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Lecture 18: The Democratization of
Finance: Consumer Finance
Trends in Democratization of
Finance
• Financial and insurance institutions began
with intellectuals and wealthy class
• Gradual spread of risk management
institutions required marketing, spread of
financial enlightenment, government
support
Radical Financial Innovation
Example I: Insurance
• Burial societies ancient Rome, true insurance
policies appeared in Italy in 14th century
• Rapid development of actuarial theory starting
in1600s with notion of probability
• Morris Robinson Mutual Life of NY 1840: highlypaid salesmen (agency theory)
• Henry Hyde Equitable Life Assurance Society
1880s: large cash value (psychological framing)
• Viviana Zelizer: challenging God and tempting
fate (psycholoogical framing)
• Inventions copied around the world
Radical Financial Innovation
Example II: Social Security
• Germany, 1889 first national pension plan
• Financial theory: concept of insurance
(Versicherung), large risks, Lujo Brentano, Gustav
Schmoller
• Psychological theory: overconfidence, wishful
thinking, hyperbolic discounting Schriften des
Vereins für Sozialpolitik
• Information technology making this possible:
paper, typewriters, filing cabinets, German
bureaucracy, pasting 11 million stamps on cards
• Invention copied around the world, same social
Glitches in the Democratization of
Finance
• Lack of consumer financial sophistication
invites their manipulation
• Simple failures of judgment—behavioral
finance
• Consumer inexperience has compounded
errors
Median Level of Assets First
Income Decile, US Households
with
Heads
Aged
51-61,
1992
• Financial Assets: 0
•
•
•
•
•
•
•
•
Retirement assets: 0
IRA: 0
401k: 0
Pension: 0
Vehicles: $300
Home Equity: 0
Home value: 0
Total Wealth: $5000
Median Level of Assets, Fifth
Income Decile, US Households
with
Heads
Aged
51-61,
1992
• Financial Assets: $3000
•
•
•
•
•
•
•
•
Retirement Assets: 0
IRA: 0
401(k): 0
Pension: $4000
Vehicles: $6000
Home equity: $29000
Home value: $45000
Total wealth: $101234
Median Level of Assets, Tenth
Income Decile, US Households
with
Heads
Aged
51-61,
1992
• Financial assets: $36500
•
•
•
•
•
•
•
•
Retirement assets: $40000
IRA: $21000
Pension: 83259
401(k): 0
Vehicles: $15000
Home equity: $77000
Home value: $120000
Total wealth: $387609
Long-Term Trends in
Household Debt
• In 1952, consumer credit was only 12% of
disposable income. Has trended upward,
now is 24%.
• In 1952, mortgage debt was 22% of
disposable income. Has trended upward,
now is almost 80%
• Trends in 1990s reflect growth in
confidence.
Saving Rate and 10-Yr. Treasury
1953-2003
Figure 3 Saving Rate and 10-Year Treasury Yield
16
14
12
10
Personal Saving Rate
8
Ten-Year Treasury Yield
6
4
2
0
1950
1960
1970
1980
1990
2000
2010
Real Ten-Year Treasury Yield
(Yield Minus Latest Annual
Inflation) 1953-2003
Real 10-Year Rate 1953-2003
10.00
8.00
Real Rate in Percent
6.00
4.00
2.00
0.00
1950
1960
1970
1980
-2.00
-4.00
-6.00
Year
1990
2000
2010
Consumer Confidence 1990-2004
Bankruptcy as Ultimate Risk
Management Device
• Economic theory says that with diminishing
marginal utility, the risk of extreme ruin is
the most important consideration.
• Without bankruptcy law, none of us could
be assured of a decent income
• Debtors were commonly jailed in US in
early 19th century.
Common Pool Problem
• Typically there are many creditors.
• Without bankruptcy, the first creditor to insist on
payment gets paid, others may not.
• Encourages aggressive actions by creditors
• Struggle by creditors to be paid first generates
wasteful and painful collection efforts.
• Creditors cannot meet and decide to split up the
proceeds since there are so many of them and time
is so short.
Early US Bankruptcy History
• Reacting to what they regarded as lenient state
bankruptcy laws in colonies, US constitution,
Article I, Section 10, prohibits states from
“impairing the obligation of contracts.”
• 1800, 1841, 1867, 1898 acts followed financial
crisis that rescued multitudes of failed debtors. In
1840, there were half a million failed debtors.
• 1841 law had a discharge provision, after
surrendering all one’s assets, one could have a
“fresh start.”
Bankruptcy Reform Act, 1978
• First major revision of bankruptcy law since 1938
• Lowered stigma of bankruptcy, relabeled
“bankrupts” as “debtors.”
• Allowed people to keep more
• Made repayment schemes more attractive
• Launched a boom in personal bankruptcies.
• Bankruptcies have increased five-fold since 1985.
Personal Bankruptcies
• US Personal bankruptcies reached 1.4 million in
1998, a record. Declined to 1.3 million in 1999
and 1.2 million in 2000, rose to 1.45 million in
2001, new record.
• More bankruptcies than divorces. (1.2 million
divorces in 1996)
• With 104 million households in US in 1999, more
than 1% of households declare bankruptcy each
year.
• Cumulative effect as years go by.
Personal Bankruptcies, US 1999-2003
1800000
1600000
1400000
1200000
1000000
800000
600000
400000
200000
0
1998.5
1999
1999.5
2000
2000.5
2001
2001.5
2002
2002.5
2003
2003.5
Chapter 7 Bankruptcy
• This is the liquidation form.
• Debtors turn over all nonexempt property to
trustee and are discharged from most debt.
• Alimony, taxes, educational loans not discharged.
• Can’t declare bankruptcy again for 6 years.
• To read Chapter 7 (or others), go to Title 11
(Bankruptcy) of United States Code,
http://www4.law.cornell.edu/uscode/11/
Chapter 7 — Liquidation
•
•
•
•
•
•
•
§ 701. Interim trustee.
§ 702. Election of trustee.
§ 703. Successor trustee.
§ 704. Duties of trustee.
§ 705. Creditors' committee.
§ 706. Conversion.
§ 707. Dismissal.
Chapter 11—Reorganization
• Primarily for businesses
• Some individuals running small businesses
may use Chapter 11
Chapter 13–Adjustment of Debts
of an Individual with Regular
Income
• Chapter 13 is a vehicle to repay part or all
of debts over time, supervised by courtappointed trustee.
• Keep all of property and receive a discharge
of portion of debt
Choosing: Chapter 7 or 13?
• Those with little assets choose Chapter 7
• Others try to make a deal with lien holder
and choose Chapter 7. (protect house or car)
• Failing that, and wishing to retain property,
turn to Chapter 13.
2001 Bankruptcy Reform Act
• Clinton vetoed 2000 bill as too harsh.
• Harsh new bills passed both houses March 2001,
Bush indicated he would sign.
• Reconciliation conference was scheduled for
September 12, 2001, cancelled.
• Would make it more difficult to escape credit card
debt, which tended to be cancelled in Chapter 7
filings since it was unsecured.
• Credit card companies lobbied hard for this.
• If can pay 25% of debt, must do Chapter 13, not 7
• Bad timing for bill, with weak labor market
Informal Bankruptcy
• Only 40% of credit card charge-offs are due to
bankruptcies. (Amanda Dawsey, L. Ausubel)
• Going bankrupt requires some planning, one has
to save $1000 before lawyer will represent you.
Down-and-outs don’t do it. Creditors may just
give up— not worth it.
• State laws allow creditors to garnish your wages,
even if you never declared bankruptcy.
Causes of Bankruptcies
• Personal bankruptcies tend to be spurred by job
loss, health problems, divorce.
• Americans run up debts they can pay only if
nothing goes wrong.
• Many bankruptcies are by people who are
“drowning in mortgage debt,” having bought too
big a house.
– Sullivan, Warren & Westbrook The Fragile Middle
Class YUP 2000
Credit Card Debt
• SWW conclude that the biggest single factor in
increase in personal bankruptcies in US has been
growth of credit card debt.Average debtor in
bankruptcy in 1997 had nine months’ income in
credit card debt.
– Credit card debt continues to be extended after initial
application
– Debt is incurred a little at a time
– Payment schedules are different, can become ever more
indebted while paying the minimum amount each
month.
Credit Card Interest Rates
• Average American had $5000 in credit card
debt, paying an average interest rate of 16%
in 1998.
• Why do they pay such high interest rates?
Challenges for the Democratization
of Finance
• Vitally important that individuals can make
use of modern risk management
• Democratization of finance can help build
proper incentives
• We have left the dark ages in consumer
finance, but have yet to reach its potential
I. Livelihood Insurance
• Replaces life insurance in dealing with largest
risks
• Long-term policies based on occupational indexes
• Repeated measures occupational indexes: Robert
Shiller and Ryan Schneider Rev. Income and
Wealth 1998
• Powerful impact on conservatism in life’s
decisions, makes for more risk taking
II. Home Equity Insurance
• Risks to values of homes greater than risks
by fire
• Oak Park Illinois, 1977
• Chicago Home Equity Assurance Program
1988
• Index-based insurance, Shiller and Weiss
1994
• Yale-Syracuse-NRC program, 2002
III. Income-Linked Loans
• Milton Friedman, Capitalism and Freedom
1962: individuals sell shares in their future
earnings, but feared “irrational public
condemnation” and feared it would be
difficult to track people and enforce
contracts
• Changing times
• Such loans should be based partly on
income indexes, to reduce moral hazard
Income-Linked Personal Loans
• Yale Tuition Postponement Option 1971-78
• Yale Law School Career Options Assistance
Program 1988-today
• David Bowie bonds, David Pullman 1997
• Australian Higher Education Contribution
Scheme (HECS) is dominant form of
student loans in Australia today
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