Saturday, October 10, 2009

After Reforms, Huge Losses From Personal Bankruptcies

The number of personal bankruptcy filings in the United States this year passed the one million mark late in September, based on numbers from the American Bankruptcy Institute. More than 4,000 people per day are going bankrupt — that’s one every 20 seconds.

It’s a pace that may soon exceed the flurry of bankruptcy filings that preceded the bankruptcy reform deadline in 2005. The 2005 reform was intended to make consumer bankruptcy virtually impossible, though in fact it reduced it by less than half. Tinkering with the qualifications for bankruptcy turns out not to make much difference when people really don’t have any money left. With consumer income falling, and now with historically high unemployment levels and credit card interest rates, lots of people are finding that they don’t have any money left. If you flip through the bankruptcy headlines, you read about personal bankruptcies that come from business failures. The high-profile personal bankruptcies involve homebuilders, auto dealers, printers, hedge fund managers, and clothing designers whose businesses fell apart, but the vast majority of personal bankruptcies involve consumers.

Ironically, the tighter rules of the bankruptcy reform rarely prevent consumer bankruptcies, but merely delay them until the consumer’s assets are thoroughly depleted. This means that creditors get less, on average, than they did before the reform. Creditors who became more confident in lending to consumers after 2005 (this, of course, added to the credit bubble and subsequent collapse) should have been more cautious instead. Creditors’ two tricks for collecting unpaid debts, seizing assets and garnishing wages, turn out to be not much help. A creditor might get a few thousand dollars by seizing a consumer’s checking account, but usually this means that the consumer’s checks to other creditors bounce, leading to more financial distress and, often, bankruptcy. Attaching a person’s wages almost always leads directly to bankruptcy. Typically a single creditor can take between a fourth and a third of a paycheck, but that is more than half of a consumer’s income after taxes and insurance and almost always forces a consumer immediately into bankruptcy. From the creditor’s point of view, this is a loophole they didn’t anticipate.

Another problem for creditors is that financially distressed consumers are getting more skilled at hiding their assets. Hiding assets is a crime if a consumer is in bankruptcy, but perfectly legal and often necessary for someone who is short of money but doesn’t yet qualify for bankruptcy.

More than 1 percent of U.S. adults have filed for bankruptcy since last year, and another 1 percent will be going bankrupt before the end of next year. This trend will not improve until consumer income starts to increase again, and that may not happen until early in 2012. Until then, the high rate of consumer bankruptcies will eat into the profits and capital of businesses that lend to consumers. The bankruptcy trend is just one of many factors that make a broad economic recovery difficult at this point.

In retrospect, the 2005 bankruptcy reforms can be seen to have destabilized the economy by minimizing the amount recovered by creditors when a consumer goes bankrupt. They made personal bankruptcy a more catastrophic financial event than it was already without reducing its frequency in any useful way. A revision to the bankruptcy code ought to encourage consumers to visit the bankruptcy court earlier, before it is too late for the court to salvage anything.