Friday, January 4, 2013

Why so many debt defaults?

In the United States, declaring personal bankruptcy is an appealing way to get out of a bad debt situation and start with a clean slate because previous debts are set to zero. One would thus expect to see bankruptcy seen rather frequently used when people are unemployed. Yet, it appears that defaulting on debts is much more frequent and is used as an informal way to get unemployment insurance.

Kyle Herkenhoff established this and finds also that the many reason for default is not negative equity, but job loss and facing a borrowing constraint while debt payments constitute a large fraction of income. But when a person is cornered in this way, why not declare bankruptcy? Herkenhoff shows with a labor search model with individually priced debt that using default as unemployment insurance is worth more than the subsequent higher cost of credit. Mortgage relief measures are thus welfare enhancing, even though they lead to higher and more persistent unemployment.

PS: The paper title page says "Preliminary, do not cite." Then why put it in a widely distributed working paper series? Leave it hidden on your web page.

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