This crisis, however, has yet to roll over into a second wave of consumer bankruptcy filings, with fewer than 40,000 reported in April – a ten-year low for the month.
While businesses and individuals can declare bankruptcy, individuals make up the vast majority of filings. Due to the high correlation between unemployment and consumer bankruptcy, a surge of filings can be expected in the coming weeks.
This will likely result in the contraction of the credit industry, with the most in-need borrowers potentially finding it more difficult to access credit. The magnitude of this bankruptcy wave, however, will be determined by three factors: the amount US households owe divided by the amount they earn, the impact of Congress’ attempts to rescue the economy, and what creditors do from here.
Two indicators of bankruptcy
Studies reveal Americans typically file for bankruptcy after costly economic events, like job loss, divorce, illness, or injury. Depending on the study, between 33% and 66% of bankruptcy filers cite job loss as the cause.
Per data from the Bureau of Labor Statistics and American Bankruptcy Institute, there is a near-perfect correlation between the quarterly individual bankruptcy and unemployment rates since 2006. Considering the current drastic unemployment spike, a bankruptcy surge is almost certain to follow.
A high aggregate household debt-to-income ratio can also indicate future bankruptcy filings. Household debt can include mortgages, credit cards, and auto and student loans. In 2007, just before the Great Recession, the aggregate household debt-to-income ratio peaked at 1.24, meaning on average, households had nearly 25%more debt than income. Today, that number is a much healthier 0.95, which should ease the severity of the bankruptcy crisis.
Creditors’ critical role
Another risk that could make the bankruptcy wave worse is if creditors use the same playbook from the financial crisis to deal with struggling borrowers.
If creditors respond to the disruption by simply raising interest rates and restricting risky debt, making it more difficult for low-income individuals to qualify for credit cards and loans it would prevent the borrowers who need credit most from receiving it.
During the Great Recession, many lenders turned off access to credit like mortgages for riskier borrowers. If these lenders use the same restrictive measures during the pandemic, it would only serve to boost consumer bankruptcies by leaving less-qualified borrowers with no other options.
Creditors can, however, employ a different approach and take steps to ease the pressure on consumers. For instance, some credit card lenders have waived fees, increased credit limits, and allowed borrowers to skip a monthly payment without accruing additional interest, waive fees, and increase credit limits. As the crisis drags on, however, creditors might need to take stronger measures to lower the risk of large debt write-offs due to skyrocketing bankruptcies.
Federal Action and the CARES Act
Another powerful means of heading off the bankruptcy wave is increased support from the federal government.
Congress has already passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act,a $2.2 trillion stimulus bill, which included measures to reduce financial stress on individuals. The legislation temporarily increases weekly unemployment benefits and opens them up to people who wouldn’t usually qualify. It also suspends principal and interest payments on federally-insured student loans and enables homeowners to apply to delay their scheduled payments. Moresuch legislative actionis expected in the coming weeks and months.
While the situation is dire, and the extent to which these measures will limit bankruptcy filings is still unknown, they will reduce the burden of job and income loss, the leading cause of bankruptcy.
The coronavirus pandemic has sown economic havoc in nearly every US industry. On the positive side, the economy, in terms of the household debt-to-income ratio, is better-positioned than it was during previous recessions, and the CARES Act contains measures to lessen the burden on consumers.
Further action from creditors can help, too, such as restructuring or forgiving some portion of consumer debt and waiving interest payments. Additionally, since the CARES Act temporarily eliminates payments on federally insured student loans, creditors could extend this to private loans to help contain the bankruptcy situation.
While job losses during this crisis were created by necessary social distancing measures – not market failure, as with during previous recessions – the bankruptcy rate will soon reflect the unemployment rate, but the response from creditors and policymakers will likely determine just how large the wave will get.