FORMAL VS INFORMAL DEFAULT
IN CONSUMER CREDIT
(with intro to macroeconomics research on insolvency)
Xavier Mateos-Planas
Queen Mary University of London
Insolvency 2014 Conference
Czech National Bank
Prague, 20 May 2014
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PART I
Quantitative macroeconomics
on insolvency
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1. RECENT DEVELOPMENTS
Considerable progress in the Quantitative Macroeconomics approach to
consumer insolvency
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Early: Athreya 2002, Li and Sarte 2006, Mateos-Planas and Seccia 2006
Standards: Livshits, Tertilt, McGee 2007, Chatterjee, Corbae, Nakajima, Rios-Rull
2007, Mateos-Planas 2013
Applications: Athreya 2009, Livshits et al 2010, Athreya, Tam and Young 2013
Frontiers: Mateos-Planas and Rios-Rull 2012, Tam 2010, Drosz and Nosal 2012
Of policy relevance, with attention to legal, institutional and regulatory
aspects
Applications largely focused on U.S., households and small businesses
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2. CONTEXT
The US bankruptcy code: Chapter 7 and Chapter 13
Legal and regulatory changes:
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Bankruptcy Reform Act (BAPCPA 2005)
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Credit card market regulation (CARD Act 2009)
Rising incidence of bankruptcy since 1970’s
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Consumer bankruptcy and unsecured debt in the U.S. (Source is SCF)
In 2007
1% filed for bankruptcy ...
... and 5% held delinquent loans
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More recently ...
... sharp drop in bankruptcies around 2005 (and shift towards delinquencies).
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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)
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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
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PART II
Formal and informal default
(with David Benjamin, SUNY Buffalo)
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More than 5% of borrowers fall two months behind in payments; Fewer
than 1% declare bankruptcy
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1. MOTIVATION AND OBJECTIVE
Most studies of personal default have focused only on (formal) bankruptcy
where insolvency outcomes (e.g., recovery) are predetermined
Yet, a large number of households with payment issues but avoiding
bankruptcy (i.e., delinquent). These informal situations involve negotiations
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In the U.S. in 2011 at least 10 million households participated in privately
negotiated debt settlements
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 with
BARGAINING and study
(1) whether it has sensible quantitative implications
(2) policies, welfare and recovery rates
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2. PREVIEW OF RESULTS
A theory where both formal and informal default occur, which is
quantitatively consistent with portfolio mix of bankrupt and delinquent
households
Policies:
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Limiting negotiations - as opposed to bankruptcy - worsens welfare
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Negotiations enhance the benefits from a tighter exemption level
Limiting debt collection is detrimental overall, but benefits some
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Policies that increase welfare are associated with higher recovery rates.
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3. MODEL
Augment standard general-equilibrium heterogeneous-agents incomplete-markets macro model
of 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, a0 )
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
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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 0 , b 0 , 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 0 q (a 0 , b 0 , s )
Cannot exceed full repayment; failure to settle prevents new debt and brings collection of
a fraction τb of debt outstanding
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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
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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
Risk aversion
Bank’s cost
Asset exemption
Risk-free interest
Persistence formal default
Parameter
σ
λ
ā7
1/q0 − 1
π7
value
2.00
0.04
0.50
0.03
0.68
Endogenous parameters
Description
Discount
Collection tax
Bargaining costs
Bankruptcy costs
Income realizations
Persistence income
Adjustment cost
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Parameter
β
τb
χB
χ7
(e1 , e2 )
(Γ1,1 , Γ2,2 )
φ
value
0.92
0.08
0.20
0.20
(0.12,0.90)
(0.40,0.80)
0.50
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Matching targets
SCF 2007. Bottom 80%.
Aggregate
Description
Wealth/inc
Debt/inc
proportion in debt
Formal default
Informal default
Log var inc
Aver interest
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targets
Model
2.01
0.137
0.349
0.0085
0.0570
0.80
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Data
2.10
0.125
0.320
0.011
0.055
0.80
.140
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Summary distribution statistics
Summary distribution and choices
Clean credit:
All
Formal defaulters
Informal defaulters
Inf. def. who settle
Inf. def. who delay
Repeat defaulters
Failed to agree:
All
Formal defaulters
Informal defaulters
Inf. def. who settle
Inf. def. who delay
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mass
debt
assets
borrowing
saving
inc
0.9635
0.0085
0.0570
0.0394
0.0177
0.0165
0.097
0.107
0.441
0.388
0.558
0.386
1.424
0.386
1.059
0.919
1.369
0.664
0.091
0.000
0.335
0.235
0.558
1.477
0.302
0.767
0.702
0.911
0.708
0.362
0.182
0.210
0.120
0.242
0.0183
0.0000
0.0183
0.0176
0.0006
0.527
0.472
0.527
0.522
0.670
0.911
0.781
0.911
0.895
1.360
0.000
0.168
0.128
0.670
0.780
0.805
0.802
0.889
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0.588
0.900
0.588
0.604
0.120
recov
0.162
0.286
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Probability of bankruptcy conditional on default:
Negotiations more frequent at higher assets and debts; notice importance of proximity to
exemption level.
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Mass distribution of default
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Recovery rates
Suggest trade-off faced re delay: by waiting longer income may increase and the lender could
recover more; but in the meantime the household will be drawing down assets and make
recovery more difficult
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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)
late payers data
informal defaulters current
informal defaulters next
bankrupt data
formal defaulters current
formal defaulters next
assets
1.10
1.50
1.09
0.46
0.55
0.43
debt
0.161
0.63
0.48
0.110
0.15
0.00
inc
0.71
0.26
0.85
0.76
0.51
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.
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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
benchmark
χB up 1.0
6.56
7.14
0.85
0.96
5.70
1.51
2.01
2.15
0.137
0.130
0.35
0.33
0.726
0.732
0.0753
0.0773
Negotiated settlements
debt
debt recovered
Benchmark
clean credit history
failed to agree in past
Higher negotiation cost
clean credit history
failed to agree in past
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–
-1.20
recovery rate
0.388
0.522
0.162
0.286
0.417
0.548
0.623
0.676
0.159
0.240
0.255
0.355
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% welf
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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
Description
d%
d7%
dB %
wealth
debt
indebt
averct
varct
% welf
benchmark
χ7 up 1.0
6.56
5.93
0.85
0.19
5.70
5.74
2.01
1.76
0.137
0.248
0.35
0.47
0.726
0.725
0.0753
0.0712
–
+1.69
Negotiated settlements
debt
debt recovered
Benchmark
clean credit history
failed to agree in past
Higher bankruptcy cost
clean credit history
failed to agree in past
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recovery rate
0.388
0.522
0.162
0.286
0.417
0.548
0.660
0.698
0.390
0.563
0.591
0.807
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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
Description
d%
d7%
dB %
wealth
debt
indebt
averct
varct
% welf
benchmark
a7 down .40
6.56
7.14
0.85
0.54
5.70
6.60
2.01
1.94
0.137
0.171
0.35
0.41
0.726
0.727
0.0753
0.0731
–
+0.54
Negotiated settlements
debt
debt recovered
Benchmark
clean credit history
failed to agree in past
Lower exemption
clean credit history
failed to agree in past
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recovery rate
0.388
0.522
0.162
0.286
0.417
0.548
0.465
0.597
0.221
0.367
0.475
0.615
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Recovery rates with stricter exemption
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Welfare changes with stricter exemption
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Debt price changes with stricter exemption
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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
Description
d%
d7%
dB %
wealth
debt
indebt
averct
varct
benchmark
τb down .04
6.56
7.36
0.85
0.99
5.70
6.36
2.01
1.91
0.137
0.071
0.35
0.24
0.726
0.723
0.0753
0.0822
Negotiated settlements
debt
debt recovered
Benchmark
clean credit history
failed to agree in past
Lower collections
clean credit history
failed to agree in past
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–
-0.71
recovery rate
0.388
0.522
0.162
0.286
0.417
0.548
0.239
0.301
0.093
0.151
0.389
0.502
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% welf
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Recovery rates with weaker collection
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Welfare changes with weaker collection
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Debt price changes with weaker collection
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7. CONCLUDING REMARKS
A sensible quantitative theory of negotiations during personal insolvencies,
which sheds new light on risk-sharing (or insurance) implications of policies
and regulations
Find that policies conducive to higher recovery are generally welfare
improving
(Some caveats though: risk-based pricing; one-period contracts; complete
information and efficient bargaining.)
Further work of personal default: mortgage modification and foreclosures;
finer details of legal and institutional environment; application to other
countries in Europe.
Turning attention to incorporated firms’ insolvency, where bargaining during
restructuring is more prevalent, as well as the role of long term credit lines
(see Mateos-Planas ad Rios-Rull 2013)
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