What’s Wrong with the Bankruptcy Reform Bill?

I asked that question of an acquaintance of mine who is an attorney working for a federal bankruptcy judge. Here is her answer:

1. There are two basic types of bankruptcy in this country: Chapter 13, which means that the individual is put on a strict, court-supervised payment plan with the goal of fully repaying creditors; and Chapter 7, which means that the court acknowledges that the debt will never be fully repaid, so that while the individual must liquidate assets and repay as much as possible, some of the debt is simply discharged by the court and taken as a loss to the creditor.

The new bill adds a “means-test” which denies access to Chapter 7 (liquidation) bankruptcy to those debtors who are deemed able to pay just $100/mo of their income to their unsecured creditors. A debtor who does not satisfy the means test for Ch 7 (i.e. the very poorest of debtors) would have to have a hearing before the court, which, incidentally, would probably swamp the bankruptcy courts.

Proponents argue that such a means test is necessary to ensure that rich individuals can not take advantage the system by declaring Ch 7 bankruptcy and thus simply having their debts written off. Yet it is already the case that every Ch 7 petition filed is screened for substantial income, and that petitions with substantial income are already either dismissed or forced into Ch 13 bankruptcy. Thus the only real contributions of this bill are to substantially lower the income barrier above which chapter 7 bankruptcy is disallowed, and to create more legal hurdles for the poorest of those in debt.

2. The new bill eliminates what we call “cram downs.” To illustrate what that is, here are facts from a typical case: a debtor owns a car that they bought in 2003. The debtor financed $10,900 over 4.5 years at 18% interest. The debtor files bankruptcy in Jan 2005 and has missed her last 3 payments. The balance owed on the car is $10,223, but the car’s value is only $7,675. Currently, the Bankruptcy Code treats $7,675 of the car loan as a secured (collateralized) debt, and allows a debtor in Ch 13 (payment plan) to pay the bank the value of the car, plus an interest of 7% (that interest rate is determined by a formula linked to the federal rate). The balance of what the bank is owed (10,223 – 7,675), however, is treated like any other unsecured debt, which would probably just get paid a few cents on the dollar. The reasoning is this: why should the bank receive payment in full – a privilege currently reserved for collateralized debt – for anything more than the value of their collateral?

The new bill would require the debtor to pay the amount owed on the car (or mobile home) in full, regardless of the actual value of the asset. This will have a Catch-22 effect on debtors. Marginal debtors will be forced into Ch 13 rather than Ch 7 bankruptcy (see above), and then, because more of their debts will required to be treated as collateralized and thus repaid in full, their court-required payments will have to be higher, increasing the likelihood that they will not have sufficient income to make those court-required payments.

3. The new bill requires mandatory credit counseling before filing bankruptcy. While I am actually not opposed to the concept of credit counseling, in reality, credit counseling agencies are generally for-profit companies and are often linked to for-profit conglomerates. These credit counseling agencies charge fees which are frequently extremely high, and don’t always provide good advice. So the bill will force people into the arms of yet one more industry that will make a profit off of the most vulnerable and financially uneducated people in society.

The bankruptcy filing rate is a symptom, not the disease. Some people do abuse the system, but there is already a method to deal with that. The vast majority of people file because of job loss, inadequate retirement savings, medical expenses, and divorce. The fastest growing group of debtors is the elderly. More than 50% of those 65 or older who file for bankruptcy do so because of medical debt. Just come to any court day of any week, and you will see the court room filled with people who depend entirely on Medicare and Social Security. In addition to the elderly, families with children will be the most hurt by this bill; the presence of children in the household increases the likelihood of bankruptcy by 302%.

If the credit card companies and sub-prime lenders are unhappy with debts being discharged in bankruptcy, maybe they should stop sending offers for credit cards with $10,000 limits to people who make $18000/yr.

The concept of bankruptcy is an important one economically, for several reasons. But one of the most important is that the threat that borrowers could become unable to repay their loans provides some discipline to lenders to ensure that they direct loanable funds to those borrowers who will best be able to use it. The threat of bankruptcy thus helps to keep capital flowing to relatively efficient uses in the economy, with all of the socially beneficial side-effects (such as higher productivity) that that entails.

This bankruptcy bill works to substantially reduce the potential losses that lenders face, and thus removes a form of market discipline on lenders. In contradiction to the claims of the banking industry that this bill will result in lower interest rates for consumers, this bill may in fact do the opposite, since it will enable lenders to make more high-interest, risky loans with reduced fear of having to absorb losses due to borrowers declaring bankruptcy. Either way, it seems that the bill will certainly add nicely to the profits of lenders, without any clear social benefit. It will unambiguously harm poor individuals, especially those who are financially illiterate. And it may make the distribution of capital in our economy less efficient. This makes for quite a list of potential accomplishments for one bill.