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                                      The economics —
                                  and politics — of reform
                                                         By Joseph S. Pomykala                        Only suckers

                                                                                                    pay their bills.
                          Ready for some big numbers? In 1998 – seven years into an economic
                          boom – one out of every 68 households in the United States filed for bankruptcy.
                          Bankruptcy filings each year are now more than double the number that occurred dur-
                          ing the entire decade of the Great Depression.
                             Are Americans becoming more inept at financial management? Are they victims of
                          the moral decay politicians and pundits preach about? It’s possible. But the root cause
                          is depressingly simple: Legal incentives make it much too attractive to shed personal
                          debt through bankruptcy.
shooting star/photonica
                                                                         The growth in credit-card lending was
         First things first. Widespread debtor dis-                   spurred by a 1978 Supreme Court ruling that
     tress seems inconsistent with the longest                       allowed banks to lend across state lines, per-
     boom and the lowest unemployment in a                           mitting them to place their offices in states
     quarter century. But in part, the paradox of                    without usury laws, and thereby evade usury
     bankruptcy amid plenty can be explained by a                    laws in their customers’ states. At higher
     fairly familiar cycle in consumer confidence.                    interest rates, banks could profitably expand
         During periods of economic growth, con-                     lending to high-risk groups. But there was a
     sumers use current economic conditions as a                     downside: Consumers could easily erase such
     proxy for their future ability to repay.                        unsecured debt through bankruptcy.
     Prosperity and optimism lead consumers to                           The democratization of consumer credit
     take more risks and incur more debts. Those                     has a parallel in the changing environment
     who guess wrong pay the price – insolvency.                     for business credit. Financial innovations and
         But when a recession hits and consumers                     expanded markets for high-yield corporate
     turn pessimistic, savings rates increase and                    debt during the 1980’s enabled firms to bor-
     they pay down debt. For example, during the                     row and expand. Similarly, the greatly
     great economic prosperity of the 1920’s, peo-                   expanded availability of consumer debt dur-
     ple threw caution to the winds and bankrupt-                    ing the last 20 years increased opportunities
     cies more than tripled. During the Great                        for consumers who could not borrow prior to
     Depression that followed, bankruptcy filings                     the lifting of state interest rate ceilings.
     actually fell.                                                      Credit-card companies were left more
         A similar cycle seems to be at work today –                 exposed, since increased personal bankruptcy
     but one that has been supercharged by                           typically obliterates unsecured debts. But
     changes in the financial system, which have                      higher interest rates on credit-card debt –
     broadened and deepened access to credit.                        now averaging 16 percent – reflects this risk
         Consumer debt has increased an average                      and compensates lenders for it. Consumers
     of 8 percent annually over the last 20 years,                   thus pay up front for their ability to discharge
     with the average family carrying $58,500 in                     debt in bankruptcy. The downside, of course,
     liabilities at mid-decade. Most of the current                  is that they cannot legally waive this right in
     debt is still in the form of residential mort-                  return for, say, lower interest rates.
     gages. But unsecured credit has grown by an                         Computerized credit scoring of applica-
     average of 14 percent annually since 1978,                      tions for loans does allow lenders to discrim-
     mainly through credit-card borrowing. Thus,                     inate between high- and low-risk borrowers.
     about 43 percent of non-mortgage consumer                       But there are practical limits to such differen-
     debt is now in the form of revolving credit,                    tiation, because of the prohibitive costs of
     compared to just 14 percent in 1978. What’s                     fuller credit investigations relative to the
     more, the median balance carried by those                       small size of unsecured loans.
     who use credit cards to borrow grew by half                         Consider a credit card company lending
     from 1992 to 1995.                                              one million consumers $2,000 each. The
                                                                     company earns, say, $300 in interest per
                                                                     account and must write off 5 percent of the
     J O S E P H P O MY K A L A teaches economics and is the asso-
     ciate director of the Center for International Business and
                                                                     loans annually. It could substantially reduce
     Management at Towson University in Maryland.                    the default rate by interviewing potential bor-

42   The Milken Institute Review
                        rowers, calling their prior employers, rating      and after filing bankruptcy…. Well publicized
                        job security and the like. But the costs of such   celebrity bankruptcies, plus “water cooler”
                        screening would far exceed the benefits. So         gossip about increasing filings, have tended to
                        consumer lenders tend to pool unsecured            reduce bankruptcy to an acceptable alterna-
                        debtors, charging everyone more or less the        tive for personal financial management.”
                        same rate. And that implies the better quality        Indeed, the discharge of unpaid debts has
                        debtors subsidize the riskier borrowers.           become more a tool of smart financial man-

                        too much debt?
                        probably not.
                        Consumer debt, as we’ve noted, has
                        increased sharply in recent decades.
                        But the consumer debt-service bur-
                        den – the portion of income the
                        average household pays to service
                        interest and principal payments –
                        fell from 15.6 percent to 15.4 per-
                        cent between 1989 and 1995. By the
                        same token, the value of consumer assets,          agement and less a matter of embarrassment.
                        mainly primary residences and liquid finan-         Some mortgage brokers even recommend
                        cial assets, has grown at about the same rate as   bankruptcy to loan applicants in order to
                        indebtedness. Thus, consumer leverage has          remove high debt loads and qualify potential
                        remained constant and the ability to service       home buyers for new loans from lenders who
                        debt has marginally improved.                      are more concerned about debt load than past
                            In the same period, though, the personal       credit history.
                        bankruptcy rate increased by one-third.
                        Debtor distress did not contribute to the rise,    a financial windfall?
                        especially in these rosy economic times.           pass the word.
                        Rather, the incentives to declare bankruptcy       Economists do not wonder why the bank-
                        have increased: More debt means more can be        ruptcy rate is so high, but why it’s so low.
                        shed through legal insolvency.                     Michelle White of the University of Michigan
                                                                           estimates that a whopping 15 percent of
                        declining moral scruples?                          households in the United States could finan-
                        It’s difficult to measure changes in attitudes      cially benefit from bankruptcy. Yet less than a
                        toward bankruptcy. But many would agree            tenth that many actually file.
                        with Judge Edith Jones of the National                Even more than 15 percent could benefit if
                        Bankruptcy Review Commission, who notes            consumers employed what economics call
                        that “at one time in our history, filing bank-      strategic behavior prior to bankruptcy. If
steve edson/photonica

                        ruptcy was regarded as shameful, and filers         debtors converted nonexempt assets to legally
                        suffered social stigma and permanently             exempt property – using cash to contribute to
                        ruined credit. The shame and stigma are no         IRAs or to pay off or reduce home mortgages
                        longer compelling.... Many debtors are well        – the percent that could benefit rises to 18
                        off and continue to be fully employed before       percent. And if debtors moved to states that

                                                                                                      Fourth Quarter 1999   43
                                                         generous. In some states, homestead exemp-
     allowed the highest property exemptions, the        tions are set by acreage, as opposed to value.
     figure rises to 23 percent.                          Florida’s 160-acre exemption allowed Paul
         Presumably, one reason filings are not           Bilzerian, the well-known corporate raider, to
     higher is the moral cost attached to bank-          retain a $6 million, 11-bedroom, 20-bath
     ruptcy. However, it’s hard to believe that such     mansion near Tampa. And rules set for 19th
     scruples explain all of the hesitation to shed      century farmers still apply. In a Virginia case,
     debt. A better explanation is linked to infor-      a bankrupt was allowed to keep his “one
     mation – or, rather, a lack of it. Simply put,      horse” – an $800,000 thoroughbred pur-
     many debtors are unaware of the sweetheart          chased just prior to filing. Courts have also
     deal awaiting them until they seek legal advice     permitted debtors to keep mink coats, Rolex
     or talk to friends who have used bankruptcy         watches and expensive jewelry as clothing
     to shed debt.                                       protected from creditors, and valuable
         This is the information age and – no sur-       antiques as exempt household furnishings.
     prise – the information gap is narrowing.               Unfortunately, the outrageous is not atyp-
     After the United States Supreme Court ruled         ical. Chapter 7’s title, “Liquidation,” is plainly
     in 1977 that state laws banning lawyers from        a misnomer, since, in 96 percent of cases,
     advertising violated free speech rights, legal      creditors receive nothing. Liquidation, in
     advertising grew rapidly. Spending by lawyers       practice, is merely a few pages of paper filed
     on television ads alone grew from $5 million        with the court to remove unwanted debts.
     in 1980 to $129 million in 1994. Bankruptcy             Alternatively, debtors can choose Chapter
     filings began to accelerate about the same           13 of the bankruptcy law, which provides
     time, and according to a study by the Federal       what is known as a wage-earner discharge.
     Deposit Insurance Corporation, the correla-         The debtor keeps all his assets, not just the
     tion was not coincidental. More people are          exempt ones, and attempts to pay back some
     finding out about the financial windfall avail-       of his debts over three to five years with
     able through bankruptcy and taking advan-           income left after provision for living expens-
     tage of the opportunity.                            es. But even here, many judges seem inclined
                                                         to aid debtors and third parties at the expense
     hard times, american-style                          of creditors. Approved expenses have includ-
     Seventy percent of personal bankruptcy              ed tithing to churches, gifts, vacations and
     filings occur under Chapter 7 of the bank-           private-school tuition for dependents when
     ruptcy law, and are known as liquidations.          public school is available.
     Debtors retain all the property that Federal            Discharges of debt under the bankruptcy
     law or the laws of their states shield from         law are generally limited to every sixth year.
     creditors, while the rest of their assets are       But once the forbidden fruit is bitten, many
     used to pay off their debts pro rata. Any debts     bankrupts come back for seconds.
     not paid in full are then wiped off the books.      Approximately 8.6 percent of filers have
        Future income cannot be garnished to pay         declared bankruptcy once before; 2.5 percent
     past debts. An investment banker earning $1         have declared three or more times.
     million a year is as entitled to a full discharge       The ease of obtaining a discharge has
     as a welfare mother.                                plainly led to abuses. Just how common these
        Exemptions to what creditors take can be         abuses are is hard to say, but the anecdotal

44   The Milken Institute Review
evidence makes for juicy read-      consumer bankruptcy filings in the u.s.
                                           CONSUMER BANKRUPTCY FILINGS IN THE U.S.
ing. One physician took his         1940-1998
family on a six-week, $60,000       1,600,000
European vacation charged to
his American Express card,
and upon return declared             1,200,000
bankruptcy. An unemployed
New York waiter amassed
debts of $170,500 over six            800,000
months for airline tickets, con-     600,000
sumer electronics, perfume,
cosmetics and gambling in             400,000

Atlantic City. He obtained            200,000
$50,000 in cash advances on
his credit cards, claimed he                       1940   1950    1960     1970    1980    1990
lent funds to a friend who dis-
appeared, and asked the court
to absolve him of his debts.                          typically absconding with property. In
                                                      England, bankruptcy was a capital felony and
it wasn’t always this way                             convicted debtors could be sent to the gal-
Roman law allowed debtors to post their bod-          lows. While the United States copied much
ies as loan collateral; upon default they were        English jurisprudence, the death penalty was
sold into slavery to satisfy creditor claims. In      replaced by a maximum 10 years’ imprison-
colonial America, the palms of those convict-         ment when the first Federal statute on bank-
ed of bankruptcy were branded with a “T” for          ruptcy was enacted in 1800.
thief. It was also common practice to nail a              Bankruptcy law was at first aimed at recov-
bankrupt’s ear to the pillory in a public place       ering a bankrupt’s assets and allowing credi-
for several hours before it was cut off. The          tors an equitable share of them. But the
“earmark” served to warn future creditors             law slowly evolved into a system for debtor
that the person was not a reputable person            protection, a means of bestowing creditor-
with whom to contract debts.                          funded debtor relief during economic crises.
    Early exemptions in the colonies were                 After the Panic of 1837 – then the deepest
meager – mainly for clothing – and the dis-           depression in America’s history – debt relief
charge of indebtedness was forbidden until            became part of the Whig Party’s presidential
the early 18th century. It was a reward for           platform. The 1841 Bankruptcy Act widened
honest debtors who showed up for court and            eligibility to all debtors, where before only
revealed their property instead of fleeing. And        merchants and traders had been eligible. It
it could only be granted if a four-fifths major-       also allowed debtors to voluntarily petition
ity of creditors approved.                            themselves into bankruptcy, instead of giving
    When the U.S. Constitution was framed,            the option only to creditors. But the liberal
bankruptcy was a form of criminal fraud.              new law quickly led to wide-scale abuse.
Creditors were plaintiffs accusing defendant          Friends and family of debtors would claim
debtors of committing acts of bankruptcy –            fictitious debts, share in the distribution from

                                                                                  Fourth Quarter 1999   45
                                                        debtors increased, and eligibility for Chapter
      the estate, and then vote for a discharge. The    13 wage-earner repayment plans widened to
      law was repealed after 13 months.                 allow debtors with significant equity in their
          The 1867 Bankruptcy Act was designed to       residences to file for bankruptcy without los-
      cope with bad debts arising from Civil War        ing their houses. This came on top of the
      losses. Creditors’ rights to vote over a bank-    Supreme Court rulings that effectively elimi-
      rupt’s discharge were cut back. States were       nated state usury caps and allowed lawyers to
      allowed to set their own property exemptions,     advertise. Consumers could easily borrow
      and those in the South legislated generous        more and lawyers could more easily prosely-
      homestead exemptions in order to prevent          tize for bankruptcy, spreading the word of
      Northern creditors from gaining title to          how they could painlessly rid clients of
      Southern property. Amendments after the           unwanted debts.
      Panic of 1873 further weakened creditor vot-
                                                  something must be done
      ing rules. But, in an echo of 1842, the Federal
                                                  Congress established a bipartisan National
      law was repealed after a return to prosperity
      and rising popular distaste for abuses of   Bankruptcy Review Commission in 1994 to
      debtors’ rights.                            redraft the nation’s bankruptcy laws again.
          Once again responding to general eco-   But it imposed no particular mandate,
                                                                   and Commission appointees

W elfare, food stamps, social
                                                                   quickly split between pro-
                                                                   debtor and pro-creditor fac-
security, disability, Medicaid —                                   tions.
                                                                      The Commission submit-
all are means tested. Bankruptcy                                   ted its final recommendations
                                                                   in 1997. But the proposed
ought to be means tested as well.                                  amendments did not attempt
                                                                   to curb the skyrocketing
   nomic distress, Congress passed the            bankruptcy rate. Indeed, some provisions
   Bankruptcy Act of 1898. The new law aban-      actually increased debtors’ benefits, and the
   doned creditor voting in consumer bankrupt-    proposal proved dead on arrival on Capitol
   cies. And this time around, the law survived a Hill. Those seeking serious reform quickly
   return to prosperity.                          drafted alternative legislation aimed at curb-
      The Great Depression led to another         ing growing abuses. Their proposed changes –
   ratcheting up of debtors’ rights. Congress     still pending – soon become known as means
   introduced payment plans for wage earners      testing.
   lasting three to five years, during which           Under existing law, debtors filing under
   secured creditors – like mortgage-holders –    Chapter 7 liquidation can often keep virtual-
   could not enforce liens. Business reorganiza-  ly all their property under generous personal
   tion became an alternative to liquidation.     property exemptions, and even repeat the
   And municipalities were added to the list of   process every six years. No test exists to see if
   entities that could discharge unpaid debts.    bankrupts could otherwise repay debts from
      The law was changed again in 1978. The      future income.
   amount of personal property retained by            But under proposed means testing

46    The Milken Institute Review
reforms, debtors would be ineligible for           consortium, Wharton Econometric Fore-
Chapter 7 relief if they were likely to have an    casting Associates estimated the financial
easy time paying back a portion of their debts     costs of bankruptcy in 1997 at $44 billion –
later on. Those debtors could still file Chapter    mostly discharged unsecured debt. If these
13 plans, using disposable income to pay back      costs were borne entirely by consumers, they
debts over three to five years.                     would amount to $400 per household, or four
    This hardly amounts to a return to             percentage points more in interest on unse-
Dickensian remedies. The means test would          cured loans.
not apply to debtors with incomes less than            Since a minority of debtors who would be
the median American income – about                 affected by means testing, the reform seems
$51,000 for a family of four. Those above the      unlikely to reverse the trend in bankruptcy
median would only be eligible for a quick dis-     filings. But, then again, it might. The admin-
charge under Chapter 7 if they could demon-        istration of the means test – estimating
strate that they could not repay at least 25       income, expenditures and creditor recovery
percent of their unsecured debts from discre-      under hypothetical Chapter 13 plans – would
tionary income over a five-year period.             significantly add to the administrative and
    However, some 80 percent of all filers         legal costs of bankruptcy. Thus the up-front
would flunk the median income test, and            costs of declaring bankruptcy could easily
only half of the other 20 percent would have       double, presumably deterring some debtors
sufficient income to pay back the minimum           from taking this road to the Promised Land.
fraction of debts under a Chapter 13 plan.
Thus, a creditor-funded study by Ernst &           and the beat goes on
Young estimated that the bill’s means testing      The battle over bankruptcy reform is plagued
provisions would reach just 10 percent of          by misunderstanding. Bankruptcy is not a
Chapter 7 filers and result in just $4 billion      form of creditor-funded relief for debtors.
more recovered by creditors annually.              Since the market for consumer loans is com-
    Judge Edith Jones defended the means-          petitive, lenders ultimately pass on costs to
testing approach at Congressional hearings.        borrowers, leaving all debtors to pay in the
Welfare, food stamps, disability and Medicaid      form of higher interest rates and more strin-
are all means tested, she noted. “Bankruptcy is    gent loan qualifications. Thus, means testing
part of the social safety net. It ought to be      would actually help most borrowers – espe-
means tested as well.”                             cially low-income borrowers – who would
    Needless to say, though, this view was not     more easily qualify for loans and pay lower
unanimous. Opponents of the changes                interest rates.
include attorney groups who are getting rich           Whatever the rhetoric, the politics will
off the bankruptcy boom (lawyers now earn          play out as a contest between lawyers and the
more than twice as much from the Chapter 7         credit card industry. Imposing means testing
bankruptcy system as unsecured creditors           is not likely to significantly stem the growing
manage to recover from bankrupts).                 tide of filings. But some day, some way,
    On the other side is the credit card indus-    Americans are going to have to face the reali-
try. Over the last decade, uncollected debts as    ty that the inability to enforce contracts
a percentage of all credit-card loans has dou-     between creditors and debtors creates real
bled. In a study funded by Visa, the credit card   costs that someone must pay.                M

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