Monday, July 6, 2009

The Bankruptcy Loophole

Bankruptcy reform in 2005 was supposed to make it virtually impossible for U.S. consumers to go bankrupt. But it turns out there is a loophole. Creditors can effectively push a consumer, even one with relatively high income potential, into bankruptcy by seizing part of the person’s wages or unemployment benefits.

In most states, a creditor can get a court order to seize a fraction of a person’s wages or unemployment benefits after just two or three late payments. But if one creditor can seize 25 percent of a person’s income, that could leave the person with no money at all to pay any other creditor. The result is that a consumer who might never have qualified for bankruptcy instantly qualifies — and the consumer is virtually forced to file right away, before 25 percent of the next pay check disappears.

A bankruptcy court can take away most of a person’s assets, but most consumers have few significant assets left by the time they reach bankruptcy. And then, a bankruptcy court will rarely force a person to pay more than five years of income to creditors — less, if a salary is not very high compared to the cost of living. This means creditors usually stand to get less than half of what a bankrupt consumer owes them — and then, the creditors’ legal fees may eat up most of the money they do collect.

At least 20 million U.S. workers are just one wage garnishment order away from bankruptcy. Some are preparing their bankruptcy filing in advance.

It might seem counterintuitive to prepare a bankruptcy filing when you do not qualify for bankruptcy, but it is the same idea as updating a resume even though you like your job. It prepares you for quick action at a time when quick action is important. If you have your resume ready to go, then hear you are losing your job, you can start applying for jobs right away.

In the same way, if you have a bankruptcy filing drafted, then find out that you qualify for bankruptcy because a creditor receives court approval to take your wages, you can add two paragraphs to the filing and update some numbers, and take it to the courthouse the next day.

In a time when some creditors are becoming more aggressive about collecting debts, fearing that consumers may have even less money next year as the economy declines, their actions are leading more consumers into bankruptcy. This creates a snowball effect. A bankruptcy affects not just the one creditor who pushes the consumer into bankruptcy, but maybe 20 to 50 other creditors at the same time. Then, as bankruptcies become more frequent, creditors become even more hasty about trying to collect.

And so, the bankruptcy reform is backfiring. Lenders were overconfident after the 2005 bankruptcy reform, and they made bad decisions that now seem to be leading to more and bigger bankruptcies than we would have seen without bankruptcy reform. A surge of personal bankruptcies is on the way that could easily exceed pre-2005 levels. This can only lead to a new wave of credit write-downs over the next two or three years, with financial damage on a scale that could look like the mortgage crisis all over again.