Like other forms of insurance, bankruptcy laws provide borrowers ex-ante risk protection but can lead to moral hazard from excessive borrowing and risk taking. While bankruptcy reforms are often explicitly intended to prevent debtors from “abusing the system,” there is currently no empirical evidence on whether bankruptcy filers increase their indebtedness in anticipation of filing. Using newly collected data on the balance sheets of personal bankruptcy filers, we develop an identification strategy to test for moral hazard in debt accumulation by bankruptcy filers and demonstrate theoretically how this could reduce aggregate welfare. We find that debtors who are incentivized by policy changes to delay filing for bankruptcy incur significantly more unsecured debt before filing, as predicted by our model of borrowers with private information about their impending bankruptcy. A significant share of the additional debt incurred by later filers is “shadow debt” — debt from the non-payment of goods and services that is not reported to credit bureaus.
The finding that consumers take on average 22 months to file bankruptcy after their first 90-day delinquency comports with the experience that bankruptcy attorneys have that clients need to "ripen" before they consult with a lawyer and then take further time to pay the costs of the bankruptcy. These delays, however, often seem to be due more from the emotional, cultural and psychological obstacles people have to overcome before filing bankruptcy than to an intent to incur more debt.
As the findings indicate debtors have $4000 more debt once they do file, with nearly $95,000 of unsecured debt, that 4% increase is also not truly substantial or necessarily significant. (Further, that amount of unsecured debt may include "unsecured" portions of otherwise secured claims, which, especially for mortgages and cars, is not necessarily discharged. While the paper does state that the amount of unsecured debt for debtors without a mortgage is roughly half of that amount, when compared, for example with statistics from Ed Flynn in the 2018 Bankruptcy by the Numbers showing that the median unsecured debt in all Chapter 7 cases was $46,574 and $31,326 for all Chapter 13 cases, this would also seem to be inexplicably higher.
This article also oddly and inaccurately asserts that "in anticipation of the debt being discharged fully in a Chapter 7 filing or at least partially discharged in a Chapter 13 filing" consumers have incentives to "strategically accumulate debt." Not only are more debts dischargeable in Chapter 13 than in Chapter 7, with most unsecured debts being paid nothing in either, Chapter 13 is actually a safer option for discharging recently incurred debts, as the discharges under §1328 is more forgiving on this count.
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