While the bankruptcy law that went into effect in October 2005 was opposed by consumer groups and supported by credit-card companies (and their campaign contributions), those things don't automatically make it bad public policy.
Nearly two years after most of its provisions took effect in October 2005, some outcomes of the Bankruptcy Abuse Prevention & Consumer Protection Act of 2005 are becoming evident. Bankruptcies are lower, but the law might also be partly responsible for the rise in mortgage defaults and foreclosures.
And it will be several years before we know if people who were shifted to Chapter 13 bankruptcy - under which they must repay their debts - were able to afford their repayment plans.
The law was ostensibly intended to curb bankruptcy abuse by people who could afford to pay off their debts. The argument by lenders was that overextended consumers were using bankruptcy as an easy way out of their debt. That claim was summarized by a March 2007 staff report by economists at the Federal Reserve Bank of New York: "Lenders blamed the steady rise in personal filing rates ... on 'soft' bankruptcy law that motivated households to borrow more than they could afford, with the bankruptcy option in mind, then repay less than they could afford in the event of bankruptcy."
On the other side were consumer advocates, who said that bankruptcy abuse was minimal, and that people who file are generally forced into bankruptcy by financial problems stemming from job loss, medical conditions, or divorce.
The Bankruptcy Abuse Prevention & Consumer Protection Act instituted a means test for Chapter 7 bankruptcy - under which most debts are forgiven. The goal was to shift filers with higher incomes to Chapter 13 bankruptcy. People whose incomes are above the state median and who have at least $100 in disposable monthly income are required to file for Chapter 13.
The law also mandated higher filing fees and mandatory credit counseling.
Under the new law, the number of people filing for bankruptcy is sharply lower - even taking into account the rush of filers prior to the effective date - and a greater proportion of people are filing for Chapter 13 instead of Chapter 7.
"Generally, we think it's working pretty well," said Philip Corwin, a consultant to the American Bankers Association.
But the current home-mortgage crisis suggests that the new law might be too stringent - that many people can't afford to both repay their unsecured debt (such as credit cards and medical bills) and keep up with their monthly mortgages.
In June, default and foreclosure rates on subprime mortgage loans hit record highs.
And according to a March report by Credit Suisse, rising default and foreclosure rates are directly tied to the new bankruptcy rules.
The Credit Suisse report is unequivocal that the law has driven mortgage-foreclosure rates higher. "The stringent means test ... means more delinquent loans have to go into foreclosure directly rather than into bankruptcy," it reads. "Therefore, it is directly responsible for the rising foreclosure rate since the end of 2005."
A second reason, the report says, is that a higher percentage of people filing for Chapter 13 can't and won't successfully complete a payment plan.
"Some consumers are too rich for Chapter 7, but too poor to succeed in Chapter 13," explained Travis Plunkett, legislative director for the Consumer Federation of America - which opposed the new bankruptcy rules.
Measured against its narrowly defined goal, the Bankruptcy Abuse Prevention & Consumer Protection Act has been successful. Fewer people are filing for bankruptcy overall, and a higher percentage are filing Chapter 13 instead of Chapter 7.
In 2006, nonbusiness bankruptcies were 597,965, down 71 percent from 2005 levels, according to the Administrative Office of the U.S. Courts. That wasn't surprising, because bankruptcies jumped 30 percent in 2005 in anticipation of the new law.
But bankruptcies in 2006 were still 42 percent lower than in 2004, and were the lowest number since 1988.
Even taking into account the half-million people who likely filed for bankruptcy in 2005 when, without the law, they might have filed in 2006, nonbusiness bankruptcies are lower; as many as 400,000 people who - based on recent history - would have been expected to file for bankruptcy in 2006 didn't.
Furthermore, the law had the intended effect of shifting people from Chapter 7 bankruptcy to Chapter 13. The percentage of people filing for Chapter 7 bankruptcy instead of Chapter 13 was 59 percent in 2006, compared to 72 percent in 2004.
A key question is the effect that filing Chapter 13 instead of Chapter 7 has on consumers. "This discussion is all very preliminary, but there is evidence" tying the new law to higher foreclosure rates, Plunkett said.
He also said that he predicts that Chapter 13 repayment-plan failures will grow in the coming years. Currently, he said, the failure rate on repayment plans (which last five years) is roughly two out of three. If that proportion rises, he said, it will indicate that the means test of the new law is too stringent.
Plunkett said the the Consumer Federation of America would have supported "modest proposals to weed out abusers," and added that the organization is not opposed to all means testing. Any means test, he said, needs to be flexible.
Another important question is what happened to those 400,000 people who didn't file for bankruptcy in 2006. It's possible, Plunkett said, that some of them are in "informal" bankruptcy; that is, they've stopped paying their bills but haven't officially filed for bankruptcy protection.
It's also possible that the bill's supporters were right, that there was significant abuse of Chapter 7 that has abated because of the means test.
Plunkett said he doesn't have enough evidence yet to support either conclusion.
But bankruptcies have begun to rise again. The Administrative Office of the U.S. Courts said June 2007's bankruptcy numbers indicated "a slow upward creep."
Nonbusiness bankruptcy filings
2004....... 1,563,145
2005....... 2,039,214
2006....... 597,965
Bankruptcy filings by chapter
Chapter 7 Chapter 13
2004 1,137,958 449,129
2005 1,659,017 412,130
2006 360,890 251,179
