March 19, 2012

Reasons For Bankruptcy Filings Analyzed

Private Enterprise Research Center logoAnalyzing the underlying reasons when and why people file for bankruptcy and assessing whether current bankruptcy laws make it too easy for individuals to wipe out their debts are focuses of a study by economists at the Private Enterprise Research Center at Texas A&M University.

In investigating underlying bankruptcy motivations, PERC Research Fellow Li Gan, along with colleagues Tarun Sabarwal, University of Kansas, and Shuoxun Zhang, Southwestern University of Finance and Economics, China, divide filers into two categories:  (1) “strategic filers,” those who are able to choose the time at which they file for bankruptcy, and (2) “adverse- events filers,” those who have little latitude in choosing the timing because of their circumstances’ immediacy.

Most bankruptcies — 84 percent — are caused by adverse events rather than strategic timing, they conclude in the “working paper” prepared at the economics-oriented think tank.

“The typical adverse events filer will plan his future without considering the low probability events that might push him into bankruptcy,” they explain. “If these events occur, he will then re-assess his situation and decide whether to file.”

The strategic filer considers all unlikely events and considers filing even in the most optimistic scenarios, the two economists contend.

“Consequently, the strategic filer decides whether to file for bankruptcy simultaneously with how much debt to accumulate, while the adverse-events filer’s debt decision would be independent of the bankruptcy decision,” they add.

The adverse event filer’s debt will usually be higher than that of the strategic filer, the note in their paper.

They found that fewer credit cards, higher risk aversion, price sensitivity and lower incomes are associated with strategic filing.

Other key findings:

  • Increases in home ownership benefit strategic filers
  • Decreases in the average spell of unemployment will reduce the filing rate of the strategic type without affecting the rate of the adverse-effect type.

The last time Congress overhauled bankruptcy laws was in 2005.

“In the months preceding implementation of the law, bankruptcies spiked,” the PERC researchers note. “Ostensibly, this fact suggests that severe financial stresses caused by shocks weren’t responsible for the majority of the bankruptcy filings. But, instead, the filers were deeply in debt, and though they naturally would have waited longer to file (if they filed at all), they found it in their economic interest to file before the new law took effect.”

Gan, Sabarwal and Zhang say they think their study advances the research into bankruptcy motivations.

“Whether bankruptcy laws today promote building up debt in anticipation of a bankruptcy instead of providing people an opportunity to recover from disastrous calamities has been a topic of debate in the past,” they observe. “There will always be example of people who can use safety nets to expand their socially inefficient behavior. To better tailor the law to prevent such behaviors, we must better understand the different types of people and how the laws differentially affect them.”

They say their study moves that understanding forward.

To view the full text of their working paper, go to perc.tamu.edu/perc/Publication/research/winter2012.pdf.

The PERC mission is to raise economic understanding and increase awareness of the importance of individual freedom to the strength of the nation’s economy, notes PERC Director Thomas  R. Saving, who holds the title of Distinguished Professor of Economics at Texas A&M, adding that research at the center is intended to address important issues of public policy.

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Media contact: Lane Stephenson, News & Information Services at (979) 845-4662

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