FORMAL VS INFORMAL DEFAULT IN CONSUMER CREDIT (with … · The US bankruptcy code: Chapter 7 and...

FORMAL VS INFORMAL DEFAULTIN CONSUMER CREDIT

(with intro to macroeconomics research on insolvency)

Xavier Mateos-Planas

Queen Mary University of London

Insolvency 2014 ConferenceCzech National BankPrague, 20 May 2014

X. Mateos-Planas () Formal vs informal default 1 / 33

PART I

Quantitative macroeconomicson insolvency


1. RECENT DEVELOPMENTS

Considerable progress in the Quantitative Macroeconomics approach toconsumer insolvency

I Early: Athreya 2002, Li and Sarte 2006, Mateos-Planas and Seccia 2006

I Standards: Livshits, Tertilt, McGee 2007, Chatterjee, Corbae, Nakajima, Rios-Rull

2007, Mateos-Planas 2013

I Applications: Athreya 2009, Livshits et al 2010, Athreya, Tam and Young 2013

I Frontiers: Mateos-Planas and Rios-Rull 2012, Tam 2010, Drosz and Nosal 2012

Of policy relevance, with attention to legal, institutional and regulatoryaspects

Applications largely focused on U.S., households and small businesses


2. CONTEXT

The US bankruptcy code: Chapter 7 and Chapter 13

Legal and regulatory changes:

I Bankruptcy Reform Act (BAPCPA 2005)

I Credit card market regulation (CARD Act 2009)

Rising incidence of bankruptcy since 1970’s


Consumer bankruptcy and unsecured debt in the U.S. (Source is SCF)

In 2007

1% filed for bankruptcy ...

... and 5% held delinquent loans


More recently ...

... sharp drop in bankruptcies around 2005 (and shift towards delinquencies).


3. QUESTIONS AND APPROACH

SOME QUESTIONS

Accounting for observed changes in consumer debt and default

Quantitative effects of policies (on debt, volatility, default, welfare)

METHODOLOGY: quantitative dynamic general-equilibrium model

Lack of commitment

Incomplete financial markets, uninsurable individual risk (precautionary motives)

Heterogeneous households: distribution of wealth and earnings (winners and losers)


4. ANSWERS AND INTUITION

SOME ANSWERS

Credit technology (e.g., rating) important driver of rise in bankruptcy and debt

Stricter means testing and tighter asset exemptions are desirable

KEY TRADE-OFF

Default is a form of insurance ...

... but raises interest rates and restricts access to credit


PART II

Formal and informal default(with David Benjamin, SUNY Buffalo)


More than 5% of borrowers fall two months behind in payments; Fewerthan 1% declare bankruptcy


1. MOTIVATION AND OBJECTIVE

Most studies of personal default have focused only on (formal) bankruptcywhere insolvency outcomes (e.g., recovery) are predetermined

Yet, a large number of households with payment issues but avoidingbankruptcy (i.e., delinquent). These informal situations involve negotiations

I In the U.S. in 2011 at least 10 million households participated in privatelynegotiated debt settlements

I In the UK, around 6 per cent of unsecured borrowers in receipt of loan forbearance

We develop a theory of both FORMAL and INFORMAL default withBARGAINING and study

(1) whether it has sensible quantitative implications

(2) policies, welfare and recovery rates


2. PREVIEW OF RESULTS

A theory where both formal and informal default occur, which isquantitatively consistent with portfolio mix of bankrupt and delinquenthouseholds

Policies:

I Limiting negotiations - as opposed to bankruptcy - worsens welfare

I Negotiations enhance the benefits from a tighter exemption level

I Limiting debt collection is detrimental overall, but benefits some

Policies that increase welfare are associated with higher recovery rates.


3. MODEL

Augment standard general-equilibrium heterogeneous-agents incomplete-markets macro modelof bankruptcy with option to bargain.

There are two main groups of agents

HOUSEHOLDS

Multiperiod-lived and risk-averse utility over (non-durable) consumption, discounted

Idiosyncratic (Markovian) shocks to income e(s)

Can borrow, and save/invest subject to convex adjustment costs φ(a, a′)

LENDERS

Buy one-period debt from households and take deposits

When bankruptcy, it takes the loss and non-exempt assets

When bargaining, it offers a settlement plan


Decisions and interactions happen through markets and institutions

MARKETS

Risk free rate q0 for assets and deposits

Price schedule for one-period non-contingent debts

q(a′, b′, s)

(a assets; b debt; s earnings)

Free entry competition in lending

BANKRUPTCY AND BARGAINING

Bankruptcy: debt is discharged; stochastic credit exclusion; asset exemption

Bargaining: settlement plan involving new debt and a transfer so the creditor receives

τ + b′q(a′, b′, s)

Cannot exceed full repayment; failure to settle prevents new debt and brings collection ofa fraction τb of debt outstanding


TIMING

If clean record:

Choose whether to default, if so whether to file or bargain

If bargain, whether or not to accept offered plan (if bank proposes)

If failed to settle:

Choose whether to try bargaining again or to file

If bankrupt:

Wait for forgiveness

EQUILIBRIUM

Competitive free-entry equilibrium in credit market and SPE in bargaining.

Delivers distribution of households across debt, assets, income and status and their savings,borrowing and default decisions


4. BENCHMARK ECONOMY

Calibration

Using macro data to pin down parameters. The model as a lab.

Based on the stationary distribution of income and wealth

Parameters set directly

Description Parameter valueRisk aversion σ 2.00Bank’s cost λ 0.04Asset exemption a7 0.50Risk-free interest 1/q0 − 1 0.03Persistence formal default π7 0.68

Endogenous parameters

Description Parameter valueDiscount β 0.92Collection tax τb 0.08Bargaining costs χB 0.20Bankruptcy costs χ7 0.20Income realizations (e1, e2) (0.12,0.90)Persistence income (Γ1,1, Γ2,2) (0.40,0.80)Adjustment cost φ 0.50


Matching targetsSCF 2007. Bottom 80%.

Aggregate targets

Description Model DataWealth/inc 2.01 2.10Debt/inc 0.137 0.125proportion in debt 0.349 0.320Formal default 0.0085 0.011Informal default 0.0570 0.055Log var inc 0.80 0.80Aver interest .178 .140


Summary distribution statistics

Summary distribution and choices

mass debt assets borrowing saving inc recovClean credit:All 0.9635 0.097 1.424 0.091 1.477 0.708Formal defaulters 0.0085 0.107 0.386 0.000 0.302 0.362Informal defaulters 0.0570 0.441 1.059 0.335 0.767 0.182Inf. def. who settle 0.0394 0.388 0.919 0.235 0.702 0.210 0.162Inf. def. who delay 0.0177 0.558 1.369 0.558 0.911 0.120Repeat defaulters 0.0165 0.386 0.664 0.242Failed to agree:All 0.0183 0.527 0.911 0.588Formal defaulters 0.0000 0.472 0.781 0.000 0.780 0.900Informal defaulters 0.0183 0.527 0.911 0.168 0.805 0.588Inf. def. who settle 0.0176 0.522 0.895 0.128 0.802 0.604 0.286Inf. def. who delay 0.0006 0.670 1.360 0.670 0.889 0.120


Probability of bankruptcy conditional on default:

Negotiations more frequent at higher assets and debts; notice importance of proximity toexemption level.


Mass distribution of default


Recovery rates

Suggest trade-off faced re delay: by waiting longer income may increase and the lender couldrecover more; but in the meantime the household will be drawing down assets and makerecovery more difficult


5. QUANTITATIVE IMPLICATIONS

PORTFOLIOS

Informal defaulters have more assets and debts, and lower income than formal defaulters

Portfolio mix of defaulters conforms data for SCF 2007.

Data (SCF) and model (income-normalised)

assets debt inclate payers data 1.10 0.161 0.71informal defaulters current 1.50 0.63 0.26informal defaulters next 1.09 0.48 0.85bankrupt data 0.46 0.110 0.76formal defaulters current 0.55 0.15 0.51formal defaulters next 0.43 0.00 0.90

Intuition: With substantial assets, use informal default first when income drops. Use formal

default later as assets are drawn down, even if income improves.


6. POLICIES, WELFARE AND RECOVERY

COST OF NEGOTIATIONS

Consider increasing the cost of negotiation to the household

Shift from negotiations towards bankruptcy

Negotiated recovery rates decline, and so must total recovery

Welfare declines

Description d% d7% dB% wealth debt indebt averct varct % welf

benchmark 6.56 0.85 5.70 2.01 0.137 0.35 0.726 0.0753 –

χB up 1.0 7.14 0.96 1.51 2.15 0.130 0.33 0.732 0.0773 -1.20

Negotiated settlementsdebt debt recovered recovery rate

Benchmarkclean credit history 0.388 0.162 0.417failed to agree in past 0.522 0.286 0.548Higher negotiation costclean credit history 0.623 0.159 0.255failed to agree in past 0.676 0.240 0.355


BANKRUPTCY PUNISHMENT

Consider increasing the cost of bankruptcy to the household

Shift away from bankruptcy

Negotiated recovery rates improve, and so must total recovery

Welfare improves


benchmark 6.56 0.85 5.70 2.01 0.137 0.35 0.726 0.0753 –χ7 up 1.0 5.93 0.19 5.74 1.76 0.248 0.47 0.725 0.0712 +1.69


Benchmarkclean credit history 0.388 0.162 0.417failed to agree in past 0.522 0.286 0.548Higher bankruptcy costclean credit history 0.660 0.390 0.591failed to agree in past 0.698 0.563 0.807


ASSET EXEMPTION

Trade-off: borrowing constraints vs insurance.

Tightening the exemption level by 20%

Shift from bankruptcy into more negotiations

It improves welfare and consumption insurance

Recovery improves


benchmark 6.56 0.85 5.70 2.01 0.137 0.35 0.726 0.0753 –a7 down .40 7.14 0.54 6.60 1.94 0.171 0.41 0.727 0.0731 +0.54


Benchmarkclean credit history 0.388 0.162 0.417failed to agree in past 0.522 0.286 0.548Lower exemptionclean credit history 0.465 0.221 0.475failed to agree in past 0.597 0.367 0.615


Recovery rates with stricter exemption


Welfare changes with stricter exemption


Debt price changes with stricter exemption


COLLECTION

Consider decreasing the collection rate τb, a form of consumer protection.

Overall, it causes a reduced access to borrowing as default now leads to lower repayments.Lower aggregate welfare follows.

Delinquent households, however, benefit from this policy.

Recovery rates decrease


benchmark 6.56 0.85 5.70 2.01 0.137 0.35 0.726 0.0753 –τb down .04 7.36 0.99 6.36 1.91 0.071 0.24 0.723 0.0822 -0.71


Benchmarkclean credit history 0.388 0.162 0.417failed to agree in past 0.522 0.286 0.548Lower collectionsclean credit history 0.239 0.093 0.389failed to agree in past 0.301 0.151 0.502


Recovery rates with weaker collection


Welfare changes with weaker collection


Debt price changes with weaker collection


7. CONCLUDING REMARKS

A sensible quantitative theory of negotiations during personal insolvencies,which sheds new light on risk-sharing (or insurance) implications of policiesand regulations

Find that policies conducive to higher recovery are generally welfareimproving

(Some caveats though: risk-based pricing; one-period contracts; completeinformation and efficient bargaining.)

Further work of personal default: mortgage modification and foreclosures;finer details of legal and institutional environment; application to othercountries in Europe.

Turning attention to incorporated firms’ insolvency, where bargaining duringrestructuring is more prevalent, as well as the role of long term credit lines(see Mateos-Planas ad Rios-Rull 2013)


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