Banks and the Bankruptcy Law

Usury is becoming a hot topic. We posted on it a few days ago; it is also featured in a January 13 New York Times Op-Ed piece, “Banks Gone Wild” by Joe Lee and Thomas Parrish, which was then picked up in the blogsphere by Mark Thoma’s Economist’s View. From the Times:

I owe about $12,000 in unsecured debt, and my payments just keep going up,” a troubled citizen signing himself T. P. recently informed a personal-finance columnist. He always paid more than the minimum amount due on his credit card bill, but “still the balance never goes down,” T .P. wrote. “Is there any way to get the interest rate down?”

The interest rate that so oppressed T. P.? A towering 29.99 percent. At this rate, the columnist said, if T. P. continued to pay little more than the monthly minimum, it could take him more than 30 years to pay off his balance — even if he never went shopping again.

Trying to fight off a collection agency while paying little or nothing on his credit card debt, another desperate borrower, R. Z., appealed to this same columnist. How could he prevent interest charges and late fees from mounting? He couldn’t, replied the columnist, as long as he legally owed the money.

Consumers like T. P. and R. Z. find themselves caught in the complexities of today’s bankruptcy laws. And their predicament is increasingly common.

Thirty years ago, the unlucky R. Z. would probably have struck many of his acquaintances as something of a deadbeat: Hadn’t he voluntarily run up a debt and then tried to slip out of the deal? T. P., on the other hand, would have received sympathy as the victim of a heartless usurer (if interest rates equal to one-third of the principal had been legal in those days).

But in today’s strange alternative universe of credit card banks, the term “deadbeat” refers not to the improvident borrower but to the solid citizen who prides himself on paying off his balance every month. As anybody with a mailbox knows, credit card issuers make unrelenting efforts to lure accounts from one another as well as to establish new accounts. And what these lenders seek are “revolvers,” people like R. Z. and T. P., who are likely to pay little more than the monthly minimum — and who eventually find themselves in thrall to mushrooming interest payments, abundantly garnished with late fees.

As for the morality involved in lending money at exorbitant rates, the word “usury” itself has taken on a quaint, archaic sound, like “jousting” or “necromancy.” What happened?

In 1978, the United States Supreme Court delivered a landmark decision that freed banks to charge the interest rates allowed in their home states to customers across the country. This decision, at a time of high inflation, unleashed a national credit storm: states scrambled to relax usury laws in order to attract banks, while banks rushed to establish affiliates in states that weakened or abolished such laws. R. Z. and T. P. are the natural products of this unhappy change. One obvious recourse for people like them is to file for bankruptcy. There’s the stigma to consider, of course. But making such a move would allow R. Z. to end the harassment by the collection agency and both men to make fresh starts free of unsecured debts.

Unsurprisingly, in the 25 years since the credit explosion began, personal bankruptcy filings have risen sharply. Bank advocates have argued that this reflected debtors’ increasing abuse of the protections granted by the Bankruptcy Reform Act of 1978. Personal bankruptcies, said the industry, were costing every household a hidden tax of $400 a year, in the form of rising prices and higher interest rates. It mounted a campaign against what banks called an “epidemic” of defaults by debtors.

In 2005, these suffering financial institutions succeeded in securing the adoption of new federal legislation, the marvelously named Bankruptcy Abuse Prevention and Consumer Protection Act. Nobody who favored this bill chose to see that the bankruptcy epidemic had been produced in large measure by the banks, or that the real hidden costs were the usurious interest rates these banks charged borrowers.

Two simple comparisons demonstrate the point: From 1980 to 2004, personal bankruptcy filings increased 443.45 percent, which is certainly impressive. But over the same time, consumer credit debt rose a bit more, by 501.29 percent. In 1980, less than one personal bankruptcy case was filed for each $1 million in consumer credit outstanding; the figure was slightly smaller in 2004.

Bankruptcies tend to rise as amounts of credit rise. No mystery there, and certainly no epidemic. It all suggests that the bankruptcy code was performing remarkably well.

But the banks got what they wanted from Washington. Since the law has been on the books, people like R. Z. and T. P. have continued to receive all kinds of credit offers (no limits there), but they may have a much harder time now fending off disaster through bankruptcy protection.

A group of credit-counseling firms that provide bankruptcy screening — a step the new law requires — report that 97 percent of the clients could not repay any debts at all, and 79 percent sought relief for reasons beyond their control, like job loss and large medical expenses and, notably, rising credit card fees and predatory lending practices.

A boomerang effect has appeared, too. The new law contains a provision forcing many debtors into Chapter 13 compulsory repayment plans. The bill’s backers expected this fresh squeeze on debtors to produce more cash for the banks, but the trend appears to be downward.

In adopting the provision, Congress disregarded the advice of every disinterested group that has looked at the question, including three presidential commissions, the Congressional Budget Office and the Government Accountability Office. It also ignored a past House Judiciary Committee report, which declared that such compulsion might well amount to the imposition of involuntary servitude.

So the lending goes on. People classed as the “working poor,” now beginning to be tapped by the credit card vendors, no doubt constitute a rich supply of coveted potential revolvers — fresh customers for the banks to draw into the credit maze, with its minimums and its unending late fees. In signing the 2005 act, President Bush declared that it would make more credit available to poor people. Unquestionably so. And 30 percent interest was just what they needed, wasn’t it?

Thoma raises the question of who is at fault, the creditors for extending too much credit, or the borrowers for being irresponsible. I for one am not certain that fault is the right way to frame the issue.

Credit cards are one of the very most profitable businesses in banking, even before the new bankruptcy bill. So banks have nothing to complain about and have every incentive to attract more customers when, if they slip up (and some do by being sloppy) they can charge high late fees and default interest rates. And that isn’t just the people with serious credit problems; remember they earn juicy returns on average Joes who somehow overlook a payment. But the chronically indebted is their best customer. They therefore have an incentive to find and create such customers.

Now no one can be forced to be irresponsible, or even to take on debt. But we have a very permissive culture around credit (in fact, banks are unhappy because they can’t get Germans and the French to use credit cards the way Americans do). College kids can get credit cards. People who are barely in the workforce can get cards. Cards offer low introductory interest rates on purchases and balance transfers. It is easy for people who are overly optimistic to get themselves in over their heads, or to take on debt on the assumption that they can pay it off, and then have an adverse event either reduce their income or make competing financial demands.

Another critical element that the piece misses: credit cards are a major source of capital for startups (the other big sources are savings and borrowings from friends and families). One study that looked again at the bankruptcy data found a good deal of it had been miscoded and a large percentage of the personal bankruptcies were effectively business failures. As a society, we are more comfortable with the idea of someone erasing his business debts and starting afresh (and having that attitude is one reason the US has such a high level of new business formation) but the new law treats people harshly if they have used personal credit to support their business and then run into trouble.