Bankruptcy Reform and Credit Cards:

Naturally, the first question everyone wants to know is isn't the need for bankruptcy reform just a response to "too much" credit card credit. In fact, this argument not only lacks empirical foundation, it lacks sould economic theory to support it.

First, the argument doesn't make much sense from an economic perspective. Unless credit cards have somehow removed the borrowing constraint on individual credit (and no one has provided any evidence that it has), there would be no reason to believe that credit cards would increase overall household indebtedness.

Instead, economic theory would predict that the primary effect of the introduction of credit cars would be to shift around patterns of consumer credit use, by substituting credit card debt for other less-attractive forms of credit, such as pawn shops, personal finance companies, and retail store credit (such as from appliance and furniture stores). In fact, this is what the evidence indicates has actually happened.

Credit cards have not worsened household financial condition, because although consumers have increased their use of credit cards as a borrowing medium, this increase represents primarily a substitution of credit card debt for other high-interest consumer debt. Although this may seem irrational at first glance given the "high" interest rates charged on credit cards, consider that for consumers the alternatives may include pawn shops, personal finance companies, retail store credit, and layaway plans, all of which are either more costly or otherwise less attractive than credit cards.

Thus, while credit cards may not be ideal in some absolute terms, their growing popularity reflects the relative attractiveness of credit cards versus these other forms of credit. Credit cards are also generally less expensive for lenders to issue, which is reflected in the overall price of credit cards relative to these other forms of credit. The result, therefore, has not been to increase household indebtedness, but primarily to change the composition of debt within the household credit portfolio. Figure 7, from my article "An Economic Analysis of the Consumer Bankruptcy Crisis" (Forthcoming this year in the Northwestern Law Review) illustrates the nature of this substitution:

Source: Federal Reserve Board and Bureau of Economic Analysis

As this chart indicates, the growth in revolving (credit card) debt has clearly been a substitution from nonrevolving consumer debt to revolving debt, thus leaving overall consumer indebtedness (as a percentage of income) largely unaffected. Revolving debt outstanding has risen during this period from zero to roughly 9% of outstanding debt. Nonrevolving installment debt, by contrast, has fallen from its level of 19% of disposable income in the 1960s, to roughly 12% today. Thus, the increase in revolving debt has been almost exactly offset by a decrease in the installment debt burden. In fact the recent bump in total indebtedness in recent years was not caused by an increase in revolving debt, which has remained largely constant for several years, but by an increase in installment debt, primarily as a result of a recent increase in car loans for the purchase of new automobiles. Thus, there is little indication that increased use of credit cards has precipitated greater financial stress among American households. Because the increase in credit card usage has resulted primarily from a substitution of credit cards for other types of consumer credit, rather than an overall increase in indebtedness.

To the extent that there is some correlation between "high" credit card indebtedness and bankruptcy, but it is questionable whether this supports the causal inference that the credit card debt caused the bankruptcy, rather than the other way around.

First, the correlation between credit cards and bankruptcy may reflect the unique role of credit card borrowing in the downward spiral of a defaulting borrower. Credit cards provide an open line of unsecured credit to be tapped at the discretion of the borrower. Thus, for many debtors credit cards are a "credit line of last resort" to stay afloat to avoid defaulting on other bills. Thus, there may be nothing more than a simple correlation—a debtor confronting a downward spiral may increase his credit card borrowing in the period preceding bankruptcy simply because it is his most easily accessible line of credit. It may appear that because credit card borrowing preceded bankruptcy it also precipitated bankruptcy filing, but if the credit card was being used as a source of credit of last resort, this correlation would not support a causal inference.

Second, a debtor's increased use of credit cards preceding bankruptcy also may reflect strategic behavior taken in anticipation of filing bankruptcy. Credit card debt is unsecured debt that can be discharged in bankruptcy. By contrast, some unsecured debts are not dischargeable in bankruptcy, and secured debts, such as home and auto loans are minimally affected. For unsecured credit card debt, by contrast, generally the debtor can retain the property purchased with the credit card and discharge the obligation. Given the choice between defaulting on secured or nondischargeable obligations on one hand versus dischargeable credit card debt on the other, the incentive is to use credit cards to finance payment of nondischargeable and secured debt. In fact, empirical evidence shows that although credit card defaults have risen in tandem with bankruptcy filings, defaults on secured home and auto loans have remained steady during this period. Debtors also will have an incentive to "load up" their credit card on the eve of bankruptcy, especially by purchasing goods that will not be classified as "luxury goods and services" but might still be quite expensive and the timing of which might be discretionary. Still others simply spend the money or save in exempt assets rather than pay outstanding bills.

One article by Gross and Souleles (cited in my article), for instance find that in the year before bankruptcy, borrowers significantly increase the use of their credit cards, running up their balances rapidly in the period leading up to bankruptcy. This finding is inconsistent with the predictions of the traditional model, which identify credit cards as a special problem because of the gradual, subconscious, and "insidious" manner in which they accumulate over time. If this is true, then the accumulation of credit card debt should be gradual and spread out evenly over time. The rise in credit card debt rises rapidly and is concentrated in the period immediately preceding bankruptcy suggests that credit card indebtedness does not cause bankruptcy in many cases, but that the debtor is already on the way toward bankruptcy when the credit card borrowing begins, and is either acting strategically or is tapping his credit line of last resort.

It also has been argued that credit cards have contributed to increased bankruptcies through a profligate expansion of credit card credit to high-risk borrowers, especially low-income borrowers. Although often-repeated, empirical studies have failed to support this theory. First, the growth in credit card debt by low-income households primarily reflects a substitution for other types of debt, not an overall increase in indebtedness. In addition, two studies have examined the hypothesis empirically and have found little support. The first study, by economists Donald P. Morgan and Ian Toll concludes, "If lenders have become more willing to gamble on credit card loans than on other consumer loans credit card charge-offs should be rising at a faster rate [than non-credit card consumer loans] . . . . Contrary to the supply-side story, charge-offs on other consumer loans have risen at virtually the same rate as credit card charge-offs." Thus "suggest[s] that some other force [other than extension of credit cards to high-risk borrowers] is driving up bad debt."

A second study, by David B. Gross and Nicholas S. Souleles, concludes that changes in the risk-composition of credit card loan portfolios "explain only a small part of the change in default rates [on credit card loans] between 1995 and 1997." Moreover, if it were true that lower-income households were dramatically increasing their indebtedness through credit card increase then this should be reflected in the debt service ratio for lower-income households. As previously noted, however, this ratio has remained largely constant for lower-income households as with all others.

Increasing use of credit cards may be causing higher bankruptcies, but not in the way suggested by critics of reform. Because credit card credit is unsecured, it easily dischargeable in bankruptcy, which may make people more willing to file bankruptcy. Many older forms of credit were secured, such as furniture and appliance credit. Moreover, it may be that people fell less of a personal obligation to repay credit card debt, as opposed credit from a local merchant. But if these explanations explain what is happening, then it seems like this is an argument for bankruptcy reform, rather than against it.

The bottom line is that the standard argument about the relationship between credit cards and bankruptcy does not appear to be consistent with either economic theory or available evidence.

Debt Service Burden and Consumer Bankruptcies:

I have read a great deal lately in the Blogosphere and mainstream media criticizing the bankruptcy reform legislation. A common refrain is that the primary reason for rising consumer bankruptcy filings is reckless extension of credit by lenders, and that the bankruptcy reform legislation improperly lets lenders "off the hook" by bailing them out from their reckless ways. Some even claim that my own data presented a few weeks ago on trends in installment versus revolving debt actually prove the point. That chart, however, presented data on the amount of consumer credit outstanding and a percentage of disposable personal income. It is useful, albeit imperfect, for illustrating the substitution effect of revolving for installment credit by households, especially because it is the only data set that I have seen that collects this information.

It turns out that when you actually look at the data, the evidence fails to support the notion that Americans are "drowning in debt" or that they creditors are recklessly extending credit to unworthy borrowers. Instead, as measured by conventional measures, the financial condition of American households is largely the same as it ever was. What has changed, therefore, seems to be the willingness of people to choose to file bankruptcy in response to financial difficulties, not an increase need to file bankruptcy because of excessive debt.

Although comparisons of total debt stock to current income flows are often used by those who purport that Americans are drowning in debt, in fact, that is not a useful measure of household financial condition, especially when other more useful measurements of household debt are readily available.

In fact, bankruptcy law generally has two measurements of insolvency: equity insolvency and balance sheet insolvency. The first is a "flow" measure of one's ability to pay his or her debts as they come due--i.e., the ability to pay monthly debt obligations out of current income flows. The latter is a "stock" measure of the ratio of total assets to total debt at liquidation.

The first, equity insolvency, is the more useful of the two for households, so I will deal with that one here. Looking at changes in equity insolvency measurements for American households, the data simply do not reveal an overwhelming debt obligation for consumers.

By contrast, those who believe the "drowning in debt" story point to the debt-to-income ratio--i.e., the ratio of total debt obligations to current income. But this is silly because it fails to account for changes in interest rates and loan maturity terms.

Consider first, the effects of changes in interest rates. The effect of lower interest rates on the debt service ratio can be substantial. Consider a 30 year mortgage of $100,000. As noted, at an interest rate of 10%, the monthly payments on the mortgage will be $877.57 per month. But if the interest rate falls to 5%, the same mortgage requires only $536.82 per month—a reduction in the current debt burden of $340 per month. This means that at an interest rate of 5%, the household could afford to increase its total principle debt burden on the mortgage by sixty percent (to over $160,000) and leave its debt service ratio remain unaffected.

Consider second, loan maturities. Consider a hypothetical borrower who borrows $100,000 at 10% interest rate. If the loan is for a term of 1 year, the borrower will be required to pay $8,791.59 per month; if the term is 5 years, the payments fall to $2,124.70 per month; for 10 years it is $1,321.51 per month; and for 30 years (the conventional term for a mortgage) the required payments are only $877.57 per month. Clearly the maturity term of the loan makes a large difference in monthly payments and the percentage of income dedicated to loan service.

Put in more simple terms--a major reason why houses have risen in value in recent years is because of the low interest rates on household mortgages. If interest rates fall, consumers can actually pay more for a house--thereby borrowing a larger principle amount and increasing their total stock of debt--but can actually have a lower monthly payment obligation than would otherwise be the case. Anyone out there who has refinanced and take additional cash out will know that it is possible to simultaneously increase one's total debt, while decreasing the monthly payment on the larger loan.

And, in fact, since the early 1990s interest rates have fallen and loan maturities have lengthened on average. Thus, even though total household indebtedness has gradually and consistently risen during this period, the household debt service ratio has remained fairly constant.

The Federal Reserve measures this phenomenon through the debt-service ratio, which has stayed relatively constant over time, even as the total amount of household indebtedness has risen. Consider the following chart from my article, "An Economic Analysis of the Consumer Bankruptcy Crisis", forthcoming in the Northwestern Law Review (working paper available here):

As this chart quite plainly shows, once we adjust household debt to take account of the record-low interest rates of the past decade, and lengthening loan maturities, we cannot blame rising consumer bankruptcies on overwhelming debt obligations. There does appear to be some relationship between short-term fluctuations in the debt service ratio and fluctuations in the bankruptcy filing rate. But the upward trend in bankruptcy filings cannot be explained by comparable changes in the debt-service ratio.

Two lessons are clear. First, Americans are not "drowning in debt." Rather, once you adjust for the record-low interest rates of recent years, it is clear that American households are roughly in the same position as they always have been. Second, make sure you have the correct data to do the job you are trying to do.

The Poor, Subprime Lending, and the Debt-Service Ratio:

The relationship between the debt-service ratio and bankrutcies holds up when you look at the lowest quintile as well. This belies the claim that the problem is profligate expansion of credit to risky low-income borrowers, which is usually what is referred to in discussing subprime borrowers. Consider this data drawn from the same article:

Again, although there appears to be a loose correlation between changes in the debt service ratio and changes in the bankruptcy filing rate, changes in the debt service ratio of the lowest quintile cannot explain the upward trend in bankruptcy filing rates over the past decade. Thus, whereas the debt service ratio for the lowest income quintile of the population was unchanged between 1995 and 1998, the overall bankruptcy filing rate soared. Similarly, whereas the debt service ratio fell from 1998 to 2001, bankruptcy filings were the same in 1998 and 2001. The debt service ratio of the lowest quintile was also the same in 1992 and 2001, but bankruptcies were much higher in the latter period. In short, changes in the lowest-income sector of society do not explain rising bankruptcy filing rates. Thus, the aggregate debt-service measurements are not concealing some sort of unrecognized distress among poor households.

I have explained the reason for this in an earlier post. There is no indication that the increased competitiveness of lending to lower-income households has changed the household borrowing budget constraint. Instead, it has largely resulted in a switching around of the types of consumer credit. So, for instance, the growth in credit card access by lower-income households has largely just been a substitution from other forms of credit, such as pawn shops, personal finance companies, and retail store credit (remember Williams v. Walker-Thomas?). The increase in competition has increased credit options to low-income borrowers, thereby enabling them to get access to credit on more competitive terms.

This also suggests that the growth in subprime lending is not creating overwhelming debt burdens for low-income households. In fact, by expanding home ownership, subprime lending has made it possible for low-income houesholds to access home equity credit, which has a lower interest rate than other credit alternatives. And while subprime lending is obviously riskier, foreclosure rates average 0.2 percent for prime mortgage loans and 2.6 percent for subprime mortgages, higher but still not that high.

In fact, the biggest differences in household financial condition in America today is not so much by difference in income, but rather differences in homeowners versus non-homeowners. This may come as a shock to critics of subprime lending, but if a person can't get a mortgage, they still have to live somewhere, and usually that is to rent an apartment. The difference, of course, is that homeownership enables both the accumulation of wealth as well as access to home equity borrowing. Renters, by contrast, are not building wealth and are limited to a motley assortment of consumer credit options. As a result, renters are much more likely to borrow on credit cards, whereas similarly-situated home owners can access a lower-interest home equity loan.

So social engineers may want to be careful about "saving" the poor from the scourge of subprime lending, because by restricting those choices they are likely just pushing them into even less-favorable credit options.