AN ANATOMY OF U.S. PERSONAL BANKRUPTCY UNDER CHAPTER 13

• Author: Wenli Li,Hülya Eraslan,Gizem Koşar,Pierre‐Daniel Sarte
• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/iere.12231
• Date: 01 August 2017

INTERNATIONAL

ECONOMIC

REVIEW

August 2017

Vol. 58, No. 3

AN ANATOMY OF U.S. PERSONAL BANKRUPTCY UNDER CHAPTER 13∗

BYH¨

ULYA ERASLAN,GIZEM KOS¸AR,WENLI LI,AND PIERRE-DANIEL SARTE1

Rice University, U.S.A.; Federal Reserve Bank of New York,U.S.A.; Federal Reserve Bank of

Philadelphia, U.S.A.; Federal Reserve Bank of Richmond, U.S.A.

We build a structural model that captures salient features of personal bankruptcy under Chapter 13. We

estimate our model using a novel data set that we construct from bankruptcies filed in Delaware between 2001

and 2002. Our estimation results highlight the importance of a debtor’s choice of repayment plan length on

other Chapter 13 outcomes. We use the estimated model to conduct policy experiments to evaluate the impact

of more stringent laws that impose restrictions on the length of repayment plans. We find that these provisions

would not materially affect creditor recovery rates and would not necessarily make discharge more likely.

In short, the bankruptcy system operates behind a veil of darkness created by the lack of reliable data

about its operations.The lack of information about “what is going on” in the bankruptcy system leads to

a distrust of its results—a belief by some that creditors, debtors,and professionals within the system are

all somehow taking advantage of one another and the public at large, and that the system suffers from

widespread fraud, abuse, and inefciency.

1997 National Bankruptcy Commission

1. INTRODUCTION

On April 20, 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act

(BAPCPA) was signed into law and ended a comprehensive legislative effort that began

under the Clinton administration. The new personal bankruptcy law imposed many new (and

controversial) changes, including higher filing fees, “means test” on debtors contemplating a

bankruptcy filing, and longer length payment plans. The aim was to ensure that debtors with

sufficient income would file under Chapter 13. The key presumption underlying this provision

was that a large number of households did not repay as much as their income allowed. In

∗Manuscript received January 2011; revised May 2016.

1We are grateful to Philip Bond, Bob Hunt, Steven Stern, Ken Wolpin, Holger Sieg, and two anonymous referees for

helpful comments and suggestions. We also thank seminar participants at the University of Pennsylvania, the Federal

Reserve Bank of Philadelphia, FDIC, 2007 Society of Economic Dynamics Summer Meetings, the Florida International

University, Southern Methodist University, University of Oxford, and University of Virginia. Ishani Tewari and Sarah

Carroll provided excellent research assistance. We acknowledge financial support from the FDIC Center for Financial

Research, Wharton Financial Institutions Center, and Rodney White Center for Financial Research. Finally, we are

indebted to Michael Joseph, the Chapter 13 Trustee for the District of Delaware, for numerous conversations and

e-mail exchanges that have enhanced our understanding of bankruptcy law and its practice. The views expressed here

are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York, Federal Reserve

Bank of Philadelphia, the Federal Reserve Bank of Richmond, or the Federal Reserve System.

Please address correspondence to: Wenli Li, Federal Reserve Bank of Philadelphia, 10 N. Independence Mall W.,

Philadelphia, PA 19106. E-mail: Wenli.Li@phil.frb.org.

671

C

(2017) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

672 ERASLANETAL.

particular, it was thought that Chapter 13 would perform better both as a collection device for

creditors and as a means to provide debtors with a financial fresh start, if stricter rules were

imposed on repayment plans.

The objective of our article is to take a first step at evaluating the impact of these stricter

rules. Specifically, we aim to assess the effect of section 1325, paragraph 4, which was added to

the U.S. Bankruptcy Code under BAPCPA and imposes additional restrictions on the length

of repayment plans for debtors with income above the state median. To do so, we build and

estimate a structural model of Chapter 13 bankruptcy using a novel data set we construct. For

a side contribution, we provide empirical evidence regarding the outcomes under Chapter 13

and its performance both as a collection device for creditors and as a means to provide debtors

with a financial fresh start.

Our model captures the salient features of personal bankruptcy under Chapter 13. In our

model, a debtor first makes decisions regarding whether or not to file under Chapter 13 and, if so,

what repayment plan to propose. Since the law requires that all of a debtor’s excess income be

applied to his repayment plan, the debtor’s choice of repayment plan boils down to its length.2In

choosing what plan to propose, the debtor recognizes that its duration has a bearing on the confir-

mation outcome that is determined by the recommendations of a bankruptcy trustee appointed

to oversee the bankruptcy process. Under the bankruptcy law, in deciding whether to confirm

a plan or not, the trustee must form an opinion as to the fairness and feasibility of the plan. The

fairness condition is satisfied as long as the debtor contributes all excess income into the plan pay-

ments. The feasibility condition requires that the debtor’s excess income is sufficient to pay the

unsecured creditors over a three- to five-year period an amount no less than they can recover un-

der liquidation of the debtor’s assets. To capture the idea that the trustee has some leeway in the

interpretation of the bankruptcy law, in our model, whether the trustee views a given plan as fair

and feasible or not is random from the perspective of the debtor. Specifically, whether the trustee

views a plan as fair and feasible depends on the debtor’s characteristics and the plan length.

Even if a plan is initially confirmed, it may nonetheless become unfair or infeasible due

to fluctuations in the debtor’s financial condition. We model this possibility by introducing

shocks to income or expenses of the debtor at a random date. Following the shocks, the trustee

reevaluates the feasibility of the plan under the new debtor characteristics. If the case is not

dismissed, the debtor decides whether to continue or voluntarily default on his plan.

Overall, our model highlights a basic trade-off debtors face in proposing long repayment

plans versus short ones. Long repayment plans are costly in that they impose restraints on

debtors for longer periods, but these plans may also be more likely to be confirmed by the

court and, ultimately, to result in a financial fresh start. In addition, our model highlights the

importance of shocks to excess income during the bankruptcy process. In particular, even

though a plan may be fair and feasible at the time a debtor files for Chapter 13 bankruptcy, it

may cease to be so later on before the repayment plan is complete.

We estimate our model using newly collected data contained in court files on all Chapter

13 personal bankruptcies recorded by the U.S. Bankruptcy Court for the District of Delaware

between August 2001 and August 2002. From the court documents, we extract information

concerning the filers’ financial and demographic information at the time of filing and the final

outcome of their cases. Specifically, we collect data on the outcomes predicted by our model:

the choice of plan length, whether the plan is confirmed or not, whether the case is successfully

completed or not, and the recovery rate of the creditors.3In addition to these endogenous

outcomes, in our model, the decision to file for Chapter 13 in the first place is also endogenous.

Although all the debtors in our sample have chosen to file for Chapter 13, we identify the

parameters associated with this decision through the variation in the decision to continue or

voluntarily default on the plan following the shocks to financial conditions.

2Excess income is income minus necessary expenses including housing payments either in the form of rent or in the

form of mortgages. Note that the mortgage debt that is not yet due is paid outside the Chapter 13 repayment plan.

3Throughout the article, by recovery rate of the creditors, we mean their recovery within Chapter 13. It is possible

that the creditors collect payments outside Chapter 13 as well. We return to this possibility in Section 7.3.

AN ANATOMY OF U.S.PERSONAL BANKRUPTCY UNDER CHAPTER 13 673

We estimate our model using the maximum likelihood approach. Our estimates confirm

that the debtor’s choice of plan length indeed affects the trustee’s opinions on the fairness and

feasibility of the plan. In particular, after controlling for exogenous debtor characteristics, we

find that longer plans are more likely to be confirmed in the first place and less likely to be

dismissed after the original plan becomes infeasible. However, whether a debtor’s income is

above the state median level does not play a significant role in the confirmation of the plan.4As

such, the means test established under BAPCPA appears inconsequential. In addition, we find

that the timing of the changes in debtors’ conditions during bankruptcy plays a significant role

in governing Chapter 13 outcomes, including the ability of debtors to obtain a financial fresh

start. In particular, when negative shocks to income are experienced early in the program, the

probability of dismissal rises significantly.

We next conduct policy experiments to assess the effect of section 1325, paragraph 4, which

was added to the U.S. Bankruptcy Code under BAPCPA. This policy imposes additional

restrictions on the length of payment plans for debtors with income above the state median.

Our results predict that this new policy would not materially affect creditor recovery rates

and would not necessarily make discharge more likely for debtors with income above the

state median. This finding is robust to alternative policy experiments that require bankruptcy

plans to meet stricter standards in other ways, such as proposing a higher recovery rate. In

fact, in these alternative experiments, some Chapter 13 filers no longer choose to file, with the

result that recovery rates and discharge rates even decline. It appears therefore that a stricter

bankruptcy code can make it more difficult for debtors to obtain a fresh start but without

necessarily helping to raise creditor recovery rates.

It is well understood that personal bankruptcy laws affect credit markets and therefore the

supply and demand for credit (Gropp et al., 1997; Lin and White, 2001), the ability of households

to insure against labor income risk (Athreya et al., 2012), their consumption behavior (Grant,

2004; Filer and Fisher, 2005), labor supply (Han and Li, 2007), mobility (Elul and Subramanian,

2002), and entrepreneurial activity (Meh and Terajima, 2008; Mankart and Rodano, 2015).

Given that the effect of the personal bankruptcy laws on these economic outcomes is through

the decision to file for bankruptcy in the first place, it is important to understand the determi-

nants of households’ bankruptcy and default decisions. In early work, Domowitz and Sartain

(1999) use a nested logit model to estimate consumers’ decisions to file for bankruptcy and

their choice of bankruptcy chapter but they take a reduced-form approach for values of each

of these decisions. Gross and Souleles (2002) estimate a dynamic probit model of default using

individuals’ credit card account data and conclude that the increase in the bankruptcy filing

rates between 1995 and 1997 cannot be explained by risk factors and economic conditions alone.

In their analysis, they do not distinguish between different default options. Using data from the

Panel Study of Income Dynamics Fay et al. (2002) test whether households are more likely to

file for bankruptcy if the financial benefits from filing for bankruptcy are higher. They compute

the financial benefits from filing for bankruptcy using the Chapter 7 bankruptcy alternative

alone. Our article contributes to the literature on household bankruptcy default decisions5and

complements these papers by endogenizing the value of the Chapter 13 bankruptcy alternative

using a structural model that explicitly takes into account the choices made by the debtors

within Chapter 13 and the uncertainties they face.6Moreover, by considering the particular

channels through which observable and unobservable debtor characteristics affect bankruptcy

outcomes, we are able to provide an assessment on how changes in bankruptcy law might alter

the outcomes in Chapter 13 and therefore the value of filing for Chapter 13.

4Whether income is above the state median appears immaterial for the confirmation of the plan; however, income

plays an important role through the determination of excess income and therefore the required plan payments.

5There are also related studies looking at bankruptcy filings at the state level. See, for example, Dick and Lehnert

(2010), Cornwell and Xu (2014), and Gross et al. (2014).

6See Eckstein and Wolpin (1989), Rust (1996), Aguirregabiria and Mira (2010), and Keane et al. (2011) for surveys

of structural dynamic choice models.