Consumer Bankruptcy in the Balance: Providing an Effective Safety Net for Overwhelmed Famililes

Testimony of the National Consumer Law Center before the Committee on Banking, Housing, and Urban Affairs Subcommittee on Financial Institutions and Regulatory Relief, by Gary Klein, Staff Attorney, February 11, 1998

Introduction

Mr. Chairman and Members of the Subcommittee, on behalf of our low-income clients, the National Consumer Law Center¹ 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?
• Can the system efficiently capture more money for creditors?
• Are substantial costs of bankruptcy passed on to consumers?
• What reforms to the system are necessary?

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 foreclosures² , repossessions, utility disconnections³ , credit card defaults⁴ 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.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 means 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?
• 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.¹⁹ It is not surprising that as more Americans borrow more money, more families have financial troubles.

These 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 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.²⁰ This generates remarkable profits for banks. However, it also makes consumers vulnerable even to small life problems which can put them over the edge.

Appropriate consumer protections designed to address the lending community's responsibility to make good lending decisions might include:

• enhanced disclosure to consumers about the consequences of making minimum payments,²¹
• enhanced disclosures concerning teaser rates of interest,²²
• protections against unilateral interest rate increases which are unrelated to a change in the lender's cost of funds,²³
• prohibition of unilateral credit limit increases,²⁴
• prohibition of security interests based in credit card agreements,²⁵
• protection against so called "cashed check loans",²⁶
• prohibition of credit card cash advance machines in casinos,²⁷
• prohibition against making credit cards available to persons such as students who have no present ability to make more than nominal payments,²⁸ and
• reregulation of interest rates.²⁹

Some of these provisions are in a bill which has been filed in the House of Representatives.³⁰ If lenders choose not to address these problems themselves, they ought not to complain about the bankruptcies which are the inevitable result.

II. If We Can't Stop American Families From Filing Bankruptcy, Can We Redesign the System to Make Them 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.³¹ Forgiveness and a fresh start have always been a part of that system.³²

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 income of a family in chapter 7 bankruptcy is approximately half the national median.³³

The credit industry has focused substantial resources on showing 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 debtors are forced into payment plans.³⁴

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.³⁵

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.³⁶

The creditor industry's own study released last year³⁷ , purporting to show the opposite, has been severely criticized by the General Accounting Office³⁸ . 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.³⁹ 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.

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,⁴⁰ more debtors would be left with the burden of unmanageable debts.⁴¹ 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.

III. Are Consumers Paying the Cost of The Current Bankruptcy System?

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. These numbers are utter nonsense. 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 the bankruptcy case 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.⁴² How likely is it that other types of savings, if any could be realized, would be passed on to consumers?

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. What Should Be Done?

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.

Although we do not agree in many respects with the Report of the National Bankruptcy Review Commission, that commission did important work, at Congressional behest, which should be treated seriously by Congress. The Bankruptcy Review Commission heard from hundreds of witnesses on consumer bankruptcy over the course of its work.⁴³ Most of the neutral witnesses, judges, law professors, economists, and bankruptcy trustees have recommended and continue to support balanced reforms rather than enactment of a creditor's wish list. The majority report of the Review Commission is reasonably balanced and a good start for Congressional consideration.

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 9011,⁴⁴ objections to discharge,⁴⁵ complaints to determine dischargeability,⁴⁶ good faith requirements,⁴⁷ Rule 2004 examinations,⁴⁸ creditor's meetings,⁴⁹ dismissals for substantial abuse,⁵⁰ and criminal sanctions.⁵¹ 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).⁵² Most of the anecdotal evidence of abuse which exists arises not because the system is broken, but rather because these provisions have been effective in bringing the abuse to light.

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.⁵³

Appropriate reforms would also do more to 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.⁵⁴

Additionally, the system should penalize dishonest creditors whose actions push people into bankruptcy. Honest creditors should be preferred to abusive debt collectors, lenders that encourage gambling in casinos, high rate 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.

Radical change has the potential to undermine the economy by changing the fundamental balance between debtors and creditors. Concerns about the health of the banking system are unwarranted during this period of record bank profits. No legislative action should ignore the significant hardships of the millions of American families who are overwhelmed by debt.

Appendix