Response to Senator Torricelli's Follow-up Questions to the Senate & House Joint Hearing on Bankruptcy Reform

Gary Klein
Staff Attorney
March 23, 1999

Question: We have been told in the past that there is a difference between provisions that are "debtor friendly" and those that are "consumer friendly". For example, some people have argued that provisions protecting the fresh start for honest families work hardship on other consumers who never file for bankruptcy. And, on the flip side, we have been told that by restricting debtors' rights, we will make the price of credit, goods and services cheaper for nonbankrupt consumers. As an advocate of both debtors and of consumers, can you comment on whether this distinction is real? Are the interests of bankrupt debtors and middle class consumers conflicting?

Response: No. Organizations that represent consumers [National Consumer Law Center, Consumer's Union, and Consumer Federation of America]⁽¹⁾ unanimously believe that proposed bankruptcy legislation is among the worst bills for consumers offered in the past 20 years. Only the credit industry calls this bill "consumer friendly".

Explanation: Bankruptcy cannot appropriately be blamed for credit industry losses that are passed on to consumers. All parties concede that the vast majority of debts written off after bankruptcy couldn't have been cost-effectively collected if bankruptcy had not intervened. "Bankruptcy losses" are really just "bad loan" losses. The problem for consumers is that the credit industry is too aggressively marketing loans to consumers that can't afford to pay their balance in full each month. The industry does this because, in the aggregate, those loans are profitable. 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. The unpublished credit industry-funded report which served as the basis for this claim has been criticized by the GAO for lack of analytical rigor.⁽²⁾⁽³⁾

Families may be discharging debt in bankruptcy, but all of the relevant empirical work, including the creditors' own studies, agrees that the debtors involved can not afford to repay those debts. Most recently, a study released by the American Bankruptcy Institute showed that only 3% of chapter 7 debtors can afford to pay back their debts.⁽⁴⁾⁽⁵⁾ A recent Ernst & Young study (funded by Visa) concludes that bankruptcy debtors can afford to pay back 10 billion dollars in debt, but they reached that conclusion only by including secured debt, non-dischargeable debt, and reaffirmed debt which is not discharged in bankruptcy and which must be repaid by chapter 7 debtors in any event.

In reality, the lending community is scapegoating the bankruptcy system for losses associated with its bad loans. If no bankruptcy system existed, it would likely cost the credit industry two dollars in collection costs for every additional dollar generated from the overwhelmed consumers that that now get relief in bankruptcy. The bankruptcy bill is, in part, an attempt to pass these collection costs on to taxpayers. The problem could be fixed if lenders were more closely attentive to underwriting. Industry consultants estimate that credit card companies could cut their bankruptcy losses by more than 50% if they would institute minimal credit screening.⁽⁶⁾⁽⁷⁾ They choose not to make that effort because high-rate credit card lenders profit, in the aggregate, by finding borrowers that cannot afford to pay their balances in full each month. Since most of that debt is repaid at high rates, the industry profits despite increasing defaults and the attendant hardship to families. There is no reason to think that any savings to lenders which would result from tightening the bankruptcy laws would be passed on to consumers. 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.⁽⁸⁾⁽⁹⁾

How likely is it that savings realized from changes in the bankruptcy law, if any, would be passed on to consumers rather than investors? Bruce Hammond, Chief Operating Officer of MBNA Corporation conceded this point at the joint hearing in which I participated. There is evidence that excessive tightening of the bankruptcy laws would actually increase credit card defaults and credit card losses, because lenders would be able to make more loans to risky borrowers. Ausubel, "Credit Card Defaults, Credit Card Profits and Bankruptcy", 71 Am. Bankr. L.J. 250 (1997). This work, by a University of Maryland economist, analyzes credit card lending trends and concludes that credit card interest rates cannot be explained by market forces. In addition, Professor Ausubel concludes that pressures related to risk are important to prevent lenders from making more unwise consumer loans leading to more defaults rather than less. Non-bankrupt consumers benefit from having a viable, effective and cost-efficient bankruptcy system in case something goes wrong in their lives. Every American is vulnerable to financial problems related to job loss, illness, death of a bread winner and a myriad of other circumstances beyond their control. Even former Treasury Secretary John Connally was forced by circumstances to file bankruptcy. The fundamental reality is that the bankruptcy system serves as insurance when unexpected financial problems strike. Although there is no proof of a connection between the bankruptcy law and interest rates, (and some proof to the contrary), even if there were proof, American consumers can and should be willing to pay a small premium for the safety valve inherent in a court system designed to help them during times of financial distress.

WHAT WOULD MAKE THESE BANKRUPTCY BILLS MORE CONSUMER FRIENDLY?

Do not increase opportunities for creditors to pursue litigation against indigent debtors in bankruptcy and avoid new requirements that would raise the costs and burdens of filing. There is no dispute that debtors that can afford to pay back their creditors should be made to do so. However, the means test provision is only one of 70 provisions that would affect consumer bankruptcy. The net result of the means test and these other provisions is that they would greatly increase the cost of bankruptcy and reduce its effectiveness. If the proposed legislation passes, only relatively well-off debtors will be able to afford relief in the bankruptcy system. They can hire expensive lawyers to navigate the new minefields. Most non-wealthy families will be unable to afford the system. Those few that can will be vulnerable to new creditor-initiated litigation that they cannot afford to defend. Create a balanced bill which includes new consumer protections designed to help consumers avoid over-extension on debt and bankruptcy. Credit card marketers go to great lengths to encourage people to generate big balances on their cards so that they pay more interest. Most even punish consumers facing legitimate financial problems by charging punitive late fees and by automatically doubling interest rates upon default. Any fair and balanced bankruptcy bill must include provisions designed to give consumers adequate information about the consequences of taking on on more debt. Some examples of important protection are:

Including these provisions in the bill would not just benefit consumers. Honest and reasonable creditors that act responsibly in the marketplace would also benefit, because more money would be available for consumers to repay their debts. Thank you for the opportunity to respond on behalf of consumers to this important question.

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1. Representatives of each organization have reviewed and agree with this response.

2. GAO/GGD-98-116R "The Financial Costs of Personal Bankruptcy" Letter from Associate Director Richard Stana to the Honorable Martin T. Meehan.

3. GAO/GGD-98-116R "The Financial Costs of Personal Bankruptcy" Letter from Associate Director Richard Stana to the Honorable Martin T. Meehan.

4. Culhane and White, "Means Testing for Chapter 7 Debtors: Repayment Capacity Untapped?" (American Bankruptcy Institute, 1998).

5. Culhane and White, "Means Testing for Chapter 7 Debtors: Repayment Capacity Untapped?" (American Bankruptcy Institute, 1998).

6. George M. Salem and Aaron C. Clark, GKM Banking Industry Report, Bank Credit Cards: Loan Loss Risks are Growing, p. 25 (June 11, 1996).

7. George M. Salem and Aaron C. Clark, GKM Banking Industry Report, Bank Credit Cards: Loan Loss Risks are Growing, p. 25 (June 11, 1996).

8. ⁵ Medoff and Harless, The Indebted Society, at pp. 12-13 (Little, Brown & Co. 1996).

9. ⁵ Medoff and Harless, The Indebted Society, at pp. 12-13 (Little, Brown & Co. 1996).