High risk unsecured personal loan

Personal bankruptcy allows households to stop or delay the repayment of debts. In so doing, bankruptcy provides a form of insurance to households. In particular, bankruptcy allows households some flexibility in timing repayments in a way that allows for sudden unforeseen contingencies. As an implicit form of insurance, bankruptcy may augment, substitute for, or even limit other forms of insurance. Conversely, the presence of other forms of insurance against life's vicissitudes may enhance or limit the usefulness of bankruptcy. In this article, I investigate the interaction between one of the largest social insurance schemes, the U.S. unemployment insurance system (UI), and the personal bankruptcy system.

An overwhelmingly large proportion of those filing for bankruptcy (over two-thirds) have recently experienced a job disruption (Sullivan et al. [2000] and Domowitz and Sartain [1999]). Further, Cochrane (1991) finds that prolonged spells of unemployment are poorly insured and therefore result in large drops in consumption levels. How does the level of unemployment insurance available to workers affect the benefits of bankruptcy protection? Conversely, how do the benefits of bankruptcy alter the benefits generated by UI? Lastly, how does the presence of bankruptcy alter the consequences of scaling back unemployment insurance?

My findings are as follows: First, in the benchmark economy, introducing bankruptcy under even low UI replacement ratios lowers welfare. Second, reducing the UI replacement ratio increases bankruptcy rates. (1) Additionally, reducing the UI replacement ratio worsens consumption smoothing less when bankruptcy is allowed than when it is not. However, while welfare falls slightly with the replacement ratio, the fall is nearly independent of bankruptcy law. Third, bankruptcy lowers asset trade, which in turn implies a more equal long-run distribution of wealth (as fewer households hold either very low or very high asset levels to deal with income shocks). However, asset trading behavior is not affected greatly by changes in the UI replacement ratio. Fourth, UI is more important than bankruptcy: if society must choose either UI or bankruptcy, it should choose UI. Last, bankruptcy's role in providing insurance is clearly dependent on the existing social safety net. In summary, unemployment insurance appears to mate rially affect the desirability of bankruptcy protection, but allowing bankruptcy does not, in the benchmark economy, alter the consequences of scaling back UI.

The environment here is an extension of the environment studied in Athreya (2002b), augmented to include unemployment. Athreya (2002b) examines the welfare implications of recent "means-testing" proposals. The present work is perhaps closest to the work of Livshits et al. (2002) and Fisher (2002). The work of Fisher (2002) is the first empirical study of the effects of public insurance on the personal bankruptcy decision. With respect to bankruptcy, this work is also related to recent research of Chatterjee et al. (2001) and Li and Sarte (2002). With respect to positive analyses of unemployment insurance and its consequences, the work is related to, but simpler than, the models of Hansen and Imrohoroglu (1992) and Alvarez and Veracierto (2001). The two preceding articles study unemployment insurance in general and the effect of severance payments on job security, respectively.

The sudden fall in earnings associated with a layoff or firing or an inability to continue working due to illness has long been cited by bankruptcy scholars as an important correlate of bankruptcy. (2) Thus, it stands to reason that the treatment received by those who become separated from their employers will influence their decision whether or not to file for bankruptcy. I turn now to a simple dynamic general equilibrium model of consumption and savings in the presence of some uninsurable income risks, including the risk of losing one s job. To simplify matters, I abstract from production decisions as well as the impact of moral hazard in increasing the costs of administering an unemployment insurance system. In ongoing research (Athreya [2002a]), I pursue a more complete analysis to incorporate moral hazard and production.

1. THE MODEL

Bankruptcy allows a borrower to essentially design a state-contingent repayment plan, whereby repayment is made only when outcomes for the borrower are relatively good. In this sense, the amount of a household's income dedicated to loan repayment can be varied, allowing it to apply limited income in a difficult period towards consumption rather than debt service. Unemployment insurance and antipoverty programs, conversely, act directly on the income of the household and help it remain above a threshold. Both of these programs can help households insure themselves within a period against uncertain job or health prospects. However, both programs must be paid for.

Allowing bankruptcy implies paying more for loans, as households are also purchasing the right to suspend or completely avoid repayment, subject to penalties. The high rate on loans also means that as households attempt to avoid borrowing, each saves so much that the return to savings may fall relative to an economy without bankruptcy. In turn, this fall mutes the effectiveness of savings to carry consumption across periods. Unemployment insurance, for its part, must be paid for via (possibly distortionary) taxes. Furthermore, as is well known, UI may introduce inefficiency, as both the effort expended by currently employed households and the job search efforts of currently unemployed households may fall. Moreover, a major penalty for filing for bankruptcy is exclusion from credit markets. In contrast, while UI may directly lower the need for borrowing and subsequent bankruptcy, generous UI makes exclusion from credit markets less painful. Thus, while bankruptcy and UI act in different ways, the presence of e ach is likely to affect the other.

Preferences and Endowments

Individuals maximize the present value of expected lifetime utility, given by

[E.sub.0] [summation over ([infinity]/t=0)] [[beta].sup.t] [C.sup.1-[alpha].sub.t] - 1/1 - [alpha], (1)

where [E.sub.0] is the expectations operator, conditional on time 0 information, [beta] [member of] (0, 1) is the discount factor, c is consumption, and [alpha] is the measure of both risk aversion and the desire for intertemporal consumption smoothing. A full description of the household's optimization problem will be given after more notation is introduced.

Consumers in this market, intended to represent U.S. households, are assumed to be risk-averse price takers. They face uncertain labor incomes and other uninsurable idiosyncratic risks. The economy is composed of many long-lived households. At the beginning of each period, all households receive a random level of labor income that depends on their employment status. Households in the economy retain employment in each period with probability [rho] and are subject to the risk of losing employment in a given period with probability (1 - [rho]). Once employment is lost, regaining employment occurs with probability [xi]. An unemployed worker receives unemployment insurance in only the first period of unemployment, that is, when the worker is newly unemployed. In subsequent periods, there is a subsistence level of income given to households. The endowment structure for unemployed households is meant to reflect the current practice of the use of a flat "replacement ratio" and the limited length of UI benefits in the United States. Newly unemployed households receive [theta]Y, where Y is mean labor income and [theta] [Cents] [[theta], 1] the replacement ratio. After the first period of unemployment, households, if unemployed, will receive the subsistence transfer of [Y.sub.min] > 0. (3)

Given the exogenously imposed flow of households out of unemployment, the replacement ratio for UI benefits [theta], and the long-run average employment rate [[micro].sub.e], it is easily shown that the per-period lump-sum tax [[eta].sub.u] necessary to finance the UL system is given by (1 - [rho])[[micro].sub.g][theta]Y. (4)

The endowments of employed households are random and cross-sectionally independent but are serially dependent. Agents are identical ex ante in terms of expected income, assets, and consumption. When employed, the after-tax endowment of a household in period t can take two values, Y = [[gamma].sub.1] and Y = [[gamma].sub.h], where the subscripts h and 1 denote high and low labor income, respectively, such that [[gamma].sub.1] < [Y.sub.h]. (5) Defining unemployment as a separate state for the endowment process is what allows for an analysis of how UI benefits interact with bankruptcy law.