Bankruptcy and Delinquency in a Model of Unsecured Debt
FRB of St. Louis Working Paper No. 2012-042C
52 Pages Posted: 18 Oct 2012 Last revised: 31 Jan 2014
Date Written: January 30, 2014
The two channels of default on unsecured consumer debt are (i) bankruptcy, which legally grants partial or complete removal of unsecured debt under certain circumstances, and (ii) delinquency, which is informal default via nonpayment. In the United States, both channels are used routinely. This paper introduces a model of unsecured consumer credit in the presence of both bankruptcy and delinquency. Our model yields three new findings: First, with respect to the choice between bankruptcy and delinquency, labor income shocks matter. Specifically, we find delinquency is readily used by borrowers with the worst labor market outcomes, even those with relatively minor levels of debt. In contrast, bankruptcy is used by households with relatively high debts, but whose long-run earnings prospects are high enough to make interest rate penalties from delinquency too large. Second, financial distress is persistent: households in poor financial conditions stay in that state for several quarters. Third, in broad terms, bankruptcy and delinquency are “substitutes,” with bankruptcy increasing as delinquency costs rise.
Keywords: Consumer Debt, Bankruptcy, Default, Life cycle, Idiosyncratic risk
JEL Classification: E43, E44, G33
Suggested Citation: Suggested Citation