Balancing the Bankruptcy Laws:
High Rate Credit Card Lending Leads to High Bankruptcy Filing Rates

Testimony of the National Consumer Law Center Before a Joint Committee of the Senate Judiciary Committee Subcommittee on Administrative Oversight and the Courts House Judiciary Committee Subcommittee on Commercial and Administrative Law, Gary Klein, Senior Attorney, March 11, 1999

Introduction

Mr. Chairmen and members of the Joint Committee, on behalf of our low-income clients, the National Consumer Law Center⁽¹⁾ thanks you for inviting us to testify today regarding consumer bankruptcies and their impact on the banking system.

There is a great deal of misinformation circulating about the increase in bankruptcy filings and purported abuses in the system. The reality is that more debtors use the bankruptcy system because more debtors are having serious financial problems. American families increasingly face foreclosure, repossession, utility shut-off, wage garnishment and extensive collection activity on unsecured credit card debt. In short, more American families are using the bankruptcy system, because more American families are having trouble paying their debts.

My testimony will focus on four questions:

Why more filings?

Does the lending industry share responsibility for consumer financial hardship and the increase in bankruptcy filings?

Are substantial costs of bankruptcy passed on to non-bankrupt consumers?

Are the amendments captured last year in the Conference Report (H.R. 3150) and reintroduced this year as H.R. 833 fair and balanced?

I. What Has Caused the Increase in Filings?

The fact that more bankruptcies are being filed is not evidence, in itself, that debtors are abusing the system. The reality is that more cases are filed, because more American families are faced with crushing debt. There is much more consumer credit outstanding than ever before. With the additional extension of credit, comes additional risk. (See the Case Study in the Appendix for a typical example of an American family forced to file bankruptcy because of the convergence of consumer debt, job loss and divorce.)

The increase in bankruptcy filings is an unfortunate consequence of several significant structural changes in the American economy. These changes have combined to create a rise not only in bankruptcy, but also in foreclosures,⁽²⁾ repossessions, utility disconnections⁽³⁾, credit card defaults⁽⁴⁾ and visits to consumer credit counseling agencies.⁽⁵⁾ Nevertheless banks continue to record profits, fueled in large part by credit card income.⁽⁶⁾

These are the factors which have contributed to the increase in filings:

Downsizing, economic dislocation, income disruptions, and underemployment. Families are increasingly impacted by instability in employment income, particularly at the lower end of the wage spectrum.⁽⁷⁾ Although unemployment remains low, many workers file bankruptcy after being forced to shift to lower paying jobs. A surprising statistic, based on data compiled by Visa and MasterCard, is that no more than 29% of bankruptcies are caused by overspending. The balance of filings are caused by other life events over which consumers have little or no control.⁽⁸⁾

Rising debt to income ratios. More families have more debt. Part of the reason for this is that the lending community has aggressively marketed credit card debt,⁽⁹⁾ because it profits from the very high interest rates. Another factor is the unprecedented increase in the cost of education and the corresponding increase in student loan debt.⁽¹⁰⁾ One family in six below $25,000 in annual income, spends more than 40% of its income on debt service.⁽¹¹⁾

Reliance on two wage earners to make ends meet. This change in a fundamental condition of the economy means that every family has double the risk. With two wage earners vulnerable to income instability, any change for either one creates enormous pressure on the family budget. Child-bearing and time off to raise children mean that a family which was getting by on two incomes is forced to rely on only one.

Rising divorce rates. A corollary of the latter factor is that when a family splits up, the pressure of running a household with less total income is impossible. Bankruptcy debtors are disproportionately single parents.⁽¹²⁾

Uninsured medical debt. At a time when a two day stay in the hospital to deliver a baby can cost as much as $20,000, the uninsured have virtually no options to manage medical debts.⁽¹³⁾ Bankruptcy has played an increasing role as the only way out.⁽¹⁴⁾

Aggressive Creditor Collection Action. Wage garnishments, debt collection by aggressive telephone calling, and pursuit of legal remedies push many families into bankruptcy.⁽¹⁵⁾ Few debtors can afford to pay an attorney to defend against a debt collection or wage garnishment action even when they have valid legal defenses.⁽¹⁶⁾ Many bankruptcy filers report that their attempts at non-bankruptcy payment arrangements were rebuffed.

Deregulation. As rates and terms of credit have been deregulated, an increasing number of American families have gotten credit on bad terms.⁽¹⁷⁾ High rate home equity loans, credit card interest rates exceeding 18%, and consumer fraud tied to credit are frequent contributing causes of bankruptcy.⁽¹⁸⁾ As some borrowers are increasingly pushed into "sub-prime" loans at high rates, the bankruptcy system is at the fulcrum of a "chicken and egg" problem. Are high risks justifying high rates, or are the high rates causing defaults which generate risk?⁽¹⁹⁾

More Credit Means More Bankruptcy. The clearest correlation of bankruptcy cause and effect is between the increase in the amount of credit outstanding and the number of filings. The number of bankruptcies and the total amount of consumer debt in our society have moved upward together in lockstep.⁽²⁰⁾ It is not surprising that as more Americans borrow more money, more families have financial troubles.

II. Does the Lending Industry Share Responsibility For Consumer Financial Hardship and the Increase in Bankruptcy Filings?

The reasons for the increase in bankruptcy filings are complex. Although banks and other lenders are correct in pointing out that they are not entirely to blame, it is disingenuous of them to assert that they should not bear some responsibility, at least to the extent of their own conduct.

Credit solicitations and other forms of marketing are designed to encourage consumers to rely on credit. Much of the marketing is done to people who once would have been considered unacceptably high risk. Due to high interest rates, the lending community has discovered that it profits when people get in over their heads so that they cannot pay their balance in full each month.⁽²¹⁾ This generates remarkable profits for banks. However, it also makes consumers vulnerable even to small life problems which can put them over the edge.

Every American family has a budget which represents a fixed pie. The 55 to 60 million households that carry a credit card balance from month-to-month have an average balance of $7,000 and pay more than $1,000 per year in interest and fees.⁽²²⁾ And, of course, the families that wind up in bankruptcy are almost always on the high side of average in their debt-load and the low side of average in income.⁽²³⁾

Are consumers at fault for using the credit which is marketed to them? Of course not. Millions of American families are not irresponsible. They are simply using the credit offered to them for the purposes for which it is offered. Families don't go out and borrow $7,000 on a credit card all at once. They make small purchases over a period of time, and make the minimum payments which the lender requests. Few consumers understand that making only the minimum payments means that their balance will grow and payments will take an ever larger piece out of their monthly budget (at 18% interest or higher) for debt service.⁽²⁴⁾

Congress should not enact legislation which undermines effective bankruptcy relief for struggling families. Some reform is necessary, but that reform should be balanced and should help consumers avoid the credit problems which contribute to bankruptcy.

We do not advocate that creditors make less credit available to low and moderate income consumers, but rather that consumers have the tools and information they need to use credit wisely. Appropriate consumer protections designed to reinforce the lending community's obligation to employ responsible credit practices include:

• enhanced disclosure to consumers about the consequences of making minimum payments,⁽²⁵⁾
• enhanced disclosures concerning teaser rates of interest,⁽²⁶⁾
• protections against unilateral interest rate increases which are unrelated to a change in the lender's cost of funds,⁽²⁷⁾
• prohibition of unilateral credit limit increases,⁽²⁸⁾
• prohibition of security interests based in credit card agreements,⁽²⁹⁾
• protection against so called "cashed check loans,"⁽³⁰⁾
• prohibition of credit card cash advance machines in casinos,⁽³¹⁾
• prohibition against making credit cards available to persons such as students who have no present ability to make more than nominal payments,⁽³²⁾ and
• reregulation of interest rates.⁽³³⁾

If lenders choose to resist legislation to address these problems for consumers, they ought not be heard to complain about the bankruptcies which are the inevitable result. Industry consultants estimate that credit card companies could cut their bankruptcy losses by more than 50% if they would institute minimal credit screening.⁽³⁴⁾

III. Are Substantial Costs of Bankruptcy Passed on to Non-Bankrupt Consumers?

A. Is the system failing to recapture money which debtors can afford to pay?

Nobody likes to be owed a debt which is not paid back. Yet our society has a system of debt forgiveness which has roots in the Bible.⁽³⁵⁾ Forgiveness and a fresh start have always been a part of that system.⁽³⁶⁾

A family's ability to repay its debts is limited by its income. Data shows that Americans in bankruptcy are far poorer than their non-bankrupt counterparts. The median after-tax income of a family in chapter 7 bankruptcy is under $20,000, or approximately half the national median.⁽³⁷⁾

The credit industry has focused substantial resources on attempting to show that despite this relative poverty, there are many families who are obtaining a bankruptcy fresh start even though they can afford to pay. Based on this assumption, they would set up a system in which some debtors are forced into payment plans.

However, if such plans are not entered voluntarily by the debtor, they have little chance of success, absent extensive and impracticable coercive mechanisms. For this reason, forced participation in payment plans has consistently been rejected by Congress and the two most recent government-sponsored commissions which have studied bankruptcy.⁽³⁸⁾

Apart from this procedural difficulty, there is no empirical evidence which shows that debtors can afford to pay. In 1989, Professors Sullivan, Warren and Westbrook published the results of an evaluation of a substantial statistical database and concluded:

The overwhelming majority of Chapter 7 debtors --90% by any measure-- could not pay their debts in Chapter 13 and maintain even the barest standard of living. ... A new bankruptcy regime that invested more time to find and to investigate the potential can-pay debtors would prompt only a small amount of new repayment. This is the classic case in which a policy maker asks if the game is worth the candle.⁽³⁹⁾

The creditor industry's own study released last year,⁽⁴⁰⁾ purporting to show the opposite, has been severely criticized by the General Accounting Office.⁽⁴¹⁾ Once the credit industry study's results are adjusted to take account of the GAO critique, it shows that only about 5% of debts could be repaid by debtors -- if they undergo five year repayment plans.⁽⁴²⁾ This means that the creditor's own study ultimately shows that bankruptcy debtors can afford to pay about a penny on the dollar per year. That result was supported recently by a study funded by the American Bankruptcy Institute showing that only 3% of chapter 7 debtors can afford to pay back their debts in a hypothetical chapter 13 plan.⁽⁴³⁾

Outside bankruptcy, no reasonable creditor would spend more than a penny to collect a penny. Proposals to require five year payment plans for many more debtors have a heavy price tag, including costs of administration and monitoring, costs to resolve disputes about capacity to repay, and costs of collecting and distributing payments.

Either the taxpayer would have to fund these costs, or if they are debtor funded, they will reduce the receipts available to creditors in a repayment plan. If taxpayer funded, every American would be helping banks and other creditors collect their one cent per dollar per year. If debtor funded, the one cent per dollar per year repayment capacity of debtors is even further reduced.

Finally, requiring five year repayment plans would have enormous social and human costs. People use the bankruptcy system for many legitimate reasons. If navigating the system is made more difficult, and if a meaningful fresh start is denied when some cases inevitably fail,⁽⁴⁴⁾ more debtors would be left with the burden of unmanageable debts.⁽⁴⁵⁾ Loss of homes, repossessions, wage garnishments, utility shut-off and family stress associated with unmanageable debts would be the inevitable result. While these social and human costs of denying chapter 7 relief to debtors may be difficult to quantify, they nevertheless remain an important part of the relevant equation.

B. Are losses associated with bankruptcy being passed on to other better off consumers in the form of higher interest rates?

The banking industry has claimed that it is losing 40 billion dollars each year to the bankruptcy system and that it is passing those costs on to consumers at the rate of $400 per family.⁽⁴⁶⁾ These numbers are ridiculous. Families may be discharging debt in bankruptcy, but the creditor's own study, discussed above, shows that these are not debts which consumers can afford to pay.

In reality, the lending community is scapegoating the bankruptcy system for losses associated with bad loans. The vast majority of debts which are discharged in bankruptcy would have been written off if no bankruptcy had intervened. The only impact of bankruptcy is that it gives debtors a legally enforceable fresh start -- the same second chance which has been guaranteed since Biblical times.

Equally important, there is no evidence that lenders would reduce rates on unsecured consumer lending if they could avoid bankruptcy losses. Between 1980 and 1992, the federal funds rate at which banks borrow fell from 13.4% to 3.5%. Nevertheless, credit card interest rates actually rose.⁽⁴⁷⁾ How likely is it that other types of savings, if any could be realized, would be passed on to consumers rather than investors?

To a large extent, the bankruptcy "problem" is nothing but a "bad loan" problem. It could be fixed if lenders were more closely attentive to underwriting. For the most part, the lending community has chosen not to take this step. The present interest rate environment has taught lenders that substantial profits can be made from extending credit to risky borrowers, such as college students. However, in exchange, the banking community must accept that it is reaching some borrowers who cannot afford to pay.

IV. Are the Amendments Captured Last Year in the Conference Report (H.R. 3150) and Reintroduced This Year as H.R. 833 Fair and Balanced?

The bankruptcy system established in 1978 has been remarkably efficient. It provides critical relief to financially troubled American families at a low cost to taxpayers. Over the years, many open issues under the bankruptcy law have been resolved by court decisions and carefully crafted Congressional amendments.

To the extent the increase in the number of bankruptcies suggests that there are problems in the consumer lending system, responsibility for fixing those problems must be shared between consumers and lenders. Congressional reform, if any, should be balanced and narrowly targeted at abuses by both debtors and creditors.

It would be a mistake to enact reforms without addressing reckless lender conduct which pushes people into bankruptcy. Offering additional credit, for example, to families already struggling to pay their debts hurts not only borrowers, but also the borrowers' honest creditors if the new credit pushes the family over the edge. Similarly, failure by one creditor to seriously consider payment arrangements outside bankruptcy for families facing hardship may lead to a bankruptcy filing which affects all creditors.

To the extent there has been a focus on debtor misconduct, the burden of proof remains on the credit industry. To date it has not been met. Simply saying that more people are using the system, is not proof that people are misusing the system.

Some observers ignore the fact that the present system already has a variety of protections which are designed to effectively root out abuses by debtors. These include: Rule 9011,⁽⁴⁸⁾ objections to discharge,⁽⁴⁹⁾ complaints to determine dischargeability,⁽⁵⁰⁾ good faith requirements,⁽⁵¹⁾ Rule 2004 examinations,⁽⁵²⁾ creditors' meetings,⁽⁵³⁾ dismissals for substantial abuse,⁽⁵⁴⁾ and criminal sanctions.⁽⁵⁵⁾ Indeed, it is unclear why the creditor community does not believe that the small number of cases where significant repayment appears possible are not resolvable under the "substantial abuse" test of 11 U.S.C. 707(b).⁽⁵⁶⁾ Perhaps additional tightening of this provision would make it work better.

An additional set of balanced reforms may be appropriate as long as they do no harm to the majority of honest debtors who urgently need help. Provisions should be narrowly targeted to address debtors who truly are abusing the system without affecting lower income debtors who would be hurt by having to litigate additional issues. Creditors should not be allowed to obtain leverage by forcing new litigation on consumers who cannot afford to pay the costs of defending.

Appropriate reforms should also create incentives for debtors to use a repayment plan option in bankruptcy in order to repay their debts. Significant actions could be taken to make the costs of those plans more manageable and to enhance outcomes for debtors who complete plans.⁽⁵⁷⁾ Provisions in H.R. 833 which limit stripdown related to automobiles and personal property and which require debtors in chapter 13 to litigate many new dischargeability issues will undermine chapter 13 rather than reinforce it.

Finally, the system should penalize dishonest creditors. These include creditors whose actions push people into bankruptcy and those who take advantage of debtors after they file by coercing inappropriate reaffirmation agreements.

Honest and careful creditors should always be paid before abusive debt collectors, lenders that encourage gambling in casinos, predatory second mortgage lenders, and lenders who are unreasonable in refusing to accept non-bankruptcy payment plans. Lenders whose actions violate the bankruptcy laws should be subjected to meaningful and straightforward penalties.

Conclusion

The lending community should not be allowed to scapegoat the bankruptcy system for lending decisions which result in bad debt. The right to participate in the bankruptcy system should require honesty not just on the part of debtors, but also by creditors. No legislative action should ignore the significant hardships of the millions of American families who are overwhelmed by debt.

Appendix

Case Study

Mrs. M is a 39-year old mother of three children, two of whom are living at home. Her financial problems started in 1994 when her husband lost his job in construction. Since that time, he has been underemployed; his earnings have declined from an average of $52,000 annually between 1990 and 1993 to an average of $26,000 between 1994 and 1997. Starting in 1994, the family's primary income has been $30,000 which Mrs. M earns as an administrative assistant at an insurance company. Mr. and Mrs. M have struggled successfully to maintain payments on a home they bought in 1987 since their financial problems began in 1994.

Mr. and Mrs. M have also had significant credit card bills since the late 1980's. Despite their financial problems, they avoided default on those debts by making minimum payments between 1994 and 1997. However, the total amount of their credit card debts increased from about $11,000 in 1994 to about $29,000 in 1997, largely due to the accumulation of interest at an average annual rate of 17.5%.

In 1997, Mrs. M's financial problems worsened, because Mr. M moved out of the family home. An additional strain was created because Mrs. M attempted to provide financial help to her oldest daughter who began her first year of college. In family counseling, Mr. and Mrs. M acknowledged that their marriage was breaking up largely because of the constant pressure of financial problems and Mr. M's continuing inability to find steady work.

Mrs. M attempted to make payment arrangements with her credit card lenders so that she could focus on her mortgage obligation. She was told that no payment arrangements were possible and that she should "borrow money to pay off the debts." Mrs. M went to consumer credit counseling where she was advised that her budget did not support any payments on credit cards. She was advised to consider chapter 7 bankruptcy in order to eliminate the credit card debts so that she could maintain her payments on the mortgage.

In September 1997, Mrs. M obtained advice from a bankruptcy lawyer and reluctantly filed bankruptcy. She will discharge approximately $35,000 in unsecured debts. She will reaffirm and continue to make payments on her mortgage and car loan -- totaling $1,320 monthly.

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