Inflation is under control and unemployment is at a 25-year low. Corporate profits and the Dow Jones Industrial Average have, at least until recently, been soaring. Despite the spreading "Asian Flu" and the stock market's recent queasiness, many economists and politicians believe the national economy remains in fundamentally good health. So why did more Americans than ever file for bankruptcy last year?
According to the American Bankruptcy Institute, personal bankruptcy filings set new national records each year between 1984 and 1992. While in fact the economic downturn of 1991 reduced personal bankruptcies during 1993 and 1994, the number has been increasing since then, with each of the last two years setting new records. In 1997 a stunning 1.35 million Americans—one in 70 families—filed for personal bankruptcy, a 20 percent increase over 1996. The Administrative Office of the U.S. Courts recently reported that nearly 342,000 Americans filed for bankruptcy during the first quarter of 1998 alone.
Creditors argue that Americans are more likely to file for protection because bankruptcy no longer carries the stigma it once did. But those declaring bankruptcy are not, by and large, high rollers or profligate spenders. According to the Consumer Federation of America (CFA), those most likely to file for bankruptcy are lower-middle-income earners with five-figure debts. Indeed, a 1997 13-city Credit Research Center study revealed that those who declare bankruptcy are struggling to get by on low incomes: Chapter 7 debtors had aftertax annual total incomes, including spousal earnings, averaging $19,620 with average credit card debts of $17,544. Chapter 13 debtors had total net incomes, including a spouse's wages, of $26,334. Net expenses for the two groups averaged $21,150 for Chapter 7 filers and $21,336 for Chapter 13 filers.
For many low-income earners, mounting debt is the often inevitable result of simply trying to get by. Twenty-five years of stagnating wages, declining health insurance coverage, and eroding pension benefits have left many average American families just one economic setback away from bankruptcy.
While ultimately each individual is responsible for his or her own spending behavior, studies have shown that unexpected crises like job loss, divorce, or medical expenses (41 million Americans lack health insurance) contribute more to bankruptcy than simple financial profligacy or mismanagement. With this in mind, bankruptcy law has been designed to give individuals a fresh start. However, if the credit card industry has its way, many Americans will find it much harder, even impossible, to start over. What's more, a good case can be made that the biggest factor in the rise in bankruptcy has been the credit card industry, which provides the only available line of credit for many low-income people.
Credit card companies and banks now send out nearly three billion preapproved credit card solicitations annually—a number that doesn't include telemarketing, which also has increased in recent years. The CFA reports that the proportion of households with incomes of less than $20,000 that received credit card solicitations increased from 40 percent to 58 percent between 1993 and 1996. Not surprisingly, during the 1990s lower-income Americans began accumulating a larger proportion of credit card debt than those in upper-income brackets. Deregulation of interest rates that creditors can charge consumers in the early 1980s fueled the drive by credit card companies for more cardholders. As profits began rising, credit card companies began putting even more money into marketing and thus picked up many bad borrowers.
A Federal Reserve study found that median outstanding debt for families rose 15 percent between 1992 and 1995 and that 40 percent of families carried an outstanding balance on a credit card during that same period. By 1995 that number had increased to 48 percent, reflecting, according to the Federal Reserve Bulletin, "the de cline in some credit card interest rates and the intensive marketing of cards by issuers in recent years." A 1997 study by the CFA found that 55 to 60 million households each pay about $1,000 each year to float credit card debts that average more than $6,000. Federal Reserve numbers reveal that in 1996 revolving consumer credit card debt totaled almost $498 billion. By the end of September 1997, the amount of revolving consumer debt had increased by 6.4 percent in 10 months to $526 billion—about $452 billion of which incurred interest charges of nearly $63 billion in 1997.
The Cost of Bankruptcy
When unexpected or uncovered medical bills are added to credit card debt, the combination can be devastating. Take, for example, the case of Jason Lanfair, whose illness required two hospital stays and six visits to the emergency room, for a total cost to him of $57,000. Though he was employed during his ordeal, Lanfair's employer-provided policy covered only 80 percent of his total medical expenses. As he tried to pay down his medical expenses, he racked up $19,000 in nonmedical debt, including car payments and balances on two credit cards. In September 1997, he declared bankruptcy.
While it will take him ten years to restore his credit rating, he still has credit. He kept one of his old cards under the condition that interest stops accruing until he pays off the balance, after which he can use it as a regular credit card again. In addition, he received a debit card with a joint savings and checking account he opened with his partner, who has a good credit rating. After maintaining a minimum balance in the accounts for six months, he will receive a credit card. But since declaring bankruptcy, he says, "I've gotten a lot more credit card offers." By erasing his debt, Lanfair has actually made himself a better risk to creditors than he was before he went bankrupt.
Those who have declared bankruptcy may not have problems getting credit, but they won't be granted introductory low rates. Instead, they will have to pay high interest rates even to purchase large-ticket items like cars. Car dealers will charge customers who have declared bankruptcy— even those who have paid off their debt and have a positive income stream—interest rates of 18 to 20 percent on their car loans, which amounts to buying a car with a credit card. And buying a house will be even more difficult for many who have declared bankruptcy.
But what if the creditors are right? Isn't it possible that the burgeoning number of bankruptcy declarations is attributable to a change in bankruptcy laws—that is, the law became more lenient so it was easier to declare bankruptcy?
Unlikely. The law has remained largely unchanged since passage of the Bankruptcy Code of 1978—the philosophy of which was that those who wind up in debt without the means to pay it off should be given a fresh start—and the few changes to the code that have been made since 1979 have mainly favored creditors.
Under the bankruptcy code, individuals typically file for either Chapter 7 or Chapter 13 bankruptcy. Those who qualify for Chapter 7 need not pay back any of their bills, except certain types of debt that cannot be dismissed, including student loans, taxes, and spouse and child support. Beyond wiping out most debt, Chapter 7 protection also halts efforts by creditors to collect debt. Once individuals are granted Chapter 7 status, most of their property is turned over to the bankruptcy estate and sold, with the proceeds used to pay off creditors. Only certain types of property can be kept under Chapter 7; for example, an individual's assets and the exemption plans available in different states determine whether people can keep their home, their car, and other property. Chapter 13 protection—known as rehabilitative bankruptcy—requires individuals to repay a certain portion of their debt over three to five years and allows them to keep their property rather than ceding it to the courts for liquidation.
Critics charge that bankruptcy laws encourage too many people to file for and receive Chapter 7 protection. In 1984, after creditors and lenders argued that bankruptcy law caused an increase in the number of personal bankruptcies, Congress approved changes to the code, removing some of the law's protections for debtors. Yet economists who study bankruptcy say there was no connection between the enactment of the 1978 law and the increase in bankruptcy. A study by Northwestern University economists Ian Domowitz and Thomas Eovaldi, published in the Journal of Law and Economics, found no evidence to suggest the 1978 code caused more Americans to declare bankruptcy. (While filings did increase after the 1978 changes went into effect, the study concluded that business cycle conditions and demographic trends were largely responsible for the increase.)
In the end, of course, consumers determine how deeply into credit card debt they go. No one is forcing them to borrow at 18 to 20 percent annual financing rates. But low-income earners, struggling to get by, will sometimes need to borrow money; credit cards are often the easiest—and sometimes the only—instrument available. And credit card companies have done little to encourage fiscal responsibility. If they were truly interested in reducing the number of personal bankruptcies, credit card companies would tighten their standards rather than lending without hesitation to those who lack the means to repay their debt. Moreover, if ordinary bank loans—which charge about 8 or 9 percent interest—were more readily available, lower-income individuals would have more options.
Marketing strategies by creditors have increased the number of households with a credit card from 65 percent to 75–80 percent during the last ten years. These companies have encouraged the accumulation of debt by charging minimum payments that often barely offset the monthly interest charged to carry a balance. They have continually increased credit limits. In addition, credit card offers lure people in with low interest rates that are valid for a limited period—yet most of us know firsthand how quickly those rates increase. Even though this facilitation of debt accumulation inevitably attracts customers the companies will have to write off as defaulters, creditors still earn higher profits on credit cards than on any other assets. "Credit card lending is twice as profitable as all other banking activity," says Elizabeth Warren, a professor at Harvard Law School. According to Federal Reserve data, credit card banks received a 2.59 percent return on assets compared with a 1.22 percent return on assets for all commercial banks. No wonder your mailbox is always full of credit card offers.
Creditors and Congress
But if the credit industry has its way, it will become harder for consumers to escape creditors by declaring bankruptcy. Two Republican congressmen—Charles Grassley, senator from Iowa, and George Gekas, representative from Pennsylvania—are leading the push for the first major changes to bankruptcy law since 1979. Their bill, in large part the result of a reported $40 million in lobbying by the credit industry, would discourage individuals from filing bankruptcy and force more of those who do into repayment plans under Chapter 13 rather than Chapter 7 protection—although it would not change bankruptcy laws for businesses. It would also force some debtors to pay back portions of their credit card debt with interest, and it would, Grassley says, "send a message to the people who today walk away from debts that other consumers end up paying for through higher prices. That message is: 'the free ride is over.' "
Under the current bankruptcy code, nobody is excluded from filing for Chapter 7 protection, although judges can dismiss a consumer bankruptcy suit if it is deemed a "substantial abuse" of the system. Under the version passed by the House (306 to 118) in June, a bankruptcy judge would have more discretion to find individuals ineligible for Chapter 7 relief. The House bill would require the court to dismiss a bankruptcy claim or convert the claim to Chapter 13 if the court decides that an individual could repay, during a five-year repayment plan, 20 percent of the debt that would be erased by bankruptcy. (President Clinton has said he strongly opposes the House version in its current form.) The Senate Judiciary Committee passed a related bill in June, and at this writing the Senate was expected to pass the bill before the October recess. Even if the President's travails momentarily distract Congress, or if the bill unexpectedly fails to pass in its current incarnation, its sponsors have made clear that they do not plan to let the matter rest.
The current bankruptcy code prevents interested parties from filing a request to dismiss a bankruptcy claim, but the proposed legislation would allow creditors to file dismissal requests any time the debtor and the debtor's spouse have a combined income that is greater than the national median family income for their size family. If a dismissal claim is denied, a creditor would have to pay the filer's legal costs, although the average cost of declaring bankruptcy would hardly deter most large creditors from filing dismissal claims.
The House version also would prohibit individuals from receiving Chapter 7 protection if a means test determines that they have "income available to pay creditors." Typically, individuals would be ineligible for Chapter 7 if their total monthly income is at least as much as the national median income for a same-size household. Most of those earning more than that would have to file for Chapter 13 protection, even though their financial situations could hardly be characterized as sound. As a result, many needy people would never receive the fresh start the bankruptcy code was designed to provide. With debtors earning a median income of just over $17,000 a year, they will owe more than a year and a half of their income.
Yet massive lobbying by the credit industry has practically ensured that consumer concerns will not be voiced. Groups representing creditors such as the American Bankers Association and the American Financial Services Association have taken out ads that proclaim "$400! That's what every American household will pay in higher prices and higher interest rates this year because of personal bankruptcies." According to Gary Klein of the National Consumer Law Center, this estimate fails to take into account that most of the debt canceled by bankruptcy wouldn't have been paid anyway. Moreover, credit card companies plan for high default rates by charging high interest. Klein argues that the bill would "create a great deal of hardship for families and children" rather than correcting the problem, which is caused by creditors making bad loans. Worse yet, the legislation would not eliminate loopholes that allow well-off Americans in certain states to declare bankruptcy while kng expensive homes and even millions of dollars in other assets.
There are ways to help people avoid personal bankruptcy without penalizing those who wind up severely in debt. Consumer education might reduce the number of individuals who carry large amounts of debt on credit cards. The CFA recommends people keep their credit lines to 20 percent or less of their income and suggests that consumers be made aware that carrying $6,000 in debt can result in interest charges of $1,000 a year.
But more drastic measures are called for. Rather than forcing more bankruptcy filers into repayment plans they may default on, credit companies should be more prudent in extending credit to low-income individuals in the first place. For example, credit card companies could limit the credit they extend to no more than 20 percent of annual income, making it less likely that low-income earners will slide too deeply into debt. In addition, credit companies truly dedicated to fiscal responsibility could start charging minimum payments large enough to make a dent in credit card balances.
As long as monied interests are so overrepresented on Capitol Hill that even Democrats willingly tout the merits of anticonsumer legislation, large creditors will continue to prey on often hapless low-income debtors. Without bankruptcy protection, says Elizabeth Warren, lower-income people "will never ever be able to pay off their debts. Visa and MasterCard will own these people forever."
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