The University Record, November 23, 1998

More American households would be better off financially if they filed for bankruptcy, U-M researcher says

By Bernie DeGroat
News and Information Services

While only about 1 percent of U.S. households file for bankruptcy each year, many more Americans would be better off if they, too, declared themselves unable to pay their debts, says a U-M economist.

“At least 17 percent of households nationally would benefit financially from filing for bankruptcy and the actual figure could be several times higher if most households plan in advance for the possibility of filing,” says Michelle J. White, professor of economics.

In recent articles published in the University of Chicago Law Review and the Journal of Law, Economics & Organization, White examines the assets and debts of about 3,900 households nationwide to determine how many would benefit from declaring bankruptcy.

Households are assumed to benefit financially from filing if doing so increases their net worth (the total value of assets minus debts), she says. Filing for bankruptcy reduces household debt (because some of it is discharged), but it may also reduce household assets if the household has assets that are not protected from creditors under federal and state bankruptcy exemptions. Net worth increases if the reduction in debt is greater than the value of assets that must be given up in bankruptcy.

According to the study, the percentage of households that would benefit from filing for bankruptcy—without planning for bankruptcy beforehand—ranges from 10 percent in Louisiana to 32 percent in Texas. The overall national figure is 17 percent.

“These calculations assume that households who file for bankruptcy do not engage in any strategic behavior,” White says. “However, debtors often get advice from lawyers and others before filing and, in the process, they may learn strategies to increase their financial benefit from bankruptcy.”

Such strategies, she says, include:

1) Selling some or all non-exempt assets and using proceeds to reduce the mortgage on the household’s principal residence, if the household’s home equity is less than the state’s home equity (“homestead”) exemption.

2) Selling the household’s principal residence and buying a more valuable home in the same state or making improvements to the existing home before filing, if non-exempt property and home equity are less than the homestead exemption even after the household pays off its mortgage completely.

3) Borrowing more on credit cards before filing and using the proceeds to buy services or exempt assets, or to reduce debt that is not dismissed in bankruptcy.

White says that if households follow all three strategies before filing for bankruptcy, about 48 percent of Florida households and more than 60 percent of Texas households would benefit financially from declaring bankruptcy.

“These figures are particularly high because Florida and Texas both have unlimited homestead exemptions,” she says.

In states with lower home equity exemptions, about one-third of households in California would benefit financially from bankruptcy if they followed the three strategies, compared with 23 percent of households in New York, 21 percent in Illinois and 19 percent in Ohio, she adds. The average for all states is 34 percent.

White says that many households that would benefit from bankruptcy do not file because creditors often do not attempt to collect on debts that are in default, so that debtors can obtain the benefits of bankruptcy without bearing the costs and the stigma of filing. Other debtors may not file because they do not realize that they could gain financially from doing so.

Still other debtors, she says, may benefit even more from delaying the decision to declare bankruptcy until the future, especially those who have some non-exempt assets that would otherwise go to creditors.

“Like shareholders in a failing corporation, these debtors can benefit by using the assets for risky investments or even for gambling,” White says. “If managers of a failing firm gamble with the firm’s assets and the gamble succeeds, then equity-holders benefit because the firm avoids bankruptcy, while if it fails, then creditors bear the loss.

“Individual debtors similarly keep more of the upside gain than they bear of the downside loss, although the existence of the personal bankruptcy exemption means that they bear some of the loss themselves when the bad outcome occurs. The value of delay, then, rises as the uncertainty in the return on debtors’ assets increases.”

White says that as more and more households learn the financial benefits of bankruptcy, the number of bankruptcy filings is likely to continue to increase at a rapid rate.

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