The Role of State-Level Exemption Laws
in Consumer Delinquency Choices

In the summer 2003 issue of The Quarterly Review of Economics and Finance, Sumit Agarwal, Chunlin Liu, and Lawrence Mielnicki of FleetBoston Financial examine the effect of the cross-state differences in three types of bankruptcy exemption laws on consumer loan delinquencies and bankruptcy behavior.

State laws differ in the percent of debtors' wages that are subject to garnishment, as well as in the dollar amount of home equity and personal property exemptions that debtors are allowed to retain when filing for personal bankruptcy. The authors use a database of over 1.5 million individual credit card accounts issued by a national financial institution between January 1994 and October 1998 and tracked for two years after origination to investigate whether state-level exemption differences can explain consumers' decisions to become delinquent on unsecured accounts and to declare bankruptcy. In this study, an account is identified as delinquent if payment becomes 90 days past due at any time within the first two years of origination. An account is flagged as "formally bankrupt" if its credit bureau account standing is "bankrupt" within the first two years of origination and flagged as "informally bankrupt" if an account is listed as a "chargeoff" but bankruptcy has not been declared. All other accounts are deemed current.

Two models are estimated. One model examines delinquency behavior-the choice to stay current or become delinquent on an account. The results suggest that a decrease in garnishment level (i.e., smaller percentage of a borrower's wages that can be garnished) and an increase in property exemption level lead to an increased likelihood that an account will become delinquent. The second model seeks to identify the determinants of informal and formal bankruptcy in addition to assessing the interdependence of these decisions. As with the delinquency choice, a decrease in garnishment and an increase in property exemption level encourage informal bankruptcy. The homestead exemption level explains only the formal bankruptcy decision. An increase in both the homestead and property exemption levels encourages formal bankruptcy "...confirming that individuals who declare formal bankruptcy intend to protect their net worth." Sagarwal et al. conclude "[t]hese results imply a certain degree of substitutability between formal and informal bankruptcy." They predict that limiting debtors' ability to discharge liabilities and establishing need-based criteria to declare formal bankruptcy (as is the case with bankruptcy reform legislation pending in Congress) lower bankruptcy filings but raise chargeoffs (informal bankruptcies). The study results suggest that an increase in garnishment rates in conjunction with the bankruptcy reform legislation would be necessary to improve default rates as well.