The Role of Default (Not Bankruptcy) as Unemployment Insurance: New Facts and Theory

80 Pages Posted: 25 Jan 2013

See all articles by Kyle Herkenhoff

Kyle Herkenhoff

University of Minnesota - Minneapolis

Date Written: October 28, 2012

Abstract

How do job losers use default -- a phenomenon 6x more prevalent than bankruptcy -- as a type of "informal" unemployment insurance, and more importantly, what are the social costs and benefits of this behavior? To this end, I establish several new facts: (i) job loss is the main reason for default, not negative equity (ii) people default because they are credit constrained and cannot borrow more, and (iii) the value of debt payments is a significant fraction of a defaulter's earnings. Using these facts, I calibrate a general equilibrium model with a frictional labor market similar to Menzio and Shi (2009, 2011) and individually priced debt along the lines of Eaton and Gersovitz (1981) and Chatterjee et al. (2007). After proving the existence of a Block Recursive Equilibrium, I find that the extra self-insurance job losers obtain by defaulting outweighs the subsequent increase in the cost of credit, and as a result, protectionist policies such as the Mortgage Servicer Settlement of 2012 or the CARD Act of 2009 improve overall welfare by .1%. The side effect of the policies, however, is a .2 to .5% higher unemployment rate during recessions that persists throughout the recovery.

Keywords: Default, Delinquency, Foreclosure, PSID 2009 Mortgage Distress, Unemployment Benefits, Block Recursive, Bankruptcy, Search, Matching, Mortensen Pissarides, Unemployment, Unemployment Insurance, Insurance, Labor, Recovery, Business Cycle

JEL Classification: E24, E32, E44, G2, J6, K35

Suggested Citation

Herkenhoff, Kyle, The Role of Default (Not Bankruptcy) as Unemployment Insurance: New Facts and Theory (October 28, 2012). Available at SSRN: https://ssrn.com/abstract=2206562 or http://dx.doi.org/10.2139/ssrn.2206562

Kyle Herkenhoff (Contact Author)

University of Minnesota - Minneapolis ( email )

110 Wulling Hall, 86 Pleasant St, S.E.
308 Harvard Street SE
Minneapolis, MN 55455
United States

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