Personal bankruptcies hit a record 1.35 million in 1997, with many analysts expecting the high mark to topple again in 1998. Unlike other milestones, however—say, the most home runs in a single season—the bankruptcy boom is not exactly a feat Americans can be proud of. It's also puzzling. After all, the U.S. economy is in its eighth consecutive year of expansion, an expansion that features both low unemployment and inflation. Moreover, the stock market—until very recently—has been booming. So why are so many Americans striking out with their personal finances?

Bankruptcy Fundamentals

Americans have been filing for personal bankruptcy since the nation's founding. Indeed, one of the main reasons the colonials moved to America was to escape England's harsh debtors' prisons. Although the power to write uniform bankruptcy laws was granted to Congress by the Constitution, bankruptcy laws vary substantially across states, since states are permitted to set their own levels and types of asset exemptions.

There are two main types of consumer bankruptcy protection: Chapter 7 and Chapter 13. In a Chapter 7 filing—the choice for about two-thirds of current filers—the debtor is required to give up nonexempt property (assets) to a trustee, who sells it and pays creditors with the proceeds.1 Exempt property includes assets that the law has deemed necessary to support the debtor and his dependents. Equity in a house, which is called a homestead exemption, is one example. Unsecured debt, like credit card debt, is wiped off the books, or discharged.

Chapter 13 filers, on the other hand, are allowed to retain more assets than Chapter 7 filers, but must agree to pay creditors their outstanding debt—in full or in part—over a period of three to five years. In both types of bankruptcy, certain types of debt are not eligible for discharge, including alimony, recent income taxes, child support and government-backed student loans.

The number of Americans filing for personal bankruptcy has been climbing since the early 1980s. Total consumer bankruptcies jumped from 287,570 in 1980 to 1,350,118 in 1997—a 369.5 percent increase that occurred mostly in the 1980s. In the past several years, as annual personal bankruptcies soared toward the 1 million mark, the media and policy-makers began paying attention. In 1994, the National Bankruptcy Review Commission was formed to study the increase in consumer bankruptcies and to recommend changes in the current federal bankruptcy code, which was enacted in 1978. In the past 18 months, several bills designed to rid the system of abuse that might be fueling the number of filings have been voted on in Congress.2

Some bankruptcy experts and policy-makers believe an increased willingness to declare bankruptcy and a diminishment in the social stigma attached to it are largely responsible for the recent jump in filings; others point to a host of demographic, social and economic factors as the cause. These factors likely also explain the wide variance in bankruptcy rates across states. An examination of recent bankruptcy statistics in Eighth District states is revealing in this regard.

A Deadbeat District?

States in the Eighth Federal Reserve District have some of the highest personal bankruptcy rates in the nation (see table). Tennessee—at 9.6 bankruptcies per thousand residents in 1997—leads both the District and the nation. Two of its border states, Arkansas and Mississippi, also have higher-than-average rates—6.0 per thousand and 6.9 per thousand, respectively—according to last year's data. Missouri was the only District state with a bankruptcy rate below the 1997 national average of five per 1,000 residents.

In addition, bankruptcy rates in District states have risen more than in the rest of the country. Between 1993 and 1997, the U.S. bankruptcy rate rose 56.3 percent. Rates in every state in the District, except for Tennessee, increased more—in some cases substantially. Arkansas led the District with a 122.2 percent gain in that four-year period, while Mississippi's rate advanced 81.6 percent. Why is bankruptcy booming in the Eighth District and elsewhere?

Economic factors like high debt-to-income ratios certainly explain much of the proliferation in bankruptcies. Since 1980, lenders have reached out to borrowers who would not have met previous income and creditworthiness standards. While this so-called "democratization of credit" has certainly benefited many households, it has also made it easier for them to live beyond their means. When polled, Americans filing for personal bankruptcy routinely list credit card bills as the pivotal factor in their decision.

But excessive credit card debt is not the only culprit. Personal bankruptcy rates are also strongly influenced by factors like divorce, medical bills and gambling, as well as state laws regarding wage garnishment and asset exemptions. These factors appear to be key explanations for the higher-than-average bankruptcy rates in Eighth District states.

Three Strikes and You're Out

Major life disruptions like divorce drive many American households over the financial edge into bankruptcy. All District states, except Illinois, had divorce rates higher than the 1996 national average of 4.3 per thousand. Tennessee, with a 6.5 per thousand rate, was ranked second in the nation behind Nevada, which had 10 divorces per 1,000 people. Arkansas and Mississippi—with divorce rates of 6.1 per thousand and 5.8 per thousand, respectively—trailed Tennessee only slightly.

Major medical expenses, which the uninsured are particularly vulnerable to, are another leading cause of bankruptcy. In Arkansas and Mississippi, the proportions of residents without health insurance—21.7 percent and 18.5 percent, respectively, in 1996—are significantly higher than the national average of 15.6 percent. Illinois and Indiana, in contrast, have uninsured rates well below the national average. These lower rates are partially due to the large number of unionized manufacturing jobs—jobs that tend to have medical insurance—in the two states.

Compulsive gambling is increasingly being blamed for the rising tide of bankruptcies, especially in states that have casinos. Four of the District's seven states are home to riverboat casinos.3 Tunica County, Mississippi, just south of Memphis, is the third-largest gambling mecca in the nation, trailing only Las Vegas and Atlantic City. The casinos in Tunica draw heavily from bordering Tennessee and Arkansas. Illinois, Indiana and Missouri also allow riverboat gaming.

Bankruptcy rates in counties surrounding casino areas do tend to be much higher than elsewhere. A recent study of bankruptcy rates found that the U.S. counties with the highest bankruptcy rates were situated close to Tunica: Crittenden County, Ark.; Marshall County, Miss.; and Madison, Shelby and Tipton counties, Tenn.4 It should be noted, however, that bankruptcy rates in these counties were high long before casinos opened. Gambling debts may be exacerbating the region's bankruptcy problem, but they're by no means the sole cause.

Bankruptcy rates also vary geographically because of differences in state laws and local bankruptcy courts. For example, rates tend to be higher in states in which creditors are permitted to garnish wages and assets; garnishment is permitted in all seven District states. Western Tennessee's historically high bankruptcy rate can partially be explained by the large numbers of Chapter 13, or "wage earner," petitions there. This option is very appealing—and heavily promoted in the Memphis Yellow Pages—to consumers who have jobs, but are unable to pay their debts.

Staying in the Game

Bankruptcy in the United States is a form of credit insurance; it provides a safety net so that individuals and businesses can take financial risks. Bankruptcy rates are rising because more Americans are living closer to the financial edge. For a variety of reasons—a strong economy, easier credit, a desire to not just keep up with, but also surpass, the Joneses—many households are biting off more than they can chew. Throw in a couple of curveballs like a divorce or a major medical illness, and it's not surprising that so many Americans are striking out.

Obviously, there are things debtors can do to reduce the chance of bankruptcy, like increasing personal savings to cover financial emergencies. Creditors could help by beefing up underwriting criteria. Additionally, bankruptcy code reform may reduce the proportion of Chapter 7 liquidations and ensure that more filers repay a portion of their debt under a Chapter 13 reorganization plan. While changes in debtor and creditor behavior—and tougher bankruptcy laws—may reduce the number of Americans going bust, bankruptcy won't go away. After all, success at the plate is by no means assured—in baseball or in the financial aspects of the game of life.

Thomas A. Pollmann provided research assistance.

Endnotes

1. Nonexempt property includes receivables, such as tax refunds, that are owed to the debtor at the time of the filing. [back to text]
2. See Brideau (1998) and McEnaney (1998) for information about efforts to reform bankruptcy laws.[back to text]
3. See Zaretsky (1994) for more information on riverboat casino development in the Eighth District. [back to text]
4. See "Bankruptcy, Gambling Linked; Areas Near Tunica Have Highest Rate" (1997). [back to text]

References

American Bankruptcy Institute. "Statistics," www.abiworld.org/stats/newstatsfront.html.

"Bankruptcy, Gambling Linked; Areas Near Tunica Have Highest Rate," The Commercial Appeal, Memphis, Tenn. (August 21, 1997).

Brideau, Carol Ann. "House Passes Bill Aimed at Slashing Record Number of Personal Bankruptcies," BNA's Banking Report, Bureau of National Affairs (June 15, 1998), pp. 957-59.

McEnaney, Maura. "Meaningful Reform of the Nation's Consumer Bankruptcy Laws is Needed; the Challenge Lies in Finding a Balanced Approach," America's Community Banker (March 1998), pp. 28-32.

Zaretsky, Adam M. "Letting the Good Times Roll on Riverboat Casinos," The Regional Economist, Federal Reserve Bank of St. Louis (July 1994), pp. 12-13.