Bankruptcy Decisions Research Articles

The Impact of Personal Bankruptcy on Labor Supply Decisions

The Chapter 7 bankruptcy code was motivated by the notion of a start, which was justified in part by the Supreme Court on the grounds that it would encourage work incentives. We ask the question, how does a fresh start affect labor supply? This question is explored in the context of a model with job search and bankruptcy choices. The model takes into account both the endogeneity and interdependence of decisions in labor and credit markets. The structural approach allows direct assessment of individuals' labor supply responses given their bankruptcy decisions. We find that Chapter 7 filers on average increase labor supply by 12.3%.

When Faith Falls Short: Bankruptcy Decisions of Churches

What does a church do when it is about to go bust? Religious organizations, like any business, can experience financial distress. Leaders could try to solve their churches’ financial problems on their own. Perhaps leaders do not view the problems as addressable with law. Or perhaps they do not think, as a moral or spiritual matter, that they should resort to the legal system, such as bankruptcy, to deal with their churches’ inability to pay its debts. Yet about ninety religious organizations seek to reorganize under the Bankruptcy Code every year. This Article relies on interviews with forty-five of these organizations’ leaders and attorneys to examine how the leaders conceptualized their churches’ financial distress as legal problems and decided to address those legal problems with bankruptcy. Through these inquiries, the Article sheds light on longstanding questions about how people and organizations decide to use the legal system versus doing nothing or solving problems through self-help. The Article thus provides one of the first assessments of how small organizations view their problems as legal problems, and the first assessment of how leaders of small organizations decide to file for bankruptcy.Church leaders’ journeys began with struggling to solve their congregations’ financial problems themselves and proclaiming that “bankruptcy from a spiritual standpoint is a no-no.” Most often, creditors’ foreclosure threats brought law to leaders’ attention. Leaders then turned to social networks for help understanding their legal options. Drawing from these results, the Article also scrutinizes how leaders’ reliance on social networks and feelings of stigma and shame because of their decisions to file influence debates about restricting access to bankruptcy.

Zombie Mortgages, Real Estate, and the Fallout for the Survivors

Part I of this Article briefly explains the context and scope of the problem of zombie mortgages – mortgages that are in default but for which the lender refuses or fails to foreclose. Zombie mortgages saddle the record owner with ongoing tax and maintenance obligations which they may not be able to escape. Zombie properties are problematic for the affected homeowners, but in many cases they are equally problematic for other individuals residing in the same neighborhood, the lenders and servicers, and the relevant municipalities who will have to face issues of negligence, blight and vandalism related to vacant properties. Part I analyzes current municipal approaches to dealing with the problem, primarily through vacant property registration ordinances (VPROs). Part II examines cases from both municipal-driven litigation as well as consumer-driven litigation where zombie debt has been legally extinguished. Part II also examines several bankruptcy decisions that potentially lead to an avenue of relief for the owners of the affected properties. Part III proposes two new unique ordinances that cities could use to combat the problem, highlights owner-based solutions in bankruptcy, and mentions other attempts that have been tried in erasing zombie mortgages. This article concludes that a compromise solution that involves the municipalities, lenders and owners is the best route to ease the nationwide problems associated with zombie mortgages.

Coping with Adversity: Personal Bankruptcy Decisions of Lower-Income Homeowners Before and After Bankruptcy Reform

We examine whether adverse life events influence the personal bankruptcy decisions of lower-income homeowners. Econometric studies suggest that personal bankruptcy is explained by financial gain rather than adverse events, but data constraints have hindered tests of the adverse events hypothesis. Using household level panel data and controlling for the financial benefit of filing, we find that stressors related to cash flow, unexpected expenses, unemployment, health insurance coverage, medical bills, and mortgage delinquencies predict bankruptcy filings a year later. At the federal level, the 2005 Bankruptcy Reform explains a decrease in filings over time in counties that experienced lower filing rates.

Health insurance and the consumer bankruptcy decision: Evidence from expansions of Medicaid

Anecdotal evidence and several observational studies suggest that out-of-pocket medical costs are pivotal in a large fraction of consumer bankruptcy decisions. In this paper, we assess the contribution of medical costs to household bankruptcy risk by exploiting plausibly exogenous variation in publicly provided health insurance. Using cross-state variation in Medicaid expansions from 1992 to 2004, we find that a 10 percentage point increase in Medicaid eligibility reduces personal bankruptcies by 8%, with no evidence that business bankruptcies are similarly affected. We interpret our findings with a model in which health insurance imperfectly substitutes for other forms of financial protection, and we use the model to present simple calibration results which illustrate how our reduced-form parameter estimate affects the optimal level of health insurance benefits. We conclude with calculations which suggest that out-of-pocket medical costs are pivotal in roughly 26% of personal bankruptcies among low-income households.

Macroeconomic Effects of Bankruptcy & Foreclosure Policies

I develop an equilibrium model of housing and default to jointly analyze the effects of bankruptcy and foreclosure policies. Heterogeneous households have access to mortgages and unsecured credit and can default separately on both types of debt. I show that the interaction between foreclosure and bankruptcy decisions is crucial for explaining the observed cross-state correlation between default policies and default rates. I use the model to argue that a major recent reform to bankruptcy reduced bankruptcy rates but increased foreclosure rates, and that the Home Affordable Refinance Program reduced foreclosures during the Great Recession.

Who Pulls the Plug? Theory and Evidence on Corporate Bankruptcy Decisions

We offer a model and evidence on firms' optimal bankruptcy decisions. In the model, both the borrower and bank lenders can trigger a bankruptcy filing. We show that debt composition has significant influence on corporate bankruptcy decisions. For example, firms with a small share of bank debt as a fraction of total debt tend to voluntarily file for bankruptcy. When a firm depends heavily on bank debt, the bankruptcy boundary is more likely to be determined by the bank. Our results highlight the control rights of large private creditors in distressed firms.

Recovery Rates and Macroeconomic Conditions: The Role of Loan Covenants

For U.S. firms from 1988 to 2007, firms with stricter loan covenants had higher firm-level default recovery rates. Covenants were stricter, moreover, when set during downturns in the business cycle. This implies a negative dependence of recovery rates on lagged macroeconomic conditions. That is, bank loan contracts established in economic recessions have tight covenants, leading later to higher recovery rates. My empirical evidence suggests that private creditors have significant influence on firms' bankruptcy decisions through the channel of covenants in debt contracts.

Who Pulls the Plug? Theory and Evidence on Corporate Bankruptcy Decisions

We offer a model and evidence on firms' optimal bankruptcy decisions. In the model, both the borrower and bank lenders can trigger a bankruptcy filing. We show that debt composition has significant influence on corporate bankruptcy decisions. For example, firms with a small share of bank debt as a fraction of total debt tend to voluntarily file for bankruptcy. When a firm depends heavily on bank debt, the bankruptcy boundary is more likely to be determined by the bank. Our results highlight the control rights of large private creditors in distressed firms.

Irreversible Investment, Financing, and Bankruptcy Decisions in an Oligopoly

AbstractThis paper examines a firm's debt level, investment timing, and investment scale choices in a continuous-time model where the output price of a good that the firm produces depends on a stochastic demand-shift variable and the total industry supply of the good. Using the simple symmetric Cournot-Nash equilibrium assumption that all firms are identical and therefore follow the same financing and investment strategies, we show that competition decreases the output price and hence encourages a firm to wait for a higher demand level before it is profitable to invest. We also demonstrate how uncertainty, bankruptcy costs, and corporate taxation affect the firm's financing and investment decisions.

The Reach of Corporate Governance Beyond the Grave: Impact on Bankruptcy Decisions and Recoveries on Defaulted Debt

The Reach of Corporate Governance Beyond the Grave: Impact on Bankruptcy Decisions and Recoveries on Defaulted Debt

Decision-making, risk and corporate governance: New dynamic models/algorithms and optimization for bankruptcy decisions

Bankruptcy and recovery prediction models are often used in auditing, large corporate transactions (M&A, strategic alliances, etc.), investment decision-making, and in the judicial setting where judges are the final arbiters in the bankruptcy process. However, all existing bankruptcy and recovery models are deficient primarily because: • The research methods were flawed. • The authors merely imposed rigid mathematical models on the bankruptcy framework. • The models do not follow an inter-disciplinary approach and do not consider many of the legal, behavioral/psychological and economic issues in financial distress. • The models do not allow for optimization and simulation in order to derive the best conditions for minimizing financial distress – such optimization-based financial distress models can be particularly useful in negotiating debt restructurings, and in bankruptcy courts where judges have to decide the timing and structure of the bankruptcy process and the final result. This article introduces various dynamic models for bankruptcy and recovery decision-making, and develops a framework and foundation for further research in the use of dynamical systems and artificial intelligence in modeling bankruptcy decision-making and legal reasoning. The paper also illustrates the need for more collaboration among researchers in law, business and computer science.

Impact of State Exemption Laws on Small Business Bankruptcy Decision

1. IntroductionSmall businesses are a primary source of employment in the U.S. economy, employing over half of the private sector workforce. Small businesses are responsible for about two-thirds of all net new jobs created. According to the 2002 Small Business Economic Indicators (SBEI),1 over 99.7% of the 5.7 million firms in the United States are classified as small- to medium-sized businesses. Hence, small businesses are a substantial contributor to economic growth in the United States.Small business owners enjoy more flexibility and freedom to capitalize on profitable opportunities than their larger business competitors. Hence, they challenge the larger firms to be more efficient, which is ultimately beneficial to consumers. Unfortunately, small- and medium-sized businesses have a very low survival rate (SBEI 2002). In 2002 (on the heels of the 2001 recession), there were 550,100 small business births and 584,500 small business terminations. Both academics and public policy analysts have become increasingly concerned about the success of small businesses.Recently there has been a surge in small business research, particularly surrounding small business credit supply and demand. Not surprisingly, much of the literature has been focused on changes in lending technologies (relationship2 versus scored3), information processing technologies (soft versus hard),4 loan size considerations,5 and loan type considerations6 as they relate to small business supply and demand. However, very few have actually examined why small- and medium-sized businesses have very low survival rates. Some studies have analyzed the sensitivities of Small Business Administration (SBA) guaranteed loans to macroeconomic changes industry risks, maturity structures (3, 7, and 15 year maturities), as well as lender and debt characteristics (e.g., Glennon and Nigro 2001, 2002; Dunsky and Pennington-Cross 2003). Meanwhile, Agarwal, Chomsisengphet, and Liu (2003) empirically assessed the significant importance of owner and firm characteristics in determining the risk of small business default while controlling for the macroeconomic and industry risks.With bankruptcy filings continuing to rise significantly in recent years, many policy makers are turning their attention to bankruptcy laws. Specifically, Congress is considering reforming personal bankruptcy laws that, if passed, will significantly impact the demand for and supply of both consumer credit and small business funding. White (2001) concludes that this bankruptcy reform could potentially reduce small business ownership but increase the supply of small business credit and, in turn, affect the growth of the U.S. economy.Small business owners have an incentive to file for personal bankruptcy when their indebtedness exceeds the value of their assets because both their personal and business debts can be discharged.7 Though the bankruptcy exemption law is primarily designed for consumers, the personal bankruptcy exemption law is a de facto bankruptcy procedure for small business owners because the debt of a noncorporate firm is the personal liability of the entrepreneur/owner (Fan and White 2003). Hence, investigating the potential impact of the exemption law on small business bankruptcy decisions may provide some insight into how the bankruptcy laws should be reformed.Further, Fan and White (2003) argue that while the expected return to creditors should be lower in states with higher exemption level upon small business shutdown, it is not entirely clear whether lenders will actually shut down a financially troubled small business. While they empirically find that small businesses in high-exemption states are more likely to be shut down, this positive relationship is statistically insignificant. The authors conclude that additional research will be needed to determine if a significant relationship exists (p. …

Interest Rates, Taxes, Bankruptcy and Financing Decisions

While most efforts in corporate finance focus on how firm characteristics influence financing decisions, recent studies indicate that interest rates can influence tax shields and bankruptcy costs, affecting the optimal capital structure. Using a yield curve factor model, I examine how interest rates affect the debt-equity choice. While the T-bill yield affects the likelihood of debt financing positively, the T-bond yield and the yield curve volatility affect the likelihood of debt financing negatively. These effects are partially due to the changes of tax shields and bankruptcy costs caused by the interest rate movements.

The Household Bankruptcy Decision

Personal bankruptcy filings have risen from 0.3 percent of households per year in 1984 to around 1.35 percent in 1998 and 1999, transforming bankruptcy from a rare occurrence to a routine event. Lenders lost about $39 billion in 1998 due to personal bankruptcy filings. But economists have little understanding of why households file for bankruptcy or why filings have increased so rapidly. Until very recently, studying the household bankruptcy decision was very difficult, because no household-level data set existed that included information on bankruptcy filings. In this paper, we use new data from the Panel Study of Income Dynamics, which includes information on bankruptcy filings, to estimate a model of households’ bankruptcy decisions. We find support for the strategic model of bankruptcy, which predicts that households are more likely to file when their financial benefit from filing is higher. Our model predicts that an increase of $1,000 in households’ financial benefit from bankruptcy would result in a 7-percent increase in the number of bankruptcy filings. Our model also predicts that if the 1997 National Bankruptcy Review Commission’s proposed changes in bankruptcy exemption levels were implemented, there would be a 16-percent increase in the number of bankruptcy filings each year. But if the $100,000 cap on homestead exemptions recently passed by the U.S. Senate were adopted, our model predicts that there would be only a negligible effect on the number of filings. We find little support for the nonstrategic model of bankruptcy which predicts that households file when adverse events occur which reduce their ability to repay. Finally, controlling for state and time fixed effects, our model shows that households are more likely to file for bankruptcy if they live in districts with higher aggregate filing rates.

Entry, financing, and bankruptcy decisions: The limited liability effect

A firm, which has a privileged right to undertake an irreversible investment project, simultaneously determines whether to exercise this project and also how many bonds to issue in the presence of demand uncertainty. The firm will not exercise the project until its net value from investing immediately equals its option value from delaying investment. The firm’s choice of debt levels balances the tax advantage of debt against a cost associated with the event of bankruptcy. The effects of uncertainty, asset specificity, and the costs to purchase capital later on a firm’s entry, financing, and bankruptcy decisions are examined and compared with those in the literature.

CONSUMER BANKRUPTCY AND CHAPTER CHOICE: STATE PANEL EVIDENCE

Between 1985 and 1996, the number of personal bankruptcy cases filed annually in the United States rose from 341,000 to 1.1 million, and the rate of bankruptcies per 100,000 adults increased from 203 to 596. By state, bankruptcy rates vary from a low of 147 in Hawaii to a high of 956 in Tennessee. A controversial aspect of bankruptcy policy is the discharge of debts permitted under Chapter 7, in contrast to Chapter 13, where the debtor agrees to repay all or a portion of unsecured debt over a 3‐5‐year period. This paper examines empirically the determinants of the frequency with which individuals choose Chapter 13 relative to Chapter 7 (chapter choice). The panel data set is a cross section of states and the District of Columbia for the 8‐year period from fiscal year 1989 to 1996. The empirical model and policy application focus on the importance of several laws for bankruptcy decisions, and legal variables are included for each state's Chapter 7 homestead exemption, personal property exemptions, and garnishment laws. This study shows that both homestead exemption laws and garnishment laws are statistically significant for bankruptcy choices. Although the marginal effect of the homestead exemption is small, there is a large range under current laws, suggesting that changes in this exemption are important for bankruptcy policy. (JEL K1, K4, D2, D9)

Section 365, mandatory bankruptcy rules and inefficient continuance

Section 365 of the Bankruptcy Code prohibits enforcement of the once common “ipso facto clause.” The clause excuses the solvent party from performance of the contract when the other party becomes insolvent. We show that the ability of insolvent firms to continue bad projects is enhanced by the absence of ipso facto clauses. Without such a clause, the firm can exploit the inability of courts always to assess expectation damages accurately to compel a solvent party to stay in a bad deal. An ipso facto clause would preclude this outcome because the clause permits the solvent party to exit costlessly. Further, an ipso facto clause improves the managers’ incentive to exert effort to avoid financial distress. These results have two broader implications. First, that the important mandatory rule regulating the ability of solvent parties to exit is inefficient suggests that the justifications for the Bankruptcy Code’s other mandatory rules should be rethought. Second, our analysis suggests that stakeholders such as contract partners of bankrupt firms may have important roles to play in inducing efficient bankruptcy decisions through their abilities to stop unproductive projects that bankrupt firms may otherwise continue.

A Review of 1997 Seventh Circuit Bankruptcy Decisions

A Review of 1997 Seventh Circuit Bankruptcy Decisions

Corporate Compliance with Debt Covenants

In this paper, I present and test a model of corporate compliance with the debt covenant requiring payment of a current obligation. This study adds to the empirical literature on forecasting financial distress by showing conditions under which debt default may be a rational economic decision by the firm's shareholders. This analysis departs from empirical financial distress studies which are often not linked to an underlying economic theory. The focus on covenant default also extends the literature which has modeled bankruptcy (Bulow and Shoven [1978]) and liquidation decisions (Titman [1984]) but which has not considered a common first symptom of financial distress-covenant default. Briefly, the model examines the costs that influence shareholders' decision to comply with or violate a particular debt covenant: payment of a current obligation. These costs include those associated with bondholders' reaction to possible default. The model predicts that shareholders will default when, holding other factors constant, (i) interest rates have declined relative to coupon rates stated in the debt issue; (ii) the probability of paying future obligations is high; and (iii) the cost of obtaining funds to pay the obligation is high. The model also predicts when stockholders and bondholders will renegotiate the debt contract and the amount of wealth transferred in the renegotiation. Finally, the