Explaining the Escalation in Personal Bankruptcies

As every creditor knows, personal bankruptcies soared in the U.S. between 1994 and 1998.  Nearly 1.4 million U.S. households filed for bankruptcy protection in 1998, about a half million more than in 1995. Perhaps even more striking is the fact that from 1992 through 1998 one out of every 20 U.S. households filed for bankruptcy. Why this occurred against the backdrop of the most favorable economic conditions in a half-century has puzzled researchers and spurred Congress to consider legislative remedies. 

An article in the January, 2000 issue of Business Economics (the journal of the National Association of Business Economics) reports the results of a new empirical study of bankruptcy filing rates across more than 3,000 U.S. counties from 1993 – 1998. The article examines three distinct but related arguments for the rise in bankruptcies. The traditional explanation for bankruptcies has been the occurrence of “insolvency events” (layoffs, failure of a small business, divorce, extended illness).  While debtor surveys consistently find that the majority of bankruptcies are triggered by insolvency events, an explanation for the rise in bankruptcies during the mid-1990s that is built around a comparable rise in insolvency events does not seem consistent with the marked improvement in the economic climate. 

Consequently, the article examines two additional explanations, which have gained popularity. Critics of the credit-granting industry argue that increasingly lax credit standards over the period encouraged consumers to run up their debt loads. Proponents of this view especially demonize credit card issuers as a driving force behind the escalation in bankruptcies. In the philosophically opposite camp are those who argue that declining social and economic stigma to filing for bankruptcy has led to more filings in at least two ways. First, declining stigma causes borrowers to live “closer to the edge.” If the apparent cost to using the bankruptcy safety net falls, households will be willing to take on more debt relative to their income. Doing so makes them more vulnerable to unexpected income or expense shocks, with a resulting higher frequency of financial problems, delinquency and bankruptcy. Additionally, as the perceived cost of using the bankruptcy safety net falls, borrowers with any given amount of debt become more likely to seek a discharge of their debts through bankruptcy, rather than incur the costs of repayment over time. In other words, the bankruptcy trigger is pulled sooner in the borrower’s debt cycle, relative to when stigma was higher. 

Researchers John Barron, Gregory Elliehausen and Michael Staten at Georgetown University’s Credit Research Center (McDonough School of Business) tested these hypotheses with a unique database composed of census data and aggregated credit bureau data.  The bureau-based data provide detailed controls for factors such as credit usage and borrower risk (aggregated to the county level). The Census data provide detailed information on insolvency events. Using a multivariate regression model, the authors examine two dimensions of bankruptcy filing rates: 1) the wide variance in filing rates per capita across U.S. counties in any given year (see chart 1) and 2) the dramatic growth in filing rates from 1993-1998 (see chart 2).  

The findings lend support to each of the three causal arguments. First, household decisions to take on higher debt loads clearly contributed to the rise in bankruptcies.   Holding household income and other, non-credit factors constant, higher mortgage and non-mortgage debt levels per debtor were associated with higher bankruptcy filing rates at the county level, as was a larger average number of debtors per household.  Interestingly, even after controlling for the amount of debt per household, the number of revolving accounts per debtor as well as the change in the number of revolving accounts per debtor were both positively associated with the bankruptcy filing rate. This result supports the hypothesis that when we observe a given amount of debt spread over a larger number of accounts it signals a riskier population. Higher risk individuals (who ultimately overextend) apparently obtain smaller revolving lines from more lenders, behavior that can be explained if individual creditors limit the credit line on a given account when they perceive a higher risk applicant. 

As for local economic and demographic factors, counties with higher average household income had lower bankruptcy rates. Similarly,  changes in a county’s average household income were inversely related to its bankruptcy filing rate. Higher unemployment rates, higher divorce/separation rates, and less health insurance coverage all contributed to higher bankruptcy filing rates. Conversely, higher average housing prices, and a higher proportion of residents over the age of fifty (who tend to have relatively more assets and may feel greater stigma associated with filing as a function of attitudes formed when bankruptcies were far less common) tend to lower bankruptcy filing rates. As a proxy for local-level social stigma, population density was positively associated with filing rates (density reflects the effect of anonymity in reducing the reputational damage of filing for bankruptcy in more densely populated areas). Counties which permit wage garnishment had significantly higher bankruptcy rates, holding other things constant, suggesting that debtors do take a calculating approach to handling financial problems and opt for bankruptcy when the advantages (escape from court-ordered garnishment) outweigh the costs. However, the unlimited homestead exemption for Chapter 7 cases found in some states (most notably Texas and Florida) had no significant effect on bankruptcy filing rates.