No Slack: The Financial Lives of Low-Income Americans

Living on the Edge of Bankruptcy

179 179 The debate over federal bankruptcy reform, including the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, and recent legislative efforts to permit home mortgage principal to be reduced through bankruptcy in the wake of the foreclosure crisis of the last several years, reflects policymakers’ beliefs on the causes of bankruptcy and inspired a spirited dialogue among academics about households’ decisions to file for bankruptcy (Keys 2010; Sullivan, Warren, and Westbrook 1989, 2000, 2003; Warren and Tyagi 2003; White 1998; Fay, Hurst, and White 2002; Jacoby, Sullivan, and Warren 2001; Gross and Souleles 2002; Gan and Sabarwal 2005; Mann 2005). Those favoring tougher bankruptcy laws that intend to make it more difficult to file or get relief argue that lenient bankruptcy laws increase the incentive to file; they argue that a decline in bankruptcy’s stigma has eroded moral restraints on filing. In their view, households engage in profligate borrowing knowing that they can evade paying debts by strategically filing for bankruptcy. Opposing scholars argue that bankrupt debtors face crushing financial burdens, often caused by adverse trigger events such as illness or divorce; they contend that many people who could file for bankruptcy do not file, indicating that stigma may be an important deterrent. In the view of many of these scholars, practices in the home mortgage and creditcard industry have increased the likelihood that households will overborrow (Mann 2005), and the 2005 bankruptcy reforms may have contributed to the increase in foreclosures on subprime mortgages (Morgan, Iverson, and Botsch, forthcoming). Living on the Edge of Bankruptcy michael s. barr and jane k. dokko 8 180 michael s. barr and jane k. dokko Data have been lacking to permit an extensive comparison of the financialservices behaviors, attitudes, and economic outcomes among low-, moderate-, and middle-income households who file for bankruptcy and those who do not. Our aim in this chapter is to fill this particular gap. The story that emerges from our data is essentially this: low- and moderate-income (LMI) households have insufficient income or assets to overcome the financial difficulties that come their way. Put another way, they have no slack. Many of them experience concurrent, serious adverse events and a range of financial hardships. Bankruptcy is but one of the outcomes associated with this persistent financial instability. There are meaningful differences between households who would benefit from filing and those who would not. These differences are muted, however, when one looks at who is actually filing, and many households who would benefit from filing for bankruptcy do not file. This result suggests that the decision to file may not be based solely on the strategic question of whether bankruptcy filing would be financially beneficial. Our research design and methodology do not allow us to untangle causation. Rather, our data confirm that the decision to file is a complex one for households, and one of myriad economic decisions made by households experiencing other financial difficulties. In sum, many of the households we study experience serious financial hardships and deploy a range of methods to cope with them, including filing for bankruptcy. Previous Research Over the past twenty years, bankruptcy filings have significantly increased, prompting researchers to seek the causes. Four causes of bankruptcy have emerged from this research: adverse trigger events, strategic timing, the decline of stigma, and market structure. While each of the theories has brought insight to the policy debate on bankruptcy reform, a number of questions concerning the appropriate empirical framework in which to ascertain the causes of bankruptcy filing remain. The adverse-events theory posits that the decision to file for bankruptcy is driven by financial shocks exogenous to the decision to file. In particular, job loss, severe reductions in income, divorce or widowhood, and high, uninsured medical costs from injury or serious illness instigate bankruptcy filings among households with low asset levels. Debt levels under this theory are not jointly determined with the bankruptcy-filing option; rather, debt levels reflect the difficulties households face in meeting the costs of housing, health care, and the like as they weather adverse shocks. The empirical approach to evaluating the adverse-events theory relies on a cross-sectional correlation between adverse events and bankruptcy filings (Sullivan, Warren, and Westbrook 1989, 2000, 2003; Domowitz and Sartain living on the edge of bankruptcy 181 1999). For households already living in a financially precarious position, job loss, divorce or widowhood, high medical costs, and negative...