Do deals with debt collectors alleviate consumer financial distress? Using new data linking court and credit registry records, the authors examine civil collection lawsuits where consumers can settle out of court. Random assignment of judges with different styles generates exogenous variation in the likelihood of settlement negotiations. The paper finds that settlements increase consumer financial distress. Settlements appear to increase distress by draining liquidity without improving access to credit or lowering total payments. Consumers might agree to distress-inducing deals for non-pecuniary reasons or because they are ill-informed of their options.
The paper looks at whether consumer are better or worse off in striking settlements with debt collections after a lawsuit has been filed, but before going to trial. The sample is drawn from collection lawsuits in Missouri, which has both a centralized electronic court documents, random assignment of judges and wage garnishment. The authors find that, even though recognizing that most consumer lose any case that goes to trial, judicial oversight of the trial process and of any subsequent settlement, results in more favorable outcomes for consumers than following out-of-court settlements. The out-of-court settlements increase the probability of subsequent delinquency, bankruptcy, and foreclosure by 20%, 160%, and 130% compared to even a judgment obtained at trial or court supervised settlement.
The paper also considers why consumers would agree to such “bad deals” in out-of-court settlements. First, is the possibility that a settlement without a judgment preserves or improves credit
scores and future access to credit. This, however, was not supported by reviewing the consumers later credit scores nor the number of credit inquiries, an indicator that those consumers are not seeking or obtaining credit. A second reason considered is that consumers seek to avoid the costs of trial and later garnishments. The authors dismiss this since, on average, garnishments on average recovery only ~38% of the amount owed, meaning a out-of-court settlement would need to be for less to be financially justified. Third, consumers may be willing to settle to avoid the risks of trial. That the results of the out-of-court settlement are worse than trial undercuts this basis for the authors.
In looking at the reasons consumers prefer the “bad deal” of an out-of-court settlement, the authors completely under-value the emotional costs that consumers bear. Avoiding garnishment, keeps an employer (and co-workers) from learning of the financial difficulties. Going to trial is an intimidating process, where consumers often have an exaggerated, but not completely unjustified, fear, probably due to watching sharp-tongued television judges, but that they will be castigated in court for non-payment. A settlement allows at least the illusion of autonomy and control over payments.
This is tied to the recurring belief that consumers are idealized examples of homo economicus, that completely rational and informed person that solely seeks to maximize utility and minimize costs. This ignores that consumers are often both completely unaware of the actual costs and risks in debt collection and make decisions based as much on emotion and morality as cost-benefit analyses, not to mention that debt collectors prey on this ignorance and decency.
Lastly, an unmentioned reason for agreeing to an out-of-court settlement may exactly be because default and bankruptcy are contemplated (as those do result in discharge and relief from the debt) and the consumer is buying time and avoiding garnishment.
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