Poverty, Debt and Bankruptcy

1. Poverty, Debt and Bankruptcy Amitava Krishna Dutt Department of Economics and Policy Studies University of Notre Dame February 12, 2008 • Introduction • Borrowing, debt and the poor • Bankruptcy • Bankruptcy reform

2. a. Introduction • Why is there poverty? Why does poverty persist? • A general perspective: Vicious cycle of poverty • Various approaches: • Poor are dysfunctional or have atypical preferences • Poor have restricted opportunities because of systemic problems • Poverty is the result of perverse incentives created by policy • Various mechanisms: • Education • Unemployment • Health • Discrimination • Credit and borrowing

3. b. Borrowing, debt and the poor • Historically borrowing and debt have often been seen as problems for the poor. • Too poor to cover their expenditures • Borrow from lenders who charge high interest rates • Sometimes perpetually indebted, debtors prison, slavery or worse • Some economic theories imply that borrowing helps the poor • Smoothing consumption during income shocks • Allows large, unexpected expenditures – medical bills, legal fees • Obtain resources which help to increase economic opportunities – education, small business

4. b. Borrowing, debt and the poor, cont. • Poor are more subjected to unexpected income and expenditure shocks • Job loss • Health problems • Car problems • Legal fees • Ability to withstand shocks from own resources is low • Poor are restricted in their borrowing opportunities and pay higher interest rates • Hidden fees, fines on credit cards, flexible rates • Pawnshops, payday lenders, rent-to-own stores • Interest payments increase, further debt • Possibility of bankruptcy

5. c. Bankruptcy • Large increase in personal bankruptcy filings – about 2 million in 2005 • More Americans filing for bankruptcy each year than graduating from college, getting divorced • Rich people were getting bankrupt, but many were poor, also middle class. But median income of people filing fell compared to medium income of population. So it seems that in terms of numbers, more of a low-income problem.

6. c. Bankruptcy, cont. • Most consumer debt discharged under bankruptcy, other than tax obligations, students loans, alimony, child support and recent credit card debt. Secured debts like mortgage, car loans, not discharged, but delay foreclosing • Two types of personal bankruptcy: • Chapter 7. Looks at assets and liabilities of debtor. Some assets are exempt – homestead exemption, work tools, clothing, etc. Debtor gives up all nonexempt assets, then used to repay creditors to extent possible • Chapter 13. Debtors keep all assets. Payments made out of future income with debtors proposing a payment plan. Approval of bankruptcy judge was required. No incentive to offer more than under chapter 7.

7. c. Bankruptcy, cont. • Why was there a high level of bankruptcy filing? Why did it increase? Main arguments: • Adverse events like job loss, medical bills (Sullivan, Warren, Westbrook, 2000). • People do it strategically, when it was beneficial for them to discharge the debt – almost like using the system (Fay, Hurst, White, 2002) • Changes in lending and credit card sector – technological and legal changes (White, 2007) • Each can be criticized: why not keep sufficient reserves by saving; why is debt high so that people can benefit; why do people in fact borrow just because its easier to borrow? • Empirically examine which factors have a positive effect on bankruptcy, and whether these have actually been going up

8. c. Bankruptcy, cont. • What causes bankruptcy filers give (surveys, court data): • High debt, misuse of credit, excessive spending, high medical expenses • Can they be expected to know? • Econometric studies: • Use data from Panel Study of Income Dynamics, or other survey data, or court data with data on other households • Regressions estimate determinants of probability of filing across filers, or bankruptcy rates, over time, across regions, etc. • Results: Income and income change (-); unemployment (+); sickness or injury (+); divorce (+); debt and especially credit card debt (+); credit card and bankruptcy laws; homeownership

9. c. Bankruptcy, cont. • So what are the causes? • High debt • Why high debt? High spending and income and expenditure shocks • High spending: • relative consumption and what is subsistence • due to low income – used cars, high repairs, furniture • credit card lending, other lenders, high interest rate • Rise in unemployment, job insecurity, changes in government policies, health insurance and coverage • Who or what is to blame? • Person going bankrupt using the system? • Problem with opportunities, system? • Easy bankruptcy laws?

10. d. Bankruptcy reform • Lenders embarked on a huge lobbying campaign • Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA) passed in 2005 • Sharp increase in personal bankruptcy prior to passage, then sharp fall, but then steady increase, but lower than before

11. d. Bankruptcy reform, cont. • Debtors cannot choose between Chapter 7 and Chapter 13 – must pass means test to file under Chapter 7 based on income • Debtors cannot propose own Chapter 13 repayment plan – income and normal spending taken into account • Increase in cost – credit counseling course, lawyers have to certify accuracy, filing fees higher. Costs now $2,500 and $3,500 for bankruptcy, compared to $600 and $1600 before

12. d. Bankruptcy reform, cont. • Much more creditor-friendly • Reduce loopholes for the rich • For the poor? • Higher costs make filing much more difficult • Lenders find lending more lucrative, increase loan pushing • What needs to be done? • Need for stricter regulation of lenders • Broader issues: macroeconomy, health, transportation, inequality