One of my commenters has asked me to explain my assertion that the bankruptcy reform bill was a bad idea. I think this is an interesting question, even though it's a little bit of ancient history, so I'm going to answer it.
For readers who were not following along at home, the bankruptcy reform bill passed in 2005 made it somewhat harder to discharge one's debts.
- If your income was above the median in your area, you had to file for Chapter 13 (which requires that you cut your budget and go on a payment plan, rather than simply discharging your debts.)
- Everyone was required to provide more documentation of their income and assets in order to file, particularly tax returns.
- It altered the procedure for writing down loans somewhat, which some advocates argued would have the effect of making car loans senior to child support payments.
- Bankruptcy lawyers were required to certify their filings, which forced them to charge higher fees--both to cover insurance, and to do more due diligence.
- It outlawed specific abuses that virtually no one is willing to defend--serial filings of Chapter 13 in order to stave off foreclosure or eviction; the practice of buying large houses in states with unlimited homestead exemptions in order to shelter assets from pending civil judgements. (This latter was made famous by OJ Simpson, who bought a mansion in Florida to shelter his money from the Goldmans.)
I covered this for the Economist, which consisted of being ranted at by two groups:
- Credit card issuers, who claimed that the steady march upwards in the bankruptcy rate was due to consumers having, suddenly and for no apparent reasons, deciding en masse to become deadbeats. Backed up by amusing but entirely anecdotal "research", they argued that the real problem was fraud, or strategic behavior by consumers who ran up debts knowing full well that they were never going to pay them back.
- Consumer advocates, who claimed that the steady march upwards in the bankruptcy rate was due to the predatory behavior of lenders, and the cruel, cruel realities of America's heartless economy. Backed up by less amusing, but not much more rigorous, "research", they argued that the real problem was skyrocketing medical bills, or strategic behavior by banks who lent money knowing full well that consumer would never be able to repay it.
Neither of these explanations were particularly plausible. Research into the causes of bankruptcy, and the amount of fraud therein, is all pretty much . . . what's the word I'm looking for? Well, I can't use that word, because this is a family blog, but the research is pretty much all garbage. Bankruptcy is one of the most shameful things that can happen to you in American society, and the first rule of survey research is that people lie about the things they are ashamed of. They certainly don't confess that they used their credit cards to have a nice shopping spree before the bank came and took it all away. Moreover, untangling the cause of a bankruptcy is often like trying to untangle the reason for a marital fight--the proximate cause is usually only the straw that broke the camel's back. For example, most Americans don't save that much. Most Americans get away with not saving that much. But those who don't are vulnerable to a sudden event--a job loss, a divorce, an illness<sup>1</sup>--that brings their income below their house/car/student loan payments. Was the cause of the bankruptcy the divorce, or the fact that they were living up to the edge of their income before the divorce?
To be sure, there was evidence of strategic behavior on the part of the consumers--but a lot of that seems to have consisted of people running up credit card bills so that they could keep paying the mortgage, not a massive conspiracy to defraud lenders. And there was evidence of strategic behavior by some borrowers--but only a lunatic would lend money that they were sure wouldn't be repaid. Both sides were advancing justice claims, when there was no real justice claim to be made. Lenders lent the money voluntarily; borrowers borrowed it voluntarily. Both of them knew the rules when they entered into the transaction--or should have. Most of the consumer advocates seemed to regard easy bankruptcy as a way to advance social justice--but credit card companies are not in the business of social justice, nor should they be. If we want poor people to have free money, we should dig down into our own pockets and give it to them, not demand that MBNA do it for us.
Ultimately, the best explanation of the rise in bankruptcies was not some sea change in either banker greed or consumer culture. Though I find it plausible that there was some easing on the stigma of bankruptcy, making it less psychologically costly to borrow, the best fit with the data is simply the fact that starting in the 1970s, it became easier to borrow. The invention of credit cards gave consumers access to something that had previously only been the province of the wealthy: substantial revolving credit. And the improvements in credit information, and the subsequent advances in credit scoring, made lenders much more willing to lend. And that, in turn, meant that consumers for the first time had substantial unsecured debts that could be discharged in bankruptcy. It's hardly shocking that we got a lot more bankruptcies.
This is not a bad thing. Contra Elizabeth Warren et. al., there's no evidence that this was, on net, bad for the poor, who used to have to get their revolving credit at loan sharks, or take out a secure loan from a pawnbroker. It certainly wasn't bad for the banks, who made a whole lot of money on the transactions. And it was good for us. I'll take on the critics of fractional reserve banking some other day--but suffice it to say that one of the many reasons that the American economy grows faster than most of the rest of the developed world is that we have better and deeper credit markets. Yes, even now--check out the Northern Rock nationalization if you think we've got problems.
There is also substantial evidence--good, solid research, not awful surveys--that easy bankruptcy is one of the hidden strengths of the American economy. American bankruptcy law offers an interesting natural experiment; the code, meaning the rules under which debts are discharged, is national, but the details of what is exempt from bankruptcy are done at the state level. Researchers consistently find that the more generous the exemptions are, the higher a state's rate of entrepreneurship. When failing is less risky, people are more willing to try.
Given that, my question for the bankruptcy reformers was: what problem does this change solve? It solves a problem for the credit card issuers, to be sure--but it does so by essentially allowing them to rewrite the terms under which they lent money, which was at least as unjust as any unjustice we might have been trying to rectify. The economic benefit of tighter bankruptcy restrictions is that they make banks more willing to lend, but this was hardly a problem for the economy in 2005. And the economic cost is that people are more afraid to take risks with their income.
Bankruptcies are down substantially since 2005, even despite the subprime crisis and the economic slowdown--giving lie to the consumer advocates who claimed that everyone declaring bankruptcy had no other choice. But I suspect that the change has cost the rest of us a lot more than it saved the banks.
<sup>1</sup> Contrary to popular belief, illness often brings on bankruptcy not through high medical bills, but loss of income to pay other bills.
Update Typo regarding Chapter 13 fixed.
Yeah, I've always found Warren's claim about most bankruptcies being due to illness or job loss pretty ridiculous: what were they doing for the decades prior to put themselves in a position so that they were incapable of weathering a few months of unemployment? Consumerism, not job loss, caused the bankruptcies of everyone we know who has declared, regardless of how they'd try and defend it.
Links to the "substantial evidence" would be appreciated.
How come no one examines why we allow bankruptcy in the first place? It's not really logical, right? I'm not suggesting debtors prison, but why is it that a person can walk away from a debt in the first place? Why not allow the debts to stay alive until the debtor can pay?
This idea that bankruptcy is 'shameful' might have played, once upon a time in Mayberry. But it hasn't been true among the people I know for a long time.
Perhaps it's because there really doesn't seem to be a lot of stigma associated with declaring bankruptcy providing you owe enough. The idea that one should suffer approbation from declaring bankruptcy over an accumulated debt of perhaps $80,000 while any number of entities can owe millions - billions - and be shielded not only from scorn, but personal accountability seems to be a mite, um, tiresome. There's a reason why people don't care for hypocrisy.
On a closely related note, some institutions are shocked, shocked I tell you, that many homeowners are simply walking away from housing they can no longer afford to own instead of doing everything they can to avoid foreclosure. Trying to get people to remain in financially untenable situations by appealing to their sense of propriety when it is quite clear that the only reason for doing so is to extract yet more money from them before their house is inevitably repoed strikes most people has being somewhat opportunistic, not to say completely amoral.
I've always found Warren's claim about most bankruptcies being due to illness or job loss pretty ridiculous: what were they doing for the decades prior to put themselves in a position so that they were incapable of weathering a few months of unemployment?
Um, they were making just enough money to pay for rent, a car, utilities and food? And some new (at least to them) clothes once in a while?
I've seen hundreds of personal bankruptcy petitions--if you haven't it is absolutely impossible to believe the percentage who file with total unsecured debts of well under 50% of annual family income. I've seen filings from people who rent cheap apartments, don't owe money for a car and have under $5000 in total debt. And they spend almost $1000 on attorney's fees.
Look, the average person is not a good budgeter or money manager. The average person who declares bankruptcy is substantially worse at it. Millions of people have essentially no savings and therefore no way of weathering one month of unemployment (w/o UE benefits--which is the case if you're a waitress and break your ankle falling off a step at home), much less a few. Maybe you can pay the rent, but you can't pay the utilities or have enough money for gas or bus fare, unless you don't eat anything. And then you have a few hundred dollars in medical bills, too.
Megan is right that a serious problem with Liz's intrepretation of the data is with medical debts--she usually assigns all filings with ANY medical debts to the "filed due to medical bills" category, when it isn't true. One could just as validly say that anyone with a car loan spent too much money and "filed due to expensive car".
And, yes, Liz does use interviews, too, but that's too easily slanted by the form of the question asked--use a broad question about "whether a medical issue caused the bk filing" and the debtor can wrap the medical debts together with the lost pay and say "Yes", when it really was just the lost pay--getting rid of the medical bills is just part of the bankruptcy.
How come no one examines why we allow bankruptcy in the first place? It's not really logical, right? I'm not suggesting debtors prison, but why is it that a person can walk away from a debt in the first place? Why not allow the debts to stay alive until the debtor can pay?
I suppose you have that same attitude towards businesses as you do towards the every day consumer. Why should business bankruptcy be treated any different(see the airlines).
Bankruptcy is one of the most shameful things that can happen to you in American society
SOV is right in that this hasn't really been true for years. I think a better generalization is that it is shameful for those who don't do it, and isn't for those who do.
untangling the cause of a bankruptcy is often like trying to untangle the reason for a marital fight--the proximate cause is usually only the straw that broke the camel's back [...] For example, most Americans don't save that much. Most Americans get away with not saving that much. But those who don't are vulnerable to a sudden event
This is right on. We no longer save before we buy, so if/when something happens we don't have the choice to forgo buying the new car and using the money instead for our illness/whatever. We now have to sell the car for a loss, because we're upside-down on the loan, or have it repossessed.
or the fact that they were living up to the edge of their income before
But it doesn't really have to be that much on the edge for major expenses to push one over it.
running up credit card bills so that they could keep paying the mortgage
Probably the smartest move, if you have to do it.
but only a lunatic would lend money that they were sure wouldn't be repaid
If you're only looking at one transaction, sure. If you're looking more holistically at a lending market, it might be less "lunatic" and more "calculated risk."
If we want poor people to have free money, we should dig down into our own pockets and give it to them, not demand that MBNA do it for us.
It is our money MBNA is lending, and we're paying for the generosity via lower interest rates paid to our deposits, no?
Researchers consistently find that the more generous the exemptions are, the higher a state's rate of entrepreneurship. When failing is less risky, people are more willing to try.
Are we talking business, or personal here? I think I look more favorably on a failed business attempt than a failed attempt to have a BMW, a boat, that 60" TV, and a $500K house on a $50K income.
why is it that a person can walk away from a debt in the first place?
I can answer that question. The purpose of bankruptcy is principally to avoid what is colorfully called the "rush to dismember the debtor," i.e. essentially a bank run on an individual.
Lots of us have debt, and most of us can service it properly. But suppose you miss one payment, and a quick check shows that your financial situation is shakier than it used to be. What should your creditors do? Should they wait and see if you get back on track? Or should they rush to court to win judgments and start seizing assets?
In a non-bankruptcy world, the temptation to rush to court is strong, because the first one with a judgment will get paid (possibly in full) by selling off the assets, and creditors who delay too long will get nothing. This means that the likelihood of someone being forced into total ruin because of one late payment is fairly high.
In a bankruptcy world, that rush is unavailing; the moment the debtor sees the lawsuit which threatens his house, he runs off to bankruptcy court and gets sheltered from his creditors long enough to get it together. Lawsuits are stayed. Numerous creditor actions taken pre-bankruptcy can be reversed. And, in the end, an orderly distribution of pro-rata shares of the debtor's assets will take place, with nobody getting any more than their share. Possibly the debtor will put together a plan to pay in full. There is no point in jumping the gun because there is no benefit to doing so.
Thus, creditors are more likely to "let it ride," or perhaps even modify the terms of their loans, in an effort to avoid provoking a bankruptcy. And, collectively, they are more likely to end up getting paid than if they were constantly shoving everyone over the brink.
One other thought. Maybe the corporate structure is a bit illogical. It's very asymmetric to allow ownership in a corporation where you get upside participation but never can have liability. (Yes, I know the law disallows corps just set up to hide personal liability.)
Maybe we would see far fewer periodic crises if shareholders were not immune to recourse? Instead of blaming S&P and Moody's, maybe the blame lies in part on the structure of corp ownership? Investors can be risk-averse b/c worst case all you can lose is your investment.
Just a thought...
Maybe we would see far fewer periodic crises if shareholders were not immune to recourse?
Yes, or maybe that would utterly, completely, destroy capital formation in the US and cut off our access to foreign capital, too, as well as ending any hope that smaller players would participate in capital markets.
Rob,
In a non-bankruptcy world the temptation to rush to court is strong, because the first one with a judgement will get paid.
I can see this to a point, maybe the credit card company could get in before the mortgage company. But that's just an argument for court managed defeasment of liabilities. What I am asking is why allow them to be sometimes dramatically reduced rather than just scheduled over a longer time?
Kind of a simple example:
Poor working guy X borrows to much on his credit cards, loses his job, and declares bankruptcy. The meager remaining assets pay off part of the debts and they are entirely discharged. Next day he wins the lottery and owes nothing to previous creditors.
why allow them to be sometimes dramatically reduced rather than just scheduled over a longer time?
I suppose because the courts don't feel like sitting on cases for 20 years at a time, settling monthly squabbles between creditors and debtors who first met during the Reagan years. Because there would be squabbles, and the legal system is fond of finality. This way, everybody walks away, hopefully all hurting enough to be more careful next time.
That said, the changes made recently do correspond to your vision: harder to get Chapter 7, more likely to be forced into a Chapter 13 payment plan.
Rob,
Maybe we would see far fewer periodic crises if shareholders were not immune to recourse?
Yes, or maybe that would utterly, completely, destroy capital formation in the US and cut off our access to foreign capital, too, as well as ending any hope that smaller players would participate in capital markets.
Yeah, there might be some downside risk. ;)
I don't think bankruptcy is really as easy as some here are making it out to be. My brother-in-law was in prison for nearly a decade and has declared bankruptcy. According to him, the bankruptcy was a far greater obstacle to overcome than a conviction for a violent felony.
Of course, he's an obstinate guy, so the reason he declared bankruptcy was because he didn't like the attitude of the Citibank credit card woman who said he had a $50 oustanding balance. So he ruined his credit over $50, which is pretty much a textbook example of cutting off your nose to spite your face.
I know one guy who has recently filed bankruptcy under the new law. For him, the reason is because he likes to spend his money on video games, computers, car paraphenalia, and music, and now that he's getting a divorce, his wife's income is no longer bailing him out.
Without commenting on the desirability on corporate officialdom sharing at least some liability for bad decisions, I would like to ask why personal bankruptcy should be considered 'shameful', while bankruptcies associated with businesses should not? Why, in fact, they're considered to be 'just business'. Sounds like a double standard to me.
could part of it be the corporate culture itself? I keep hearing comments about how the sort of poor performance shown here would cause a CEO in the land of the Rising Sun to resign in disgrace . . . sans bonus. Here you've got operators like Mozilo who are completely unashamed of their corporate behaviour. Those options and bonuses? You'll have to pry it out of his cold, dead hands.
SoV: I see no compelling reason for any difference in shamefulness* other than the shamelessness of many wealthy people.
* Here I'm thinking of bankruptcies of mature, well capitalized companies. Small business/entrepreneurial bankruptcies are a different case.
* If your income was above 50% of the median in your area, you had to file for Chapter 13 (which requires that you cut your budget and go on a payment plan, rather than simply discharging your debts.)
--- No. Well kind of. If your above median you have to do a means test; you can still do a chapter 7 as long as your disposable income after deducting expenses is too low to pay 10000 to unsecured creditors over 5 years.
* Everyone was required to provide more documentation of their income and assets in order to file, particularly tax returns.
Yep. But not as much as you'd think. 2-3 paystubs and the latest tax return, and a deed of trust if there is a mortgage. That's usually it.
* It altered the procedure for writing down loans somewhat, which some advocates argued would have the effect of making car loans senior to child support payments.
Child support is undischargable. Period. It doesn't get touched in a 7 and it if you can't afford to pay your secured debt and the unsecured priority debt you can't file a 13; forced back to 7. I have no idea who argued that, but it hasn't worked out that way in the real world at least.
I have no idea who argued that, but it hasn't worked out that way in the real world at least.
Well, secured debt (e.g., a car loan) is always senior to priority debt (e.g., child support payments). And secured debt is undischargeable. Period, too. The issue is what happens to the unsecured part, if any, of the, e.g., car loan. In a 7, both before and after the '05 bill, no cramdown. In a 13, you used to be able to cramdown a car loan, but now you must be at least 30 months into the repayment.
So, under the new law, the unsecured boot (if you will) on the car loan is, technically, senior to the priority child support payments. However, as T noted, this is really not a real world issue, as non-payment of all priority debts (on a monthly basis, not necessarily in full) makes a Chapter 13 plan legally "not feasible" and therefore not something that will allow the debotr to get a discharge.
The assumption that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made is more difficult for people to discharge debts is really more of an urban myth, than anything grounded in fact. What I find more infuriating is how you provide completely inaccurate information as "fact."
BAPCPA made it more difficult for bankruptcy attorneys. In fact, when he signed the bill, President Bush made a special point of commenting that the bill targeted "mills" - law firms who churn out bankruptcies at a rather astonishing rate.
BAPCPA now requires more documentation, more investigation, and more preparation. It made the process more expensive, and frankly, it lowered the number of "mills" out there who were probably doing a half-baked job anyway. But let me hit a few of your bullet points:
1. FACT: If you earn more than 50% of your median income in your area, you are NOT required to file a Chapter 13. There is nothing in the code supporting such a statement.
2. FACT: Everyone is required to provide more documentation (you're right on that one).
3. FACT: Higher fees are not for higher insurance premiums. Higher fees are for more work. Good attorneys are charging more.
Please don't spread misinformation - and please get some facts about what leads people to bankruptcy rather than pontificating.
Can the people who are saying things like "FACT:" and "period" actually provide some documentation to support their claims, or the very least, their bona fides?
I don't know much about bankruptcy or bankruptcy proceedings, and I can't tell who's zooming who.
For the convenience of SoV and others, the bankruptcy code is Title 11; the whole US code is normally available here but the site appears to be down.
I surprised by the no-cramdown claim (cramdown is the enforcement of a bankruptcy judgment over the objections of creditors). 11 USC sec. 727 allows objections but doesn't seem to make them dispositive.
A list of non-dischargeable debts may be found in 11 USC sec. 523, and it does include child support.
Being over the median income doesn't force you to file a Ch. 13; the relevant section is 11 USC sec. 707(b). But being below the median income makes a forced Ch. 13 much less likely and forbids creditor from demanding it (see paragraph 6).
Thanks. The site is up now.
I have handled more than 10,000 bankruptcy cases over the past 25 years as a bankruptcy trustee. I also, occassionally represent debtors.
It is difficult to tell to what extent job loss or medical debt is the primary cause of a bankruptcy because when people lose their jobs they use their credit cards to survive. They use their credit cards for prescription drugs, doctor bills and other medical expenses.
Although personally I am adverse to debt (perhaps an occupational hazard) I will admit at times I felt that debtors should have been given a pin when they filed for supporting the consumer economy.
Remember that this country was first populated, to some extent, by people who were escaping from debtor's prisons. The power to establish bankruptcy laws is given to Congress under the Constitution.. Bankruptcy is as American as apple pie.
Sure some people abuse the law. There is hardly a law that is not abused by some. But have some compassion. The banks have made a fortune off of credit cards despite the bankrupties by charging fees and interest rates that are immoral if not illegal.
A consumer based economy needs an release valve. Without a legal remedy people may eventually give up in despair and turn to alternatives which would be worse for society.
A little clarification of bankruptcy terms - Zaleriana refers to cramdown, but what was meant is called "stripdown."
A cramdown is a term most frequently used in Chapter 11 cases referring to a plan that is confirmed over creditor objections. Technically, chapter 12 and 13 plans are all cramdown plans because the need only conform with certain statutory requirements to be confirmed. In Chapter 11, a plan must be voted on and be accepted by creditors unless -- and this is the cramdown provision -- the judge finds that the proposed plan is in the best interest of creditors (meaning that they get more than they would if the debtor was liquidated) and that no creditor in any class gets paid anything until all creditors in all higher classes are paid in full.
The stripdown provision acknowledges the reality of declining-value collateral that secures a loan. The paradigm for this situation is the car loan. Shortly after a loan on a new car is initiated, the car starts declining in value, to the point where the loan balance (assuming a minimum down payment) exceeds the value of the car. If there is no bankruptcy, the lender repossesses the car and sells it. What the lender recovers on the loan is whatever it can get for the collateral. While the lender could sue the borrower for the deficiency, it almost never happens because there's minimal likelihood of recovery, and the cost would exceed the amount.
The Bankruptcy Code, as written in 1979, recognized this fact of life, and provided that an undersecured creditor's claim would be split into two parts: a secured claim for the market value of the collateral, and an unsecured claim for the balance. If a debtor wanted to keep the collateral, the secured claim had to be paid in full; the unsecured balance would be paid whatever all the other unsecured debt would be paid (zero, in the case of the majority of individual Chapter 7 cases). This was called "stripping down" the undersecured creditor.
The 2005 revisions eliminated the ability of individual debtors to strip down their undersecured creditors. Now, if a debtor wants to keep the car (or TV set, or sofabed, or whatever), they must pay in full.
There is a philosophical tension here. The social-justice types ask why the undersecured creditor should get a windfall in bankruptcy by getting paid more than they'd make by repossessing and selling. The personal-responsibility types ask why the individual should get to keep the goodies yet pay less than they agreed to.
However, what I find interesting about this is why, if the '05 reforms were supposed to promote responsibility, they didn't eliminate the stripdown for corporate debtors. In other words, if SkyHigh Airlines files a chapter 11 and its planes are worth less than it owes on them, it can strip the lenders down in its plan, in exactly the way that Sally, a SkyHigh flight attendant who just got laid off, can't do on her car loan.
Ooops. There was one other point I was going to mention - As originally written, the Bankruptcy Code didn't permit the stripdown of debts secured by real property that was the debtor's principal residence; a policy decision by Congress to protect the morgage industry.
The mortgage relief bill now in Congress proposes allowing mortgages to be stripped down to market value, which is why the banking industry is in a frenzy about it. Don't blame them, what with some pundits predicting a 20% decline in housing values in the next few years; having to write down the value of your mortgage book by 20% would be a horrible hit for a bank.
In other words, if SkyHigh Airlines files a chapter 11 and its planes are worth less than it owes on them, it can strip the lenders down in its plan, in exactly the way that Sally, a SkyHigh flight attendant who just got laid off, can't do on her car loan.
Sally is technically eligible for Chapter 11 if she likes. 11 USC sec. 109(d)
You wrote, "And there was evidence of strategic behavior by some borrowers--but only a lunatic would lend money that they were sure wouldn't be repaid."
Really? I agree that it is dangerous behavior, but it has been engaged in by the credit card industry for years, ever since they realized that they could earn record short-term profits by cranking interest rates and penalties while lending to poorer and poorer borrowers (and I mean that in both the economic and credit sense.) You can see the complete interest rate explanation here.
Now that the mortgage meltdown has laid bare the same sort of reckless behavior in the mortgage-backed securities industry (that is, trading long-term risk that principle won't be repaid for short-term reward that you pocket now) can anyone fail to understand that creditors bear the greater responsibility for reckless borrowing--and have the best ability to prevent it? We don't want to stop irresponsible borrowing: the entire American economy is now dependent on it.
As for corporate bankruptcy being somehow "different" in kind, the owners of First Magnus, a large mortgage company that recently declared bankruptcy and laid off 6,000 employees without paying them what was owed, have recently started a new mortgage company. Meanwhile, those employees are struggling to survive, searching for jobs (and health insurance), and we call them "deadbeats."
can anyone fail to understand that creditors bear the greater responsibility for reckless borrowing--and have the best ability to prevent it?
I fail to understand it. Nobody makes you borrow if you don't want to. They simply make it possible.
Meanwhile, those employees are struggling to survive, searching for jobs (and health insurance
I suppose it's out of bounds to suggest that they work for the new mortgage company? They're still getting screwed out of their old paychecks, but at least they'd have jobs again.
And I'm not sure exactly what you'd favor in the corporate bankruptcy context; the owners lose their entire investment, lots and lots of creditors lose, so what exactly do you think is supposed to happen? Manna from heaven? If the money's not there, it's not there.