> 15:35.225
and, through the lens of economic theory, we can infer

15:35.225 --> 15:37.985
that there are large insurance benefits of bankruptcy

15:38.605 --> 15:42.065
and limited moral hazard making generous bankruptcy more

15:42.065 --> 15:42.425
desirable.

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