Ebook The Role of Information in Consumer Debt and Bankruptcy
Consumer debt and bankruptcy are central issues today because of their explosive rise over the last 20 years in the U.S. economy. Although many explanations have been proposed, there is still no convincing understanding of these trends. A candidate story is the drop in information costs. This driving force may be important because during the same period there was impressive technological progress in the information sector often called IT revolution and the financial sector uses information intensively to evaluate credit risk.
This story has not been evaluated mainly because there is no quantitative theory of consumer debt and bankruptcy where the cost of information production plays an important role. The purpose of this paper is to provide such a theory and to quantify how much of the rise in debt and bankruptcy can be attributed to the drop in information costs.
The number of annual bankruptcy filings increased by 1.3 million from 286,444 to 1,563,145, almost 5.5 times between 1983 and 2004, as depicted in Figure 1. Before the early 1980s, the rise in bankruptcy was moderate. According to Moss and Johnson (1999), “from 1920 to 1985, the growth of consumer filings closely tracked the growth of real consumer credit. Since then, however, the rate of increase of consumer bankruptcies has far outpaced that of real consumer credit.” Therefore, a study about the rise in bankruptcy should also consider the trend in consumer debt.
According to White (2007), credit card debt rose from 3.2% of median family income to 12% from 1980 to 2004. Other statistic, the ratio of bankruptcy filings to the number of households in debt, is particularly useful because it increases only if the number of filings grow faster than the number of households in debt. This statistic, referred to as the bankruptcy rate hereafter, increased from 0.92% to 3% between 1983 and 2004.
This paper builds a quantitative theory of consumer debt and bankruptcy with asymmetric information and costly screening. The type of an individual, i.e. the income group the individual belongs to, is persistent and unobservable. Lenders would like to know the individual’s type because persistence implies that her type is useful to predict the probability of bankruptcy. In particular, individuals with lower income have higher risk of bankruptcy because they are more likely to have low income in the next period. The availability of costly screening divides the lenders into two groups, those that use a screening technology, informed lenders; and those that instead design debt contracts to induce borrowers to reveal their type, uninformed lenders.
Individuals decide, given the cost of information, which kind of lender they prefer to borrow from. When screening costs go to zero, the model collapses to the one of Chatterjee, Corbae, Nakajima, and Rios-Rull (2007), where there is perfect information so all the individuals borrow from “informed lenders”. Instead, if the cost of information is higher, some individuals will borrow from uninformed lenders. Since low-income individuals are more likely to file for bankruptcy, they accept a higher interest rate than high-income individuals to borrow more. As a consequence, uninformed lenders can achieve self-revelation of types: the contracts for high-income individuals have lower interest rates and tighter borrowing constraints. Thus, under these contracts when information costs are high enough some individuals are borrowing constrained.
This fact is crucial for under standing the effect of information costs on debt and bankruptcy. As information costs drop, individuals borrow more, and the number of bankruptcy filings rises. More debt generates more bankruptcy because the benefit from bankruptcy discharge of debts is increasing in the amount owed, while the costs temporary exclusion from financial markets and income lost are independent of the individual’s debt size. Therefore, a drop in information costs leads to more debt and more bankruptcy, two comparative statics results qualitatively consistent with the facts presented above.
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