Throwing Consumers to the Wolves

Frank Monroe is one pissed-off federal bankruptcy judge. Just before Christmas, Judge Monroe was forced to deny Guillermo Sosa, an Austin, Texas, house painter, and his wife, Melba Nelly Sosa, emergency bankruptcy protection to avoid foreclosure on their mobile home. While sympathetic to the Sosas, Judge Monroe's hands were tied by the new bankruptcy law. The so-called Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) required that the Sosas receive consumer credit counseling before filing for bankruptcy. Unaware of this stipulation, they had failed to do so, making them ineligible.

In his angry ruling [PDF], Monroe wrote that "the parties pushing the passage of the Act had their own agenda … to make more money off the backs of the consumers in this country. … To call BAPCPA a 'consumer protection' act is the grossest of misnomers."

The BAPCPA went into effect on Oct. 17, 2005. Banks and other lenders promised it would stop deadbeats from abusing the bankruptcy system, save billions, and lower interest rates for responsible borrowers. House Judiciary Committee Chairman James Sensenbrenner, R-Wis., predicted the bill would recoup "billions … in losses associated with profligate and abusive bankruptcy filings."

That did not happen. On the contrary, Bankrate data found that the average credit card interest rate actually rose 1 percent in the six months following the passage of the Bankruptcy Act.

Panicked debtors trying to beat the Oct. 17 deadline filed more than 2 million bankruptcy petitions in 2005, 32 percent more than in 2004. Some 500,000 people filed for bankruptcy in the two weeks alone before the Act took effect. This uptick in filings cost Bank of America $320 million, JP Morgan Chase predicted their credit card defaults would top $2.3 billion and Discover Card lost $180 million. On the other hand, credit card companies will undoubtedly make up this loss, and more, in the long run.

Who are the "deadbeats" Congress is trying to weed out?

Leslie Linfield of the Institute for Financial Literacy says, "Almost half [of bankruptcy filers] have incomes below $20,000 a year, and almost 40 percent indicate that their indebtedness is due to illness or injury." The other half may be workers pushed into an economic corner. A 2006 Federal Reserve study found that real median income dropped 6 percent from 2001 to 2004, while average family income fell by 2.3 percent. The gap between stagnant or declining wages and the rising cost of living is partly being made up by debt. For example, Americans who roll over credit card balances owe anywhere from $5,100 to $14,000, depending upon whose numbers are used. High debt levels are fueled by easy credit that helps lessen the pressures on business to increase wages.

The Bankruptcy Act erected four major hurdles to deter bankruptcy. First, the Act makes it harder for people to qualify for a Chapter 7 bankruptcy that would erase most of their debt. Instead, most debtors have to file for Chapter 13, in which they face a three- to five-year court-ordered repayment plan.

Second, the Act requires more documentation from filers, including pay stubs and tax returns, and subjects them to a means test based partly on their average income over the past six months.

Third, the law muzzles and restrains bankruptcy attorneys -- the bane of the credit industry. Bankruptcy attorneys are labeled as "debt relief agencies," which prohibits them from dispensing certain kinds of financial advice. Other restrictions imposed on attorneys include the responsibility of vouching for the accuracy of information provided by clients. Because of these restraints, lawyers must spend more time on each case and bill more. Houston bankruptcy attorney Jeff Norman estimates that he charges 20 percent to 30 percent more due to the new law.

Lastly, BAPCPA requires all filers to undergo credit counseling through a Department of Justice (DOJ) approved agency before and after filing for bankruptcy. Credit counseling agencies can provide filers with a counseling certificate after one or two sessions, or they can develop a debt management plan (DMP) based on consolidating credit card balances into a negotiated agreement with creditors. In turn, creditors may lower interest rates and forgive fees.

This is an inherent conflict of interest since the majority of agency revenues come from the 8 percent to 15 percent voluntary Fair Share contribution paid by creditors on each payment they receive. Because of this arrangement, credit counseling agencies are actually soft touch collectors for credit card companies.

The $40 to $100 for a compulsory credit counseling session is a burden on already destitute filers. While creditors believe that debt counseling will push 30 percent to 50 percent of bankruptcy filers into repayment plans, this just isn't happening. A survey by the National Association of Bankruptcy Attorneys (NACBA) of six DOJ approved credit counseling agencies found that 96.7 percent of their 61,335 customers were too insolvent to repay their debts. Rather than being overspending deadbeats, 79 percent were in financial trouble due to job loss, medical bills, death of a spouse or divorce.

Institutional creditors are neither naive nor ill-informed. Armed with sophisticated information systems, most know they can't stop bankruptcies. Insolvent debtors simply cannot repay their debts. The primary goal of BAPCPA is to create a gauntlet of obstacles that will make filing more drawn out and complicated. The intent is to delay Chapter 7 bankruptcy filings for as long as possible, since each month a consumer is not in bankruptcy relief there's a chance they'll pay at least a portion of the payment. Delaying tens of thousands of bankruptcies for a month or two will result in millions for creditors. This partly explains why compulsory credit counseling was included in the law, even though a Visa-funded study found that 74 percent of consumers drop out before finishing their DMP.

Liberal credit policies and minuscule minimum payments on credit card balances kept some cardholders in debt for decades This system ticked along nicely until federal regulatory agencies became concerned about high consumer debt and required that minimum monthly payments be raised from 2 percent to 4 percent. Overnight, monthly payments on a $9,000 (18 percent APR) credit card balance doubled from $180 to $360. This was a tipping point for some consumers with high balances.

Not coincidentally, this change occurred at roughly the same time the new bankruptcy law was passed. With less possibility for a bankruptcy escape, creditors had borrowers just where they wanted them.

Prudent lenders target creditworthy consumers. Conversely, they assume a greater risk when they seek out less creditworthy customers who pay higher interest rates. Higher potential profits have always been associated with greater risks. One problem with the new bankruptcy law is that it shifts the risks from the lender to the borrower without giving the borrower anything in return. For example, the high rates charged in subprime loans are less defensible now that the risk has shifted. The Act also insulates lenders from the risk of lending by not holding them liable for their credit issuance decisions. Lenders want it both ways -- extend subprime credit to borrowers with shaky credit histories and then make it impossible for them to get out of the debt. The Bankruptcy Act is an invitation to exploit the growing subprime market with less risk for lenders.

Poor and moderate-income consumers are being forced into a corner by stagnant salaries, high debt and rising prices. John Rao of the National Consumer Law Center recounts that Congress was warned that bankruptcy filings were a symptom not a disease. Rao is right. Bankruptcy is not a disease, but a symptom of a society racing to the bottom in terms of wages and benefits -- an "ownership society" in which citizens own most of the risks, and a society where conservatism is anything but compassionate.

Not surprisingly, BAPCPA excludes anything relating to Chapter 11 or business bankruptcies, an area where consumers desperately need protection.

Judge Monroe wrote in his ruling that by passing the Bankruptcy Act, Congress ignored the scores of judges, academics and lawyers who spoke out about the flaws of the Act. "It should be obvious to the reader at this point how truly concerned Congress is for the individual consumers of this country," he wrote. "Apparently, it is not individual consumers of this country that make the donations to the members of Congress that allow them to be elected and reelected and reelected and reelected."


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