Commentary

Bankruptcy Reform Needed Now More Than Ever

By L. Jacobo Rodríguez
September 27, 2002

The Administrative Office of the U.S. Courts recently announced that bankruptcy filings surpassed 1.5 million for the first time in the 12-month period that ended on June 30, 2002. Abortion politics may end up killing the bankruptcy overhaul bill that was approved by the conference committee in the final days of July — the Bankruptcy Abuse Prevention and Consumer Protection Act. But that does not make reform irrelevant or diminish its urgency. Although the proposed legislation is far from perfect, it would curb the abuses that occur under the existing bankruptcy code — a code that makes it attractive for many debtors, including those who can easily pay their debts, to file for bankruptcy.

At present, debtors can file for bankruptcy under Chapter 7 or Chapter 13 once every six years. Consumers who file under Chapter 13 agree to a court-approved plan to repay their debts over three to five years using future earnings. They do not have to liquidate their current assets to repay creditors.

Consumers who file under Chapter 7, however, must use their present wealth above an exemption to repay their debts, but their post-bankruptcy earnings remain untouched. The exemption includes personal items, equity in owner-occupied housing, retirement accounts and cars. The justification for exempting those items and future income is that it provides filers with a “fresh start” in life after bankruptcy.

But because the exemption levels are usually high or filers have few nonexempt assets, in over 90 percent of Chapter 7 cases there is no property to be liquidated. The result: Creditors get nothing. Consequently, most consumers who file for bankruptcy do so under Chapter 7 rather than Chapter 13. Indeed, of the 1.5 million bankruptcy cases filed from July 1, 2001, until June 30, 2002, more than 1 million were Chapter 7 cases.

Under current law, the benefits of filing for bankruptcy greatly outweigh the costs for many households. The costs include the filing fee (usually a few hundred dollars), any attorneys’ fees, the amount of debt repaid, and the tarnished reputation that comes from filing. The benefit is the debt discharged, which, given the leniency of Chapter 7, usually is a large percentage of the total unsecured debt owed. The net financial gain, then, is the difference between the benefits and the costs — a figure that is often substantial. Michelle White, an economist at the University of California-San Diego, estimates that about 15 percent of U.S. households could benefit from filing for bankruptcy under the current system.

From a policy perspective, a problem arises because lenders, who have a hard time distinguishing between good and poor credit risks, increase the interest rates for all consumers to recoup the losses that they incur from unpaid loans. As more and more consumers file for bankruptcy and discharge their debts, interest rates for consumer credit increase to compensate lenders for their losses. White estimates that the average borrower pays $500 a year in extra charges to compensate lenders for those unpaid loans. Thus, to the extent that innocent consumers are paying for the sins of the guilty, the current system works against honest debtors.

The proposed legislation would reduce the perverse incentives of the current system by introducing a means test to bankruptcy. More precisely, consumers who earn more than the median income in their state and have enough disposable income to repay, over a five-year period at least one-quarter of their debts-or $6,000, whichever is higher-would have to file under Chapter 13. The likely effect is that more people will file under Chapter 13 or refrain altogether from filing after the legislation is implemented (assuming that the bill passes). But more people might rush to file for Chapter 7 bankruptcy before the change goes into effect.

The legislation, however, would not affect individuals whose incomes are below the regional median. For that reason, the current system, with all its problems, would remain unchanged for a great number of consumers. Indeed, it is estimated that fewer than 15 percent of the people who would otherwise file under Chapter 7 would be forced to file under Chapter 13 under the reform plan. A better reform would have also forced those whose incomes are below the median to pay a (smaller) percentage of their debts based on their ability to pay — but to pay something nonetheless.

The reform legislation also leaves many loopholes, such as the homestead exemption (albeit with tighter limits), contributions of up to 15 percent of gross income to charities, allowances of up to $1,500 per child per year for schooling, contributions to ERISA-approved retirement plans, and an exemption for all tax-free retirement accounts, with a $1 million cap for IRAs, which make it easier for filers not to pay their debts.

A bankruptcy system, no matter how stringent, will always allow some debtors to abuse it to the detriment of honest consumers. Those consumers and creditors, however, will likely welcome a reform bill that removes the incentives people have to cheat. The 107th Congress should politics aside and get the job done.

L. Jacobo Rodríguez is a financial services analyst at the Cato Institute.