ARM-BREAKING, CONSUMER CREDIT AND PERSONAL BANKRUPTCY

The consumer credit transaction is analyzed as a contract which provides insurance as well as present consumption for the borrower. Creditors' remedies such as "arm-breaking" are shown to facilitate provision of insurance (forgiveness of debts) when lenders cannot monitor outcomes. Alternatively, if outcomes are observable but lenders do not ex ante know the risk associated with each borrower, the market may generate an excessive amount of arm-breaking and agreements to forgo discharge following bankruptcy as low risk borrowers signal their characteristics, suggesting that government limitations on such provisions might be efficient. The secured credit transaction is shown to be a complex contract which attempts to provide efficient repayment, seller incentives for performance and mitigation following default, and insurance for the borrower. Garnishment and discharge of debts following bankruptcy are also considered.