Bad credit: cashing in on the new bankruptcy law

Commonweal, May 20, 2005 by Mark Sargent

Remember "welfare queens"? That absurd image of black, inner-city, unwed mothers--purposely popping out illegitimate babies so that they could dine on filet mignon purchased with food stamps--strongly influenced the welfare "reform" debate and its pernicious outcome. The welfare-queen image was never an accurate description of the women who actually depended on welfare support, but it embodied precisely the type of simple-minded morality tale that too often drives social policy in this country. And it is happening again.

On April 20, President George W. Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The Act's proponents--mostly banks and large credit-card companies--conjured up the image of families of "mall rats," middle-class moms, dads, and kids hitting the malls en masse and purposely maxing out their many credit cards, knowing that they could dodge the resulting debt simply by declaring personal bankruptcy and starting afresh with a new cycle of credit. This new type of financial planning, it was argued, not only hurts the lender, but hurts us all by pushing up credit-card interest rates and fees. The remedy: Find some way to stop them before they spend again!

More precisely, the Act's remedy is to make it more difficult for individuals to declare bankruptcy under Chapter 7 of the Bankruptcy Code--under which all eligible assets are sold to pay off debt, and whatever amount can't be repaid is discharged--especially if a debtor's income is higher than the state median. In addition, the law will require many debtors to pay higher legal fees and agree to a court-ordered repayment plan under Chapter 13 rather than have their debts discharged completely in a nonjudicial proceeding. On the face of it, this seems sensible. But is it really? That depends on whether the Act has accurately identified bankruptcy "abuse" as the problem, and addressed it both equitably and effectively.

To be sure, there is a bankruptcy problem in the United States, and it is tied to the consumer-debt explosion. Between 1980 and 2004, total consumer debt grew from $288 billion to more than $2 trillion. Revolving consumer debt (mostly on credit cards) expanded from $58 billion to $800 billion. Personal bankruptcies zoomed simultaneously: 1.6 million people filed in 2004, versus fewer than 300,000 in 1980 and about 800,000 in 1990. Nationally, 1 in every 72.8 households has declared personal bankruptcy. In some states, the average is much higher. The number of working and middle-class people barely avoiding bankruptcy by juggling credit cards and home-equity loans is also enormous, though hard to quantify.

How did this happen? Did Americans simply become more greedy and irresponsible as part of a general dissolution of the national character? Was the explosion of consumer debt another manifestation of our increasingly consumerist and materialist capitalist culture? While there is a real moral dimension to the phenomenon, the explosion can be traced to concrete historical events.

In the late 1970s, state laws made it difficult for companies to offer credit cards to higher-risk borrowers, because the usury limits prohibited charging the high interest rates lenders needed to charge such borrowers to compensate for the risk of lending to them. The combination of high inflation and judicial decisions questioning the enforceability of usury limits in the late 1970s led to the demise of the state usury laws and a revolution in consumer debt. Banks and credit-card companies were freed to charge higher interest rates. They developed new techniques for managing defaults, evaluating credit-worthiness, and pricing consumer credit, and thus were able to profit from consumers who previously had been shut out of the credit market. The most profitable companies were the biggest ones (such as MBNA) because they had the economies of scale needed for national marketing, processing, and risk-bearing. This produced massive market concentration, as well as the ability to offer credit cards to more and more people. By 2003, just ten credit card lenders controlled 80 percent of the market. These megalenders became ever more aggressive and efficient in making credit available to middle- and lower-income borrowers. All of this led to predatory lending and a huge increase in so-called "sub-prime" debt, that is, debt incurred by the people least able to repay it.

Compounding the increase in credit-card debt has been an equally massive increase in home-mortgage debt--buy not principally the debt incurred to buy a home. Americans have been borrowing on their equity at a record clip, currently more than $150 billion a year in the form of home-equity loans--many of which are used to pay off higher-interest credit-card debt. The steadily increasing value of real estate has created an irresistible temptation to liquidate part of homeowners' real-estate investment and turn it into spendable cash.

Over the last twenty-five years, changes in law, credit practices, and marketing allowed ordinary people--even college students--to accumulate debts that previously would have been unthinkable. As credit availability expanded, demand was stimulated, in part intentionally and in part inevitably, until the system began to feed itself and grow exponentially. Bankruptcy filings began to burgeon, not just because many borrowers couldn't handle the debt, but because the Bankruptcy Reform Act of 1978 made declaring bankruptcy easier for the consumer.