Every Friday for the past several years, the Business Section of the Washington Times prints a chart of prevailing consumer banking rates for consumer financial products. During that time, average credit card interest rates have consistently been lower than interest rates on consumer “personal loans” by one or two interest rates (i.e., traditional unsecured consumer loans). This is, of course, one reason why credit card borrowing has risen over time, reflecting a rational substitution by consumers for other more-expensive or less-attractive forms of credit, such as personal loans, pawn shops, and retail finance loans. Interestingly, during this same period, average rates on home equity loans and automobile loans have shown no consistent pattern, as neither is consistently higher or lower than the other (today, new car loans have lower interest rates than home equity loans). All of the interest rates on all other forms of consumer credit have remained basically constant over this time, suggesting that the jump in credit card interest rates is a result of increased risk for credit cards, rather than a general rise in interest rates or the cost of funds.
Beginning in late-April, however, for the first time since the Times has been reporting these rates, the interest rates on credit card loans shot up above those for personal loans. The most likely explanation, of course, is that in mid-April the Bankruptcy Reform Legislation was enacted–but the new rules do not go into effect for 6 months (except for the new homestead exemption cap, which went into effect immediately).
In fact, consumer bankrutpcy filings exploded in March and April, when it became apparent that the bankruptcy reform legislation was likely to be enacted. As shown in this chart, bankruptcy filings jumped from 99,000 in January and 103,000 in February, to 165,000 in March and 170,000 in April. (I am told by a researcher with access to this data that the week after the President signed the bill in April was the second-highest bankruptcy filing week in history, but I haven’t been able to confirm it independently.)
So what is going on here? Quite plainly, consumers are responding to incentives–in a very big way. Critics of reform generally argued that consumers do not respond to incentives, but that bankruptcy filings are caused exogenously by debt levels and financial hardship. Indeed, it is often said that consumers are so distraught by their financial plight, that they can’t even think rationally about whether to file bankruptcy.
Those of us who favored reform, on the other hand, argue that financial hardship cannot fully explain bankruptcy filing trends and that the consumer bankruptcy decision is at least to some extent a function of individual choice, and that the rising bankruptcy filing rate of the past two decades can be explained in part as a response to the incentives provided by the bankruptcy code to file bankruptcy (such as in my forthcoming article in the Washington & Lee Law Review).
The first week of May, average credit card interest rates jumped in one week from about 9.5% to 10.7% and has remained above the personal loan interest rate, which is at 10.26% today (and has remained around that level). What is going on? Well, for whatever reason, it appears that as consumers have accelerated their bankruptcy filings to make sure they get them in before the new legislation takes effect, this has impacted credit card risk dramatically more than personal loans, as further suggested by the fact that the jump in credit card interest rates occurred with a lag of about a week or two after the bill became law, and immediately after the April filing numbers were released.
Do consumers respond to incentives to file bankruptcy? The experience of the past few months strongly suggests “yes.” Although this is obviously very casual empiricism, it is backed by a volume of economic theory that predicts that consumers would respond to anticipated changes in the bankruptcy laws exactly as they apparently have–by rushing to file bankruptcy before the new law takes effect. In turn, this would increase risk for those consumer credit products most prone to moral hazard (namely credit cards), and that this surge of bankruptcy filings would drive up interest rates for all consumers. This also suggests that when the legislation goes into effect in October (after the 6 month lag), bankruptcy filing rates would be predicted to fall, and credit card interest rates will be predicted to return to their historic rates below rates for personal loans (everything being constant).
By contrast, others have argued that bankruptcy filings are primarily occasioned by financial hardship (debt, medical problems, etc.) and that bankruptcy is a last resort. Thus, changing the incentives to file bankruptcy (by changing the law) is predicted not have any effect on bankruptcy filing rates. If that is the case, it is awfully difficult for me to understand how bankruptcy filings increased 60 percent from February to March alone. Overall, from January to April–the period when bankruptcy reform went from dead to enacted–bankruptcy filings are up 71%. It is hard to see how this surge can be squared with the “distress” model of consumer bankruptcy.
Faced with a 60% increase in filings in one month with no obvious alternative explanation, it is hard to escape the conclusion that consumers do respond to the incentives of the bankruptcy code. Unfortunately, human nature being what it is, in the short run we are all stuck with higher credit card interest rates to make up for all of these strategic bankruptcy filers. But, if economic theory holds equally well once the law takes effect, we can expect lower credit costs in the long run.
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