The Federal Reserve Bank of Philadelphia published a paper by Stephanie Wilshusen which made some very enlightened observations about why consumers struggle with getting out of debt.
In the paper, “Meeting the Demand for Debt Relief” it describes the options available to borrowers who seek assistance in managing their debts and discusses the information and incentive problems associated with these options.
I found some of the points raised to be very interesting.
“In choosing among debt relief options, consumers often rely on the expertise of others, but consumers typically have little or no experience evaluating that expertise. In addition, the features of some options are not readily observable in advance, which leaves consumers vulnerable to the practices of opportunistic firms. There have been numerous complaints about unfair and deceptive practices within the debt relief industry. Significant changes in state law governing debt relief services are already underway. Recent legislation and new regulations at the federal level are affecting both credit counseling agencies and debt settlement companies. Finally, implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is likely to result in fundamental change in the regulation of the debt relief industry at the federal level.”
“Until recently, many settlement firms tended to collect the majority of their fees from consumers before the first settlement offer was made. This created a potential inconsistency in the timing of payments for services relative to when the primary service (a reduction in debt owed) was performed. As a result, a less than scrupulous settlement firm may not have had an adequate incentive to engage in protracted negotiations on behalf of the consumer. In addition, much of the risk of failure remained with the consumer, who may not have been able to save a sufficient dollar amount over a sufficient period of time in order to settle a debt before a garnishment or some other shock forced the consumer out of the plan and possibly into bankruptcy.
A business model in which participation in intermediated arrangements and reimbursement are more dependent on the quality of screening (and the success of settlement negotiations) could mitigate the potential misalignment of incentives of the intermediary with respect to the interests of consumers and lenders. In other words, if the incentives are structured properly, it is possible that settlement negotiations initiated by an intermediary could be an appropriate solution for some consumers.
But an alternative to such an approach already exists in the form of the Chapter 13 wage earner plan. It enjoys the advantages of an automatic stay on collection activity and an attorney advising the consumer, as well as a trustee that approves and administers the plan. On the other hand, Chapter 13 plans are costly to administer and are not always successful. The existence of debt management plans and other privately negotiated workouts suggests that bankruptcy is not a perfect substitute for these arrangements. But in order for these private arrangements to function in ways that improve outcomes for consumers, the incentive to screen and to perform must be reasonably well managed.
Shopping for Debt Relief Help
In most markets, low barriers to entry and vigorous competition make it possible for consumers to obtain high-quality services at reasonable cost. For a variety of reasons, this does not appear to be the case for debt relief services. The issues related to screening and incentives just described are compounded by the difficulties consumers face in choosing from a complicated menu of options offered by diverse providers. For most consumers, these are services obtained just once or twice in a lifetime. As a result, consumers in financial distress often rely on the expertise of others, but they often have little or no experience in evaluating that expertise.
In some ways, the provision of debt relief services is an example of what economists call credence goods. In such markets, including automobile repair, consumers may not know what they really need, but they will eventually learn the value of what they get.
Unfortunately, this learning occurs too late to inform a good choice in the first place. Without some form of mitigation, markets for credence goods can function poorly. The result can be overtreatment, for example, costly and unnecessary repairs; undertreatment, that is, the easy repair is made even though it does not resolve the problem; or simply overcharging for the services provided.
If these problems are sufficiently serious, many consumers may choose to abstain from participating in these markets altogether. The result is an inefficient quantity and quality of services provided. Such potential market failures suggest a role for government intervention, but they also suggest that effective interventions may not be easy.
What is Needed
Going forward, it is extremely likely that the design and supply of loan workout products will depend on the evidence of their efficacy. Creditors will require such evidence to determine under which circumstances to offer repayment alternatives and the terms of those plans. In addition, regulators require proof that loan modification efforts address borrowers’ financial problems and not simply delay loan loss recognition. Therefore, the need for careful assessments of credit counseling services could not be greater.
In evaluating existing products and treatments and designing new ones, counseling agencies and policymakers must develop a deeper understanding of how consumers make decisions about incurring and repaying debt and the long-run impact of those choices. Historically, however, consumer credit research has tended to focus on the bankruptcy decision. Relatively few studies examine what happens to financially distressed borrowers who have not filed for bankruptcy and the efficacy of the alternatives available to them.
Despite the importance of evaluating the benefit and cost of the options available to financially distressed consumers, to date, there have been few rigorous studies documenting the value to consumers of credit counseling. In part, that is because there are organizational and methodological challenges to conducting this research. Among the organizational impediments has been the inability to access the necessary data for rigorous analysis. Until recently, there has been little systematic data available to researchers about which consumers seek assistance, what treatments they receive, and the outcome of those treatments. In addition, tracking borrower outcomes is difficult because, typically, researchers know little about those who are not treated. Finally, counseling agencies lack information from creditors on account performance, and without that information, the opportunity for learning through a systematic feedback loop is lost.
An important methodological impediment has been the reluctance to employ the best research designs used for decades in other disciplines, such as medicine. These are randomized controlled experiments. Without such an approach, researchers can’t clearly distinguish between the role of treatment and selection in evaluating outcomes. Is it the treatment that counseling agencies provide that influences consumer outcomes or the kind of consumers that agencies attract? The distinction between the effects of counseling from borrower motivation is critical for policy analysis and better product design.
Some counseling agencies have been reluctant to participate in randomized controlled trials due to concerns that the experiments might represent denial of service if the same standard of treatment is not offered to all clients and at the time help is requested. Randomization applied along two margins might address these ethical concerns. First, experiments can be designed to randomize the assignment of clients into two treatment groups: one that receives the standard treatment and another that receives an enhanced version of the standard treatment. In this way, nothing is being denied to consumers, and the value of the incremental treatment can be ascertained. Second, for capacity-constrained counseling organizations, experiments can be designed to randomize service delivery to fairly allocate the scarce counseling resource so that consumers are not turned away. In either case, a successful trial of a new treatment helps to build the case for the resources necessary to implement it more widely.
To conduct a randomized controlled experiment, it is necessary to compare counseled consumers to observationally similar borrowers who do not receive counseling, and creating these sample populations is not easy. Although it is difficult, some research on the effects of credit counseling has been conducted. For example, Elliehausen et al. (2007) found that credit counseling improves credit bureau profiles measured several years after counseling, even for clients who received only financial counseling and did not enroll in a DMP. For clients who are See the study by Finkelstein et al. (2011) in which the researchers used a randomized controlled design to gauge the effects of expanding access to Medicaid for low-income adults.
advised to enroll in a DMP and who in fact start a DMP, Barron and Staten (2011a,b) provide evidence that these clients have a significantly lower incidence of bankruptcy and experience a significantly greater increase in credit risk scores in the subsequent four years than those who are recommended for a DMP but do not enroll in a plan.
However it is conducted, rigorous assessment of counseling outcomes is vital for making good policy decisions and for the future of the industry. The most robust studies would incorporate data from several sources and would follow consumers for a period of time after they sought counseling and provide a picture of clients’ circumstances leading up to counseling. Detailed intake data collected by agencies from consumers when they seek assistance, credit bureau data to describe clients’ borrowing and payment behavior, and creditor data on individual account-level performance are the ingredients for an evaluation of outcomes. In addition, a survey administered after counseling has been completed to account for changes in family structure that are not observable in the other data would be useful. Developing a solid understanding of what works and why can inform the modification of product offerings, the appropriate role of government, and the optimal combination of private-public funding of debt relief services.
Issues That Prevent People From Seeking Debt Relief Help
A basic question of public policy in credit markets is whether private renegotiation of consumer debt contracts in default is complementary to, or substitutes for, the bankruptcy process. Over a half century of experience with nonprofit credit counseling in the U.S. suggests that these activities are indeed complementary. Each year, more than a million distressed consumers have the opportunity to at least consider an alternative to filing for bankruptcy, and a significant number do choose an alternative.
But this experience, together with the more recent experience with debt settlement firms, suggests that there are substantial issues that must be addressed in order for these private mechanisms to work properly. Among others, these issues include incomplete information, the incentives of multiple parties, and the ability of distressed consumers to shop effectively.
As the last 20 years have demonstrated, these issues pose a significant challenge for consumers, creditors, the many legitimate providers of debt relief services, and regulators at the state and federal levels. These challenges are not insurmountable, but they do require adequate resources to be addressed in a systematic manner.
Debt relief services are an example of credence goods for which consumers have difficulty shopping because there are important unobservable characteristics of the service and service providers. These difficulties, combined with relatively low barriers to entry and exit, likely complicates the problem of disciplining firms and may leave consumers vulnerable to opportunistic intermediaries. In turn, enforcement efforts after the fact may not be as effective as they otherwise would be. While much more analysis is required to reach a definitive conclusion, these characteristics at least tentatively suggest that greater use of rulemaking, combined with more ample resources for enforcement, could be a more effective strategy for disciplining firms.
If private workout arrangements are to work effectively, there is a need to establish appropriate incentives for consumers, creditors, and any intermediaries involved. Financially distressed consumers have limited assets or cash flow with which to pay for coordination and expertise, especially since those are resources that come at the expense of any debt payments the consumer can make. And the willingness of creditors to offer concessions depends on their belief that concessions will make the difference between writing off an account and being repaid. This, in turn, depends on the ability of the creditor, or an intermediary such as a credit counselor or a settlement firm, to effectively screen consumers applying for relief.
A complicating factor is the speed with which these markets can change. Just a few examples of the dynamics in the debt relief industry include the adoption of new technologies that have changed economies of scale, the dramatic change in the mix of services provided and sources of funding due in part to new laws, and at times rapid entry and exit.
Finally, more research is needed to better understand why consumers become financially distressed, to inform the design of products to get them out of trouble and interventions to keep them out of trouble, and to evaluate the efficacy of the competing options available to consumers.
For those interested, the rest of the paper can be read here.