Arm‐breaking, Consumer Credit and Personal Bankruptcy

Abstract

The consumer credit transaction is analyzed as a contract which provides insurance as well as present consumption for the borrower. Creditors' remedies such as “arm‐breaking” are shown to facilitate provision of insurance (forgiveness of debts) when lenders cannot monitor outcomes. Alternatively, if outcomes are observable but lenders do not ex ante know the risk associated with each borrower, the market may generate an excessive amount of arm‐breaking and agreements to forgo discharge following bankruptcy as low risk borrowers signal their characteristics, suggesting that government limitations on such provisions might be efficient. The secured credit transaction is shown to be a complex contract which attempts to provide efficient repayment, seller incentives for performance and mitigation following default, and insurance for the borrower. Garnishment and discharge of debts following bankruptcy are also considered.

Redistributive Taxation and Personal Bankruptcy in U.S. States

“…Bankruptcy provides a fresh start for agents who have been hit by a sufficiently bad shock (see, for example, Rhea 1984;Jackson 2001;Hynes 2002). Bankruptcy provides insurance at a cost, however, since households receiving bad shocks can default, while households without bad shocks repay at higher interest rates.…”

The Law and Economics of Consumer Finance

“…Alternatively, Creditor might seek to destroy Debtor's reputation by publicizing the default; to cause psychic harm by liquidating a guarantee from a loved one; or, in the case of loan sharks, to break bones. Even though these actions provide no direct benefits to Creditor while conferring costs on Debtor, they may be efficient because they reduce moral hazard (Rea, 1984).…”

“…In an extreme case, the only mechanism that the creditor may use to force repayment is to deny future credit (Allen, 1983). Collateral with personal value to the debtor and other forms of creditor remedies ensure that a defaulting debtor cannot in fact repay if the debtor would rather repay the loan than endure the "punishment" of repossession (Rea, 1984;Scott, 1989).…”

“…Thi s would be true regardl ess of whether the market is competiti ve or monopo li stic (Aghi on and Hermalin , 1990;Rea, 1984).6…”

“…As we saw above, however, even collection mechani sms that are inefficient at the time of collection may be efficient ex ante precisely because they are "coercive." They can, in theory, reduce moral hazard by increasing the cost to the debtor from defaulting (Rea, 1984) and adverse selection by enabling the creditor to di stinguish among debtors by ri sk level (Bester, 1985). (See generally Epstein , 1975;Scott, 1989.)…”