Financing their champagne tastes

Insight on the News, March 9, 1998 by Keith Russell, David Wagner

Although most Americans are enjoying sound financial health, personal bankruptcies are plaguing the country, with more than 1 million filings in 1997. What is the cost to the U.S. economy?

The bullish U.S. economy is rumbling along, the Dow Jones industrial average is sitting at an all-time high, unemployment levels are at 30-year lows and Republicans and Democrats are bickering about what to do with surpluses in the federal budget. From Wall Street to Main Street, Americans never have been more financially secure.

Some Americans, that is. In fact, bankruptcy filings also have risen to record levels: more than 1.3 million in 1997, according to the American Bankruptcy Institute. That is a sixfold increase since 1980, a year of hyper-inflation in which more than 200,000 Americans sought refuge from creditors in the nation's bankruptcy courts.

As a result, moves are a foot in Congress to curb bankruptcy filings by various means, including limiting the use of the Bankruptcy Code's Chapter 7 (which offers a total discharge of debt) in order to divert consumer debtors instead to Chapter 13 (a repayment plan). The key mechanism would be a means test: If you have the ability to pay off at least some of your debts, you would have to proceed under Chapter 13, not the more debtor-friendly Chapter 7.

Historically, the number of bankruptcies surge and decline in inverse relationship to the economic times. When times were bad, it was not unusual to see a sharp increase in filings, says Pennsylvania Republican Rep. George Gekas, chairman of the House Judiciary subcommittee on Commercial and Administrative Law. "Other than the last two decades, we only see `spikes' in the number of bankruptcy filings during times of recession -- which makes sense. During difficult times it's always tougher to make ends meet," Gekas said at a recent press conference.

There is general agreement that the long-term trend for bankruptcies is upward. "Each peak rises further, while each trough is shallower," notes Michael J. Herbert, a bankruptcy scholar at the University of Richmond's T.C. Williams School of Law, in his 1995 textbook Understanding Bankruptcy.

But with the economy sailing full-speed ahead, why are more and more Americans filing for bankruptcy? "It's a pretty complex issue," says Lynn Sprang, who speaks for the American Financial Services Association, or AFSA, a trade group that represents big credit lenders such as General Motors Acceptance Corp., Ford Motor Credit and GE Capital. While big credit corporations complain that the bankruptcy system is too lenient and has transformed what used to be a debtor's last resort into a perverse form of "financial planning," advocates for debtors say abuse is highly exaggerated and that creditors have no one to blame but themselves for making shaky loans.

Nor is there agreement on how much the added bankruptcies are costing the economy. According to a recent study by the University of Pennsylvania's Wharton Econometric Forecasting Associates, or WEFA, bankruptcies cost the U.S. economy $44 billion in cancelled debt last year and could cost $220 billion by 2000 -- a little more than $400 per year for the average U.S. household. Put in perspective, that's "five weeks' worth of groceries or 20-plus fill-ups at the gas pump to me," Gekas says.

Skeptics, including Gary Klein of the National Consumer Law Center, say studies such as that by WEFA are flawed. "It assumes that all debts that are discharged under bankruptcy would automatically be collected by creditors," which isn't the case. Most of that debt would have been written off anyway, Klein claims, so WEFA's calculations are inflated.

But as William P. Binzel, a vice president at MasterCard International, notes: "Debts discharged in bankruptcy don't disappear -- they get passed on to consumers in the form of higher interest rates. Any lessening of that transfer is in the public interest. "

At the same time, as often is the case when influential industries embrace regulation, bankers who helped write these banking laws may have ulterior motives. "Assessing who is able to pay partly and who isn't and who should go Chapter 13 and who should go Chapter 7 is a costly process," explains Bernard Trujillo, a bankruptcy scholar at the University of Wisconsin Law School. "The credit industry would like to transfer to the public, through the court system, the costs occasioned by its overextension of credit."

Meanwhile, concern about increased bankruptcy filings in a time of general prosperity has caught the attention of enough lawmakers on Capitol Hill to set the stage for the first real reform of the bankruptcy code since 1978. Three years ago, Congress tried to take a tentative first step, forming the National Bankruptcy Review Commission to look into the problem. Last October, the nine-member panel released its recommendations to Congress in a report that included a number of suggested safeguards to protect debtors against creditors wishing to block the discharging of debts owed them.