What are the empirics of household financial distress (FD) in the United States, and to what extent can we understand them as arising from the choices of optimizing consumers who face uninsurable risks? The goal of this paper is to answer these two questions. We tackle the first question using newly available proprietary panel data, and we tackle the second by estimating a battery of state-of-the-art quantitative models of defaultable consumer debt over the life cycle.
The term “financial distress” can be defined in a variety of ways. Our primary definition is this: an individual is said to be in financial distress in a given year if, in that year, at least one of their credit relationships (accounts) is at least 120 days past due, that is, “severely delinquent.” Because severe delinquency is, in practice, an expensive way to repeatedly roll over debt, this definition plausibly captures financial distress. Put another way, because severe delinquency captures borrowers who face a high marginal cost of credit, it captures those with heavy debt and limited capacity to either self-insure or smooth consumption over time. While lack of access to additional credit and the costs ensuing from failing to repay debt as promised are arguably the essence of financial distress, severe delinquency is not the only definition of FD one could use. Another measure of FD is one that tracks the extent to which consumers have depleted the credit lines available to them, and we will report on FD measured in this way as well.
As we will show, both measures we consider lead to a single, more general, conclusion: while many U.S. consumers (35% using our primary definition, e.g.) experience financial distress at some point in the life cycle, most distress events are primarily accounted for by a much smaller proportion of consumers in persistent trouble. In particular, under the baseline definition, the incidence of FD is nearly double its unconditional rate 6 years after the initial distress event, and just 10% of borrowers account for half of all distress events. We also find that the persistence of FD is essentially invariant over the life cycle.1
The persistence of financial distress is important to measure and understand because it provides essential guidance to the appropriate interpretation of the risks facing households over a lifetime. For example, if financial distress is highly transitory, a given incidence for it over the life cycle would suggest that most or all households face similar risks over their lives, with each episode not lasting very long. If, on the other hand, financial distress is highly persistent, the same incidence would be disproportionately accounted for by a much smaller number of borrowers who repeatedly, or in a sustained fashion, experience distress. The latter is what we find in the data. Our empirical findings clearly indicate that the risk of financial distress is one that is, in a sense, resolved early in life: Most borrowers know that they will face few problems with timely debt repayment in the years ahead, and a much smaller few know that they will face a future of repeated instances of distress.
Our work contributes in two ways. First, to our knowledge, our work is novel in providing a detailed description of the incidence, concentration, and dynamics of financial distress. Second, ours is the first to attempt to account for these facts. We proceed with a formal structural estimation of a battery of alternative models of consumer debt and default and describe their implications. This analysis reveals that the facts of financial distress, along with overall wealth accumulation, can be largely accounted for through a straightforward extension of a workhorse model of consumer debt with informal default that accommodates a simple form of heterogeneity in time preference.
By allowing for informal default, we capture an empirically relevant pathway for (non) repayment, as reflected by the substantial delinquency rates observed in U.S. data. By contrast, formal default (in its dominant “Chapter 7 Bankruptcy” form) is by construction very short lived—it removes all unsecured debts—and thus fails to capture the ongoing difficulties experienced by households. In other words, informal default is the path for the many who are not ready to take the more extreme step of declaring bankruptcy but nonetheless face the difficulty–the financial distress–arising from potentially lengthy periods of costly debt rollover.
To keep the model tractable for estimation, we follow Livshits, MacGee, and Tertilt (2007), which was the first paper to allow for delinquency, or rollover at a “penalty” rate of interest, as an option in the period following a bankruptcy in case of an “expense” shocks.2 As our results will show, informal default appears important in generating the observed persistence of financial distress at short horizons (1–3 years after the initial distress event).