The calm before the storm of bankruptcies

Though the numbers haven’t shown it yet, many are bracing for a spike in personal bankruptcies once coronavirus relief efforts and stay-at-home orders have been exhausted.

How lawmakers prepare for the expected wave in bankruptcy will be critical to the pace of economic recovery.

Based on a review of historical bankruptcy filing rates, there are certainly indications that a wave of bankruptcy filings may materialize. The data analytics firm AIS InfoSource found a tight historical correlation between bankruptcy filings and increased unemployment coupled with rises in mortgage delinquencies.

Since 2008, bankruptcy filings have increased more or less in tandem with job loss and missed mortgage payments, according to this chart.

There are some legitimate questions, however, about whether this correlation will repeat in the current economic crisis. Unemployment has risen quickly, and to levels not seen since the Great Depression. Mortgage delinquencies have also increased and may reach as high as 19%, according to a Black Knight report.

But there are countervailing factors as well.

The current unemployment crisis was artificially created by state and local government stay-at-home orders in response to the pandemic. In past business cycles, increases in the unemployment rate resulted from shocks or recessions —not from a deliberate government decision to freeze most economic activity.

In fact, past government policy using fiscal and monetary tools was designed to stimulate job creation. When states and cities reopen, unemployment rates may well decrease. But many expect the post-coronavirus unemployment rate will be elevated for some time.

Mortgage delinquencies may also be a less reliable predictor of bankruptcy filings.

Many homeowners will benefit from a mortgage forbearance program enacted as a part of the coronavirus relief bill. For mortgages owned or guaranteed by the federal government, homeowners can miss payments without facing foreclosure. An imminent foreclosure often precipitates a bankruptcy filing, which stops the foreclosure and allows the homeowner to catch up on missed payments.

Currently, personal bankruptcy filings are actually lower year over year. According to data from the federal courts, there were 186,000 consumer bankruptcy cases in the first quarter of 2019. By contrast, there were only 175,000 for the first quarter of 2020.

Perhaps more strikingly, the rate of consumer bankruptcy cases for April of 2020 was 46% lower than April of 2019. So, what’s happening?

One explanation could be that some courts have been closed for business, making the logistics of filing for bankruptcy more difficult. Some law offices have also been closed and consumers may be reluctant to declare bankruptcy without meeting with an attorney beforehand. Also, the federal stimulus payments and expanded unemployment benefits may be keeping consumers afloat for the time being.

The current lull seems likely to be unsustainable. Surely, unemployed consumers will burn through savings and exhaust unemployment benefits, and mortgage forbearance cannot continue forever. When that happens, many consumers will seek to wipe out credit card debts or stop a foreclosure from proceeding.

Whether the tight correlation between bankruptcy, unemployment and mortgage delinquencies continues to hold in the next few months is impossible to know with certainty. There are valid reasons to think that this time things will be different.

But it would be very surprising not to see a spike in bankruptcies later this year, especially in states with longer stay-at-home requirements.

So, what should the policy response be? Temporary modifications, like changes made to the Bankruptcy Code in the coronavirus relief bill (the CARES Act), have made bankruptcy faster and more easily understood. As the economy continues to reopen, however, it is important that temporary changes not become permanent.

It’s also important to ensure that any bankruptcy law changes are targeted and not overly broad. For instance, a proposal in the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act to allow higher-net-worth homeowners to shield home equity in bankruptcy would merely increase risk for lenders. And the proposal seems unrelated to stabilizing the financial health of at-risk consumers.

The House proposal would only benefit homeowners, not renters who often live paycheck to paycheck. In fact, according to additional research from AIS InfoSource, the average amount of home equity protected in bankruptcy is approximately $77,000.

These are uncertain times, and policymakers should expect an increase in bankruptcies. Congress has already made temporary bankruptcy law changes to assist consumers in financial distress. It is imperative that future changes, if any are needed, be temporary and targeted. The current public health crisis should not lead to unfocused policy changes that will increase credit risk and slow the economic recovery.