lecture 18 the democratization of finance consumer finance l.
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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

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trends in democratization of 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
Radical Financial InnovationExample 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: highly-paid 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
Radical Financial InnovationExample 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 security principles in U. S. today
glitches in the democratization of finance
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
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
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
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
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.
bankruptcy as ultimate risk management device
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
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
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
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
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.
chapter 7 bankruptcy
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
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
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–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 court-appointed trustee.
  • Keep all of property and receive a discharge of portion of debt
choosing chapter 7 or 13
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
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
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
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
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
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
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
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
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
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
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