Friday, June 24, 2005

What's wrong with the bankruptcy law

Before the mid-19th century, if you were loaning someone money that you knew they had no fiscal means to repay, they would indenture themselves to you for a set length of time as payment. This system of exchanging debt for labor worked in general (America was largely colonized by indentured servants), but it also led to all sorts of abuses by creditors, from company stores to peonage contracts to forced family labor. Modern bankruptcy laws were created partially in response to these abuses. Congress just rewrote the bankruptcy laws, and I finally figured out what’s actually bothering me about the changes.

For those of you who haven’t been following this, a little background. There are two main types of bankruptcy filings: Chapter 7 and Chapter 13. In a Chapter 7 filing, all of your assets (things like clothing and pots and pans are exempt) are liquidated by a trustee and the proceeds are divided among your creditors, and your remaining debts are discharged. Chapter 7 is the “fresh start” bankruptcy: quicker and eliminates more debt, but at the cost of your real property, and it stays on your record for ten years. Naturally, it’s a better option if you don’t actually own a house or a car. When you file for Chapter 13, a judge figures out how much you owe, how much you earn, and how much you can afford to pay. For three to five years, you pay all of your disposable income to a trustee, who then allocates it to your creditors. At the end of the bankruptcy period, all of your remaining debt is discharged. A Chapter 13 filing doesn’t forgive any kind of secured debt (mortgage, home equity loan, car loan, etc.); from the date you file, you still must make payments on time. But your bankruptcy trustee covers your back payments and fees from your plan payment. Under either type of filing, certain debts are non-dischargeable: some student loans, fraud judgments, and others. And the old advice to the soon-to-file (go ahead and rack up some more debt before you file, what can it hurt?) is actually wrong; any new debt and cash advances on credit cards taken in the 60 days before filing is non-dischargeable.

All that is the way it used to be. Congress just retooled federal bankruptcy laws in a bunch of ways that reduce the power of bankruptcy judges, make it harder to file, and make it much harder for debts to be forgiven. The new law sets much more stringent requirements about Chapter 7; if you can afford to pay back debt, you have to file Chapter 13 instead, and it uses a pretty strict “means test” to make the determination about what you have to pay back. I’m okay with that. If you can afford to pay back money you actually owe, you should pay it back, even if it’s a hardship to do so. I’m not okay with other parts of the bill, though, and some of them are sneaky—you read the text and don’t realize the implications of some of the relatively simple stuff. For instance, added to the list of non-dischargeable debt under Chapter 13 are fees and penalties. If you hold a lot of credit card debt and are a likely candidate for bankruptcy, you’re paying more in fees and penalties than you are in interest. They’re also making bankruptcy attorneys responsible for any errors in the filing. This means that the burden for fact-checking now falls on the bankruptcy attorney, who’s getting paid by the hour by the person filing. The cost of filing is expected to double or triple as a result.

Traditionally, a judge had the power to decide the specifics of a bankruptcy settlement, based on the circumstances of each case. The new law implements a strict set of guidelines to which judges must adhere. As a rule, when judges varied from the old guidelines, it was on the side of leniency. Now not only are the guidelines are stricter, but the judges have less power of judgment. The guide for living expenses comes from the IRS rules for tax evaders, which tend to underestimate how much things cost. An example: say you’re living in New York state, driving a Honda Civic ($200 payment) for 1000 miles a month. At 25mpg and $2.30 a gallon in New York today, that’s $92 in gas. Say you’ve had a wreck two years ago; Progressive says your lowest rate is $145 a month. So, if you don’t need any repairs and drive a cheap car, you’re spending $437 a month on transportation. But the IRS says that a reasonable amount for a two-person family to spend on transportation is $384. You owe the difference to your creditors, and a judge can’t change it. The “means test” also removes from judges’ hands the first decision in a bankruptcy case: whether to file Chapter 13 or Chapter 7.

It’s fact that large chunks of the text were handed to congressmen by business interests and inserted into the bill verbatim. A lot of special interests got their voices into the bill, including some I didn’t expect. For instance, the pawn-shop industry association had a section inserted that guarantees that a person’s markers at a pawn shop can’t be negotiated during bankruptcy proceedings. The debt-counseling industry got its fingers in, too: before you can file, you’re required to undergo mandatory debt counseling*. One of my favorite chunks of law says that after you file, you have to pay your credit card companies before you pay child support. Here’s a list of rejected amendments:
  • an amendment to exempt active-duty military personnel from the new, stricter rules
  • an amendment to protect debtors whose financial problems were caused by serious health problems
  • an amendment to exempt caregivers of ill or disabled family members from the new rules
  • an amendment to exempt people whose financial difficulties were caused by identity theft
And, my personal favorites:
  • an amendment to cap asset protection trusts (currently no limit) to $125,000 dollars.
  • “the Enron amendment”: requires corporations to file for bankruptcy in the jurisdiction where their headquarters is located.

So it’s nice to know that, while we can screw our troops, our disabled, and victims of crime, rich people can still shelter all the money they want from a bankruptcy court, and big companies can still shop around for the friendliest venue.

A group of 90 law professors wrote an essay on the problems with the law and sent it to members of congress, who of course ignored it. But if you’re curious, you can read the letter online here. My big problem is one they didn’t even mention. Credit card companies are the biggest sponsors of the new law. They’re also the biggest beneficiaries. Almost everything changed by the new law is geared to make bankrupt people pay more. We know Washington is corrupt, we know big business is unethical. But what really bothers me about the new bankruptcy law is that credit card companies have now effectively exempted themselves from one of the fundamental principles of economics: risky investments pay more. That’s the reason why mortgages have lower interest than credit cards: worst case scenario, you almost always get your money back on a mortgage, because you can always take the house. Credit cards are unsecured, and they throw credit at absolutely everyone -— even people they know are bad risks. That’s how they justify interest rates one basis point below the usury ceiling**. Credit card companies knew the bankruptcy laws and made the business decision sometime in the 1990’s to extend credit to people they knew were bad risks, and figured that the amount they would lose in bankruptcies would be overbalanced by the higher rates and fees they could charge. By lending lots of money to bad risks, the credit card industry helped to create an increase in bankruptcies. And that increase was one of the chief justifications for the new law. And the new law means, in effect, that credit card companies can take the same profits for much less risk.

* Not a bad idea, but when you've hit the point where you're desperate enough to file for bankruptcy, it's probably too late for credit counseling.
** And why credit card companies incorporate in states like Delaware, where the usury ceiling is highest.