Quarter 1, 1998
by John Campbell

Bankruptcy is the last hope for someone crippled by debt. An integral part of the American legal system, indeed a directive expressed in the Constitution, bankruptcy law promotes individual liberty and productivity through the discharge of debt. And it is well used in our credit-driven market economy. Last year, a record 1.34 million Americans, roughly 1 percent of households, filed for personal bankruptcy. Filing rates have been rising for most of the period after World War II, but the increase has been sharp since the early 1980s.

Public responses to the rise in filings tend to take on a moral timbre. Media reports on bankruptcy, for example, often feature a pathetic credit card junkie or a high-spending actor. The image of the bankrupt individual as a "deviant," observes legal historian Iain Ramsay, has long been a staple of popular culture. This image now has the upper hand in shaping policy. Since the early 1980s, it has led to more restrictions on what debt can be canceled, and intense lobbying by the credit industry for further limitations.

But willful abuse, if one means people intentionally piling up debt, then filing in order to renege and start spending again, probably mars only a small fraction of bankruptcies. Under the broadest measurable definition of abuse - someone who files more than once after waiting the necessary six years - the evidence suggests that this group composes a small fraction of all people who file, perhaps in the range of 2 percent or more, and a far smaller proportion of the millions who could benefit from filing, but choose not to.

Reformers who seize on anecdotes of abuse want to force more bankruptcy filers into plans that require repayment of debt. Yet most repayment plans now in existence fail because the debtor cannot meet the obligation. Many reform proposals, moreover, would do little to counter the underlying forces that have caused insolvencies to surge in the first place. More attractive initiatives would reduce the incentives to file, while continuing to ensure that the casualties of our modern, credit-driven economy have the chance to start over after they fail.

FROM COERCION TO RELIEF

Insolvent debtors have been scorned in virtually all societies, and in the past were dismembered, enslaved, or imprisoned. Bankruptcy law is believed to have started in England under King Henry VIII in 1542, and for much of the time since remained a form of criminal law, a legal coercion to reach all of a debtor's assets. Colonial Americans, some of whom were fleeing England's debtors' prisons, adopted bankruptcy laws that departed from their English counterparts in fundamental ways. The colonies granted discharge of debt not just to merchants and traders but to anyone who became insolvent, and they preferred voluntary bankruptcy, declaring that it was primarily the debtor rather than the creditor who needed help. The Constitution in 1787 gave Congress the power "to establish ... uniform laws on the subject of bankruptcies," but Congress generated three systems that aborted before it implemented a permanent regime of bankruptcy relief in 1898.

This concept of a forgiving "fresh start" creates a sense of fairness, and allows individuals to function as productive risk-takers, providing us with a form of insurance that we can't buy privately. In a serfdom, life is stable and there are no defaults, but in an entrepreneurial economy, where credit is the universal solvent, reversals are inevitable. Hunt's Merchants' Magazine in 1841 saw utility in the risk management provided by bankruptcy: "The American people are proverbially enterprising; and a facility for obtaining credit, co-operating with a temperament active and sanguine, constantly tempts to enterprises of peculiar hazard, and oft-times singularly disastrous in their results."

The salvation through bankruptcy of "citizens lost to themselves, lost to their country" comes at a cost, of course. Part of it is borne by the filers themselves in the form of attorney and court fees. In New England, these range from $700 to $1,100 for a filing under Chapter 7 discharge, and $900 to $1,700 for a Chapter 13 repayment filing. More broadly, taxpayers (who pay for the bankruptcy courts) and creditors and some borrowers share the cost of this social insurance. The cost of customer defaults on credit card balances, for example, comes largely out of the credit card issuers' profits, says economist Lawrence Ausubel. The companies are willing to bear this cost, he says, because the spread between credit card interest rates and the cost of funds is sufficiently large that it remains profitable to lend even to relatively risky customers.

In response to the rise in bankruptcy filings, various changes over the past two decades have restricted the fresh start. Exceptions to the discharge of debt, including alimony and student loans, have proliferated. Legal changes that encourage Chapter 13 repayment rather than Chapter 7's fuller discharge have expanded, making that alternative more common - from a fourth of filers in 1980 to about a third today. The usage of Chapter 13 varies widely across bankruptcy districts, so for debtors in many parts of the country, bankruptcy may now typically provide a "stale" start rather than a fresh start, in the phrase of law professor William Whitford.

WHO FILES?

Despite these restrictions, filings have continued to rise in all states and all districts. To understand why, it helps to know who is filing.

Sociologist Teresa Sullivan and law professors Elizabeth Warren and Jay Lawrence Westbrook examined a sample of bankruptcy filers in 1981 and again in 1991. They found that in many respects, filers are a broad cross-section of middle America, resembling the general population in occupational prestige, age, and education, although lower in income. There are important differences between filers and the rest of the population, however. Nearly half of filers in 1991 reported a layoff, job termination, or other work interruption in the preceding two years. More of them were self-employed, which leads to more variable income, and to the use of credit cards to finance risky startups. By the time they filed, they were in deep debt, with the median obligation totaling nearly twice their annual income; median nonmortgage debt, the short-term, high-interest kind, totaled more than one year's income. And between 1981 and 1991, the filers had generally become poorer: Their median income and assets had dropped, both absolutely and relative to the general population, over this period.

For some, descent into bankruptcy is a plunge, for others, a slow slide. The range of trajectories can be seen in a windowless hearing room in Manchester, New Hampshire, where about thirty people are having their bankruptcy court hearing with Jeffrey Schreiber, a Chapter 7 trustee and also an attorney. Schreiber, who represents the interests of unsecured creditors, quickly examines each person's petition, and then fires off a routine series of questions. The interrogations usually last about five minutes. The filers hold, or held, ordinary jobs - a plumbing and heating contractor, a receptionist, purchasing agent, waitress, appraiser, real estate broker, surveyor, law school student. Two cases raise Schreiber's suspicions. One man may have fraudulently transferred title of his house to his wife. Another wants to make his Individual Retirement Account an exempt asset. All of these people mention some calamity such as a layoff, illness, divorce, or accident. And many have run up credit card debt to a level they could not sustain.

Jeffrey Kittaeff, a trustee and bankruptcy lawyer in North Andover, Massachusetts, is in Manchester for several cases. Most of his clients, Kittaeff says, do not know how much debt they owe. Instead, when they receive their monthly credit card statements, they look at the box to the upper right: "minimum payment." Can they swing that month's payment? Next, they look at "available credit." Often, their credit limit has been raised, giving a false sense of security. After a layoff, a reduction in hours, or a medical problem that's not insured, they realize that they can't pay the minimum on all of their cards, and the bills are growing. "When they sit down with me, it's the first time they've totaled up their debt," Kittaeff says.

INDEBTED

There are several plausible explanations for the long rise in bankruptcy rates. The evidence points to two phenomena in particular: the expansion of household debt and the growing volatility of incomes.

Since then, the revolution in information technologies and the development of sophisticated financial instruments have created a profusion of choices at lower cost. Access to home mortgages and secured consumer loans has become broader, thanks in part to the bundling of loans into securities bought by investors worldwide. Congress also helped broaden access to credit by promoting mortgage securities and prohibiting loan discrimination.

Demand for credit has increased along with rising household net worth, and as more of the population has moved into the high-borrowing years of ages 25 to 54. (To consume some of their greater wealth, people have been borrowing more rather than selling assets.) This democratization of credit raises living standards and helps fuel our entrepreneurial, risk taking economy. But it also allows people to get deeper into a hole. Household debt as a share of disposable income has risen to record levels. The growth in unsecured credit has been even more dramatic; more than half and perhaps as many as 80 percent of U.S. households today use a credit card, up from 16 percent in 1970.

The new credit economy is especially treacherous for borrowers who are uninformed or under equipped. Lenders' easing of credit standards after the 1990-91 recession resulted in an explosion of credit card mailings, says economist Mark Zandi of Regional Financial Associates, a forecasting firm. At the same time, mortgage lenders have been aggressively extending low down-payment loans, often to the same people getting credit card and consumer loan solicitations. The most precarious borrowers in recent years, Zandi observes, have been lower-middle income households, for whom debt service burdens spiraled up. Real incomes for many of these households have been stagnant, and earnings became more volatile during the '80s, as employers relied more heavily on contingent workers and reduced hours. As the cushion of savings for more households is eaten away, delinquencies and bankruptcies rise.

These are primarily economic explanations, but social factors may aggravate the economic trends. Law professors Frank Buckley and Margaret Brinig, studying the rise in bankruptcy filings from 1985 to 1991, conclude that changes in social norms explain some of the variation in filings over time and among districts. Filing rates, they find, are higher in regions with weaker social networks, as measured by such variables as intercounty migration, membership in a mainline religion, and the share of divorced residents.

Increased mobility and divorce, however, do not mean that the social stigma surrounding bankruptcy has disappeared. Careful studies find little evidence that the rise in bankruptcies has eroded a general sense of responsibility to pay debts. To the contrary, some evidence suggests a persistent reluctance to choose bankruptcy. Economist Michelle White, examining the balance sheets of American households, finds that roughly 15 percent of them would benefit from filing, compared to the 1 percent who actually did file last year. An even larger share of households would benefit if they acted strategically to shift assets from nonexempt to exempt bankruptcy categories. Evidently, it still takes a calamity to break the legal and social contract that credit entails.

There may be an erosion of social sanctions against people who declare bankruptcy. But that is just as likely to be a consequence of higher filing rates as a cause. If a friend or relative files, it becomes harder to think of bankrupt debtors as deviants.

The socioeconomic signs point to a continued surge of default on debts, many of which will tip into bankruptcy. Of late, there has been an expansion of the numbers of people at high risk for default and ultimately bankruptcy. These include compulsive gamblers, uninsured drivers, and perhaps most important, individuals with no, or minimal, health care insurance. Economists Ian Domowitz and Robert Sartain examined 1980 bankruptcy records and find that even small amounts of uninsured medical debt substantially raise the probability of someone's filing for bankruptcy. Medical debt in excess of 2 percent of income results in a propensity to file which is twenty-eight times that of the average household. The extent of health coverage, moreover, has diminished in the years since the records they studied, leading Domowitz to speculate that perhaps one-third of bankrupt individuals currently could be filing on the basis of medical debt alone.

ROUGH JUSTICE

Strange as it may sound, there is an optimal level of bankruptcy in a society based on a flexible or volatile employment system, a limited social safety net, and entrepreneurial risk taking. Buying a house, a car, furniture, or a vacation is commonly accepted behavior, and generally requires credit. Yet borrowers are subject to shocks they can't control. Since we can't buy explicit insurance against such shocks, bankruptcy fills that need. It is the end game of delinquency, a time when creditors can't get much more out of the debtor. Lenders, moreover, wouldn't make as much money if they extended credit only to people who are certain not to default.

Whether we are above the optimal level is not clear. Without doubt, many of the people who file have overspent and mismanaged their finances. This has led a growing chorus in the credit industry and the legal system to advocate Chapter 13 repayment as a more responsible route than Chapter 7 discharge. Their moral argument motivates current legislation that would disallow Chapter 7 for most filers and force them into Chapter 13.

Many debtors presented with the choice of Chapter 7 or 13 also find the notion of repayment attractive. They typically are ashamed about their situation, would like to repay at least some of their debt, and exhibit classic debtor's optimism: They tend to underestimate their expenses and the future risks associated with credit. So if the local legal culture promotes Chapter 13, debtors will be influenced accordingly. "Many debtors do not choose a chapter with full understanding of the alternatives and their consequences," writes law professor Jean Braucher.

This might not be such a bad deal, except for the result: Two-thirds of Chapter 13 plans fail before, usually long before, repayments are complete. No one knows exactly what happens to these debtors after their plans fail, but the consensus guess is that most refile under Chapter 7, while the others are subject to creditors' claims once again. As for the ethical dimension of honoring one's debts, some bankruptcy scholars and practitioners raise a parallel concern of equal importance: the debtor's obligation to family, to rebuilding their lives through a fresh start. Once that is accomplished, the debtor always has the opportunity to repay debts on his or her own.

The weight of evidence shows that bankruptcy filers have grown poorer and that the increased usage of Chapter 13 repayment plans is neither completely voluntary nor very successful. Given these trends, there's little empirical basis for sharp restrictions on the debtor's chance for a fresh start.

Efficiency and fairness, however, can be improved. Since so many households have an incentive to file for bankruptcy, yet most repayment plans don't succeed, reformers might consider taking the best features of Chapters 7 and 13 and combining them into a single procedure, as proposed by economist Michelle White. Filers would be obliged to repay part or all of their debt both from assets and from a fixed fraction of future earnings, but exemptions would exist for both. The asset exemptions could be uniform across the country, or vary among the states. Either way, White's reform is based on the principle that ability to repay depends on both wealth and future earnings. Even a minimal level of repayment reduces the incentive to file bankruptcy, which makes the system more efficient. At the same time, bankruptcy would still offer relief to households that have little ability to repay, by setting a relatively low rule for repayment, say 10 percent of future earnings over three years. This would concentrate more of the benefit from bankruptcy on the least affluent households.

Liquidation Versus Repayment

Our federal bankruptcy system gives debtors one of two basic alternatives. Chapter 7 of the federal code discharges, or wipes away, most unsecured debt; any assets left are liquidated and distributed to creditors. But secured debt must be paid off or the property will be repossessed, so home mortgages and car loans are nearly always paid in full. Thus the ability to repay under Chapter 7 is based on the debtor's wealth, not future earnings. Chapter 7 also permits someone to "reaffirm" and repay certain debts, and some credit card issuers and retail chains are aggressive in convincing debtors to sign this legal obligation. Roughly one-third of debtors reaffirm one or more of their debts.

Chapter 13, available to any individual "with regular income," offers a completely different deal, one based on the debtor's future earnings rather than on wealth. The debtor can keep more assets, but agrees to pay creditors some or all of the debt over three to five years. Home mortgage payments cannot be rescheduled, but the debtor can stretch out mortgage arrears while maintaining the regular payments. Two out of three debtors fail to complete their payment plans and receive no discharge.

Under either chapter, certain debts such as recent income taxes, alimony, child support, and government-supported student loans cannot be discharged.

The Price of States' Rights

Despite the intent of the Constitution, U.S. bankruptcy law is anything but uniform in practice. Changes to the federal code in 1978 introduced asset exemptions that were more generous than were many state exemptions. For political reasons, Congress allowed the states to opt out of the federal exemptions, and most states do. So homestead and property exemptions now vary from unlimited in Texas and Florida to zero in Rhode Island.

This wide variation in asset exemptions gets incorporated into the price of certain types of credit, and thus borne by some borrowers. Economists Reint Gropp, Michelle White, and John Karl Scholz find that the probability of consumers being turned down for a loan is 6 percentage points higher in a state with an unlimited homestead exemption, compared to a low-exemption state. States with generous exemptions also increase the amount of credit held by high-asset households and reduce the availability and amount of credit to low-asset households.

The American Way

The United States has been unique in providing a fresh start through bankruptcy. Other developed countries offer severely limited protection from creditors, and require repayment. Of course, many of them provide more extensive safety nets through health care, unemployment insurance, and other social programs. And the use of personal credit is far less extensive abroad; the United States has significantly more credit card transactions per person than in any other country except Canada (where bankruptcy filings have also soared). Personal debt is still not looked on favorably in much of Europe and Asia. As the safety nets are being scaled back, and personal credit expands modestly, some countries are now implementing more comprehensive bankruptcy laws. They are moving closer to the U.S. system, which, for all its flaws, holds out the essential promise of a fresh start.