Cash-strapped families are seeking bankruptcy protection at nearly the same rate and in the same manner as they did before the much-debated 2005 bankruptcy law reform, a trend critics say proves the reform was a failure.
Congress wrangled for eight years before passing a reform act aimed at curbing abuse and ending an alarming rise in bankruptcy filings. With the economy in tatters and personal fortunes often in even worse shape these days, the bankruptcy law is beginning to undergo scrutiny again.
For now, Congress is focused on efforts to stem home foreclosures by altering the law so that bankruptcy court judges will be allowed to modify certain mortgages to help people keep their homes. But once that’s settled, attention will turn to the 2005 bankruptcy reform.
“There is continuing concern about the bankruptcy-reform bill and what its effects have been,” says Sen. Sheldon Whitehouse, D-R.I., who leads the Senate Judiciary subcommittee that oversees bankruptcy law. “We are looking at a number of things that we can do to address the problems.”
On Tuesday, Whitehouse will hold a hearing that will discuss legislation he has introduced that would allow families burdened by exorbitant credit card rates and fees to more simply discharge their debt under bankruptcy. He is considering several other proposals.
Critics of the 2005 reform say filing is more tedious, more difficult and costlier for ordinary debtors. They also believe the reform benefited banks over consumers. An independent study says the reform has helped contribute to the surge in home foreclosures. Supporters, however, say the reform has helped reduce fraud and has not trampled on debtors who really need to file for bankruptcy.
One aspect critics and supporters agree on: The national economy depends on consumer spending, and bankruptcy helps debtors rebuild access to credit so they can again contribute to the economy.
“One of the primary purposes of the bankruptcy law is to provide a way to grant debt relief to the honest-but-overextended debtor, who through no fault of his own is burdened by more debt than he can pay,” says Sam Gerdano, executive director of the American Bankruptcy Institute, an independent research and education organization.
Personal bankruptcy filings started increasing dramatically in 1996 and continued to climb until 2005, when they hit a record 2 million. After the reform passed, filings dropped dramatically, as Congress had hoped, but in part because many debtors had rushed to file before the law changed. But last year, filings increased 32 percent to 1.1 million, according to AACER, a bankruptcy-court-data company.
This year, filings are expected to grow to nearly 1.4 million, although if layoffs continue and consumer credit continues to be hard to come by, they may reach 1.6 million, says Robert Lawless, professor of law at the University of Illinois. In February, filings surged to the highest rate since the law changed.
Before the reform, a family overwhelmed with home mortgage and credit card debt most often filed for Chapter 7, which would allow them to have all unsecured debts, including credit card bills, discharged. That might have freed the family to pay the mortgage and keep their home.
But a major goal of the reform was to force such families to rely on Chapter 13 bankruptcy instead, which requires them to repay debts in full, or in part, over several years.
That doesn’t seem to have happened. Last year, Chapter 7 filings – accounting for 76 percent of personal filings – continued to outpace Chapter 13 filings. Chapter 7 filings made up 80 percent of the total filings in 2005; 72 percent in 2004.
The incomes of families who have filed for bankruptcy since 2005 are indistinguishable from those who filed before the law changed, according to a study by six university professors, including Lawless. The study, “Did Bankruptcy Reform Fail?” was published last year by “The American Bankruptcy Law Journal”.
A major provision of the reform affected higher-income debtors. They now have to undergo a means test. “The law now requires that an individual filing for bankruptcy furnish a copy of their most recent tax return and their last two pay stubs,” says Philip Corwin, an outside bankruptcy counsel for the American Bankers Association. “That’s to prove that their income is really their income.”
The new requirements are more onerous than that, some experts say. The means test requires pages of paperwork for income, tax returns and pay stubs, which many people don’t keep, says John Pottow, professor of law at the University of Michigan Law School, who participated in the study. Debtors also must provide a detailed budget of their expenditures. Those who don’t pass the means test are not allowed to file for Chapter 7.
The families who have filed under the new law owe more debt, particularly more unsecured consumer debt, according to the law journal study. “All we have done with the law is to delay the inevitable and possibly made situations worse,” says Pottow.
Shirley and Steve Morse, who live in Prescott, Ariz., say credit card bills buried them in debt and made them unable to cope with unexpected problems.
Before their finances fell apart, they had used Steve’s 401(k) retirement savings to buy a new home and furnishings. Because he had a full-time job and Shirley worked part time, they thought that they could cover their two car payments and mortgage. Rising home equity, they figured, would help rebuild their retirement savings. But in 2007, Steve needed emergency gall bladder surgery. He charged what insurance didn’t cover on credit cards. Then Shirley became sick and lost her job. While she was ill, Steve was fired.
Late last year, the Morses filed for Chapter 7 bankruptcy, which cost them about $2,560 in fees.
“Not cheap for people in trouble money-wise,” Shirley says. And filing didn’t exactly wipe the slate clean for them: They’ve moved in with a family member after losing their house and have given up one car.
“Their health care cost precipitated the bankruptcy filing, and the job loss in the midst of that was the final blow,” says their bankruptcy lawyer, Monte Rich. It’s unclear if filing under the old law would have helped save their home, he says. But filing would have been easier, faster and less expensive, he says.
Filing fees have gone up, and because the process is more complex and time-consuming, associated legal fees are costlier. And many debtors must pay for credit counseling and debtor education courses that are required to complete filing.
It all leads to delays in filing for bankruptcy, consumer experts say. “That means somebody with credit card debt is kept longer in what some call the “sweat box,’ ” Whitehouse says. His legislation would eliminate the means-test requirement for those who have been hit by excessive rates.
Credit card fees pile on profits
Credit card fees and interest rates were at the center of the reform debate. During a multiyear, multimillion-dollar lobbying effort by credit card companies to change the law, Americans were told that they had to pay higher credit card fees because bankruptcy filings had caused the industry to lose about $40 billion a year. “Congress should do as much as possible to reduce the $400 hidden tax on every American family due to the increasing number of bankruptcies that are filed in this country,” said then-Rep. Steve Chabot, R-Ohio, during a House subcommittee meeting in 1997 at the outset of the eight-year battle for reform.
Since the reform passed, the credit card industry’s profits have grown. It earned $19.9 billion from penalty fees in 2008, up from $14.8 billion in 2005, according to R.K. Hammer, a consulting firm. The industry’s pretax profit climbed to about $39 billion in 2008 from $30.6 billion in 2005, according to CardTrak, a credit card research firm.
But there has been no rollback on credit card fees, says Robert McKinley, founder of CardTrak.com. Punitive rates are just as aggressive as they were before, even though the prime rate has dropped dramatically. In 2005, the punitive rate was 30.99 percent as the prime rate was up to 7.00 percent, McKinley says. Last year, the punitive credit card rate was 30.88 percent, but the prime rate was only 4.00 percent, which he calls an unprecedented rate spread.
In addition, credit card payment grace periods have continued to fall since the bankruptcy reform, according to a report by Michael Simkovic, a former Olin Fellow at Harvard Law School. “The data is unambiguous: 2005 Bankruptcy Reform benefited credit card companies and hurt their customers,” says the report, released in July.
Generally positive
Not so, says the banking industry. “We never promised that the average family would save $400 a year,” says Corwin. “We just said that it costs money if dishonest people are not paying debts that they can repay. Then, for the honest people, it’s reflected in their cost of credit.”
The bankruptcy-reform bill generally has been positive for average Americans by providing lower fees and rates, and better rewards programs, says Scott Talbott, chief lobbyist for the Financial Services Roundtable.
The best customers have seen their credit card rates go down. But it’s not because of the change in the bankruptcy law, McKinley says. Rather, the decline is related to the decline in the prime rate.
Not everyone saw their rates go down, however, because credit card interest rates are based on an individual’s risk profile, Talbott says. And more people are falling behind on bills now.
Even if it is harder to seek bankruptcy protection, the financial industry says a major goal was reached: the prevention of bankruptcy fraud and abusive behavior. Last year, 76 federal bankruptcy fraud cases were filed, compared with 112 in 2007, 102 in 2006 and 107 in 2005, the Department of Justice says. DOJ provides no data about why fraud declined last year, only noting that fraud fluctuates for various reasons. “We think the anti-fraud benefits more than outweigh the very negligible burden on individuals filing for bankruptcy,” Corwin says.
Not everyone agrees.
“The new law was unfortunately overzealous,” says Karen Gross, president of Southern Vermont College and visiting professor of law at New York Law School. “In today’s economic environment, it should be abundantly clear that people are not filing bankruptcy lightly or easily. We’re in a deep economic crisis.”