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

See all articles by Kartik Athreya

Kartik Athreya

Federal Reserve Banks - Federal Reserve Bank of Richmond

Juan M. Sánchez

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Xuan Tam

University of Cambridge - Judge Business School

Eric R. Young

University of Virginia

Multiple version iconThere are 4 versions of this paper

Date Written: January 30, 2014

Abstract

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

Athreya, Kartik and Sanchez, Juan M. and Tam, Xuan and Young, Eric R., Bankruptcy and Delinquency in a Model of Unsecured Debt (January 30, 2014). FRB of St. Louis Working Paper No. 2012-042C, Available at SSRN: https://ssrn.com/abstract=2163785 or http://dx.doi.org/10.2139/ssrn.2163785

Kartik Athreya

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Juan M. Sanchez (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Xuan Tam

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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