The upside to bankruptcy protection

The toll that excessive private debt can take on the growth of the U.S. economy has been well documented in the wake of the bursting of the housing bubble in 2006 and the subsequent Great Recession. But high levels of indebtedness also have a significant effect on the lives of households at the microeconomic level. A new working paper released today by the National Bureau of Economic Research shows just how large this impact can be for individual households and the benefits of policies to help individual borrowers manage indebtedness.

The paper, by Will Dobbie of Princeton University and Jae Song of the Social Security Administration, looks specifically at the effect of Chapter 13 bankruptcy protection. Chapter 13 allows individual borrowers to keep more of their assets in exchange for paying back at least some of the debts owed. The American bankruptcy system allows borrowers to choose between Chapter 12 and Chapter 7, which gives the borrower debt relief and protects their wages in exchange for surrendering the certain assets the borrower still has, such as a second car or investments in stocks. In contrast, Chapter 13 doesn’t wipe the slate clean, but instead makes debt more manageable.

The paper by Dobbie and Song goes beyond previous efforts to measure the effect of bankruptcy protection in two ways. The first is the data they use—administrative tax data linked to bankruptcy data—which gives them a very precise look at the outcomes of a half-million borrowers that entered bankruptcy protection. Second, they control for the fact that borrowers who apply for bankruptcy are likely to have bad outcomes relative to the rest of the population. Dobbie and Song control for this problem by using the fact that bankruptcy judges are randomly assigned, which means they can compare very similar borrowers who got different treatment in bankruptcy because of which judge they were assigned.

The results are quite stark. Chapter 13 protection boosts annual earnings by $5,562 and decreases the probability of dying in the next five years by 1.2 percentage points. But these really aren’t gains per se. The relative difference is because bad outcomes for borrowers that don’t receive Chapter 13 protection are so much worse. Basically, Chapter 13 protection is not a program that actively improves outcomes for those in bankruptcy, but rather protects them from the ravages of high debt loads with no help.

Dobbie and Song also find a social benefit to Chapter 13 protection. We know how home foreclosures can put downward price pressures on nearby homes. We also know that foreclosures may even have an effect on the health of nearby residents. Dobbie and Song find that the probability of foreclosure in the next five years decreases by 19 percentage points due to Chapter 13 protection.

This new paper by Dobbie and Song is an important contribution to our understanding how policymakers can help individual households deal with debt once the load becomes unmanageable. Given the experience of the recent housing crisis, deepening our understanding of how to handle private debt is an endeavor well worth additional research.

September 29, 2014


Credit & Debt

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