The problem of personal debt is as old as the existence of money. In ancient Rome, people who were unable to pay their debts became temporary slaves to their creditors, ordered to toil on their land until the overdue sum was paid back. In 19th-century-England, broke Britons were sent to debtors’ prisons, miserable dungeon-like edifices, until their family or friends bailed them out.
Associate Professor Felipe Severino teaches Corporate Finance in the Tuck MBA program. His current research focuses on the effects of personal bankruptcy on household debt, the role of collateral lending in small business starts, and the impact of credit supply in house prices.
The process is a little more humane today. Law-abiding creditors can obtain a court order to garnish debtors’ wages—kind of like a payment plan. Still, the scale of delinquent debt in the U.S. is staggering. According to the Federal Reserve Bank of New York, 14 percent of U.S. consumers have been subject to third-party collection in recent years, for sums totaling $55 billion annually.
Less is known, however, about whether or not consumers in the collection system are making sound decisions in how they choose to discharge their debt. They have two options: negotiate with their creditors to make a lump-sum payment to clear the debt, or let a judge issue an order to have their wages garnished. Which one should they choose?
In a study of Missouri debt collection lawsuits, Tuck professor Felipe Severino makes a surprising discovery: consumers who negotiate an out-of-court settlement have far worse financial outcomes than those who go through the court system. “The guiding principle we use in this paper is that debtors should only negotiate if it leads to a better outcome than walking away and letting the court decide,” said Severino. “We argue that people are making a mistake when they settle.”
The guiding principle we use in this paper is that debtors should only negotiate if it leads to a better outcome than walking away and letting the court decide. We argue that people are making a mistake when they settle.
— Felipe Severino, ASSOCIATE PROFESSOR OF BUSINESS ADMINISTRATION
Severino and his coauthors focused their study on Missouri to exploit a statistically friendly condition: judges in collection courts are randomly assigned, but some judges encourage debtors to negotiate with creditors first (to, in effect, “talk it out”), while others administer more garnishment orders. The talk-it-out judges are like a treatment group, while the standard judges are the control group. This environment allowed the researchers to compare the outcomes between the two groups.
“We found that the consumers who draw the talk-it-out judges do in fact tend to settle more than the consumers who draw the other judges,” Severino explained. “But even though they settle more, they go on to do worse financially than the consumers who draw the judges who say nothing about negotiating.”
How do they do worse? Consumers in the talk-it-out group were more likely to either declare bankruptcy or have their homes foreclosed upon in the first year after the settlement. Severino attributes this to a simple fact: for most Americans, coming up with $3,000 to $5,000 (the average debt in their sample) for a lump-sum settlement is very difficult, and it might affect their ability to pay their mortgage or car payments on time. Having their wages garnished a little at a time, while still unpleasant, can be a more financially secure arrangement.
We found that the consumers who draw the talk-it-out judges do in fact tend to settle more than the consumers who draw the other judges. But even though they settle more, they go on to do worse financially than the consumers who draw the judges who say nothing about negotiating.
— Felipe Severino, ASSOCIATE PROFESSOR OF BUSINESS ADMINISTRATION
Severino sees two strong lessons from this research. First, consumers need to be better educated about their legal rights in debt collection, so they can make sound decisions. “We think there’s a serious issue with consumers being unaware of what happens if they exercise their legal rights,” Severino said. Second, the debt collection industry should be studied more intensely, to better understand how consumers interact with collectors.
Thankfully, debt bondage and debtors’ prisons are a thing of the past, but they have been replaced by a more Byzantine and bureaucratic legal system where the correct path is seldom clear—and where knowledge can help. Seeking legal assistance may be wise, but also expensive. “It’s not clear there’s a great solution here,” Severino said. “But consulting resources such as the Consumer Financial Protection Bureau is a good idea.”
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