Personal Bankruptcy & Consumer Credit Crisis
before the Subcommittee on Administrative Oversight and the
April 11, 1997
Written materials provicded to the Subcommittee
The American Bankruptcy Institute (ABI) is the nation's largest multi-disciplinary organization devoted to research and education on issues related to insolvency. We have more than 5,500 members, including attorneys, accountants, judges, bankers, credit managers, trustees, academics and financial service professionals. The ABI is non-profit and non-partisan and we generally take no advocacy positions before Congress, although we regularly appear to assist Congress' understanding of our nation's bankruptcy laws. We submit this statement to assist the Subcommittee's understanding of the implications of recent increases in the rates of delinquency and default on consumer loans as they relate to rising bankruptcy filings.
Bankruptcy Filing Are At Historic High LevelsBankruptcy is booming in America like never before. For the first time in the history of the U.S. courts, the number of bankruptcy petitions filed has topped the one million mark, according to data released from the Administrative Office of the U.S. Courts. In 1996, there were 1,178,555 bankruptcy petitions filed, a more than 27 percent increase over 1995, when 926,601 new cases were filed. Consumer bankruptcies are driving this increase as more than 95 percent of all filings (1,125,006) were by individuals. This represents a 28.6 percent increase in non-business filings over a year ago. This figure is more than double the number registered a decade ago.
Moreover, the trend continues to rise. The number of new bankruptcies filed during the fourth quarter of 1996 -- 311,131 -- was the highest three month figure in U.S. history and is the fifth consecutive quarter to register an increase in filings. For calendar year 1997, we are now projecting between 1.2-1.3 million new cases.
Approximately 11 million cases have been filed since the Bankruptcy Code went into effect in late 1979. Between 1984 and 1992, bankruptcies increased by 179 percent, with each year setting a new record. During much of this period, the national economy was expanding rapidly from a recession in the early 1980's. Filings fell off by 10 percent in 1993 and 5 percent in 1994, but increased by over 11 percent in 1995, before last year's 27 percent increase.
On a per capita basis, filings in the 1980's were about double the level of the 1970's but they have doubled again in just half of the decade of the '90's. This is nearly 8 times the rate of the 1930's, a period commonly identified with economic failure. Unlike the 1980's, when bankruptcy filing increases were regionalized in the oil patch, farm belt or east and west coast real estate markets, today filings are up in every judicial district in America.
About 80 percent of filings are in Chapter 7, or straight bankruptcy, where individuals receive a general discharge from most unsecured debt while retaining exempt property. The next largest group of filers is in Chapter 13, where creditors may be repaid in installments over a 3 to 5 year period.
Filings are occurring at a rate of 1 bankruptcy per 100 households. To illustrate that number in real terms, consider it roughly equal to finding one family in bankruptcy as you drive up and down one aisle of your average crowded shopping mall parking lot this weekend.
Filings Are Driven By Increases in Consumer DebtConsumer spending is essential to the national economy, accounting for about two-thirds of GDP. Thus cutting back on the availability of consumer credit would likely have an adverse effect on economic growth. But the image of the debt-strapped American household comes into focus when one examines the rising levels of consumer debt. Revolving credit, primarily credit card debt, has been the fastest growing component of consumer debt, averaging annual increases of 20 percent over the past two years, as credit card companies and retailers aggressively competed for business. The typical household with these debt burdens has an annual disposable income of about $20,000 and credit card debts of more than $10,000. Consumer debt, at $1.1 trillion in installment credit and over $465 billion in revolving credit, has more than doubled in the past decade and is up 51 percent in the last three years alone. As former Fed Governor Lawrence Lindsey stated in testimony before the House Banking Committee last fall, such levels have far outpaced income gains, making this trend unsustainable. There is a strong perception among our members that people are not spending income, but are rather spending credit.
The Impact on HouseholdsToday, consumer credit is as easy to use as it is to obtain. The last holdouts of the cash economy, grocery stores and supermarket chains, now universally accept major credit cards. Cash advances on credit cards can be obtained at or near the growing number of gambling casinos nationwide. Credit cards may now be used to pay everything from the electric bill to state income taxes. The availability of these "conveniences" can have an adverse effect on budgetary discipline on even an "high earning" household.
Of course, some households are much better prepared to manage these debts than are others. Since an important factor here is household income, it is useful to consider the distribution of credit debt among income groups. The 1995 Survey of Consumer Finances reports, for different income groups, the percentages with credit card debt and the median credit card debts for these households with debts.
Keeping in mind that these debt levels are probably underreported by 50% or more and that average household debt is nearly double median household debt, it is evident that the group in the population that is most encumbered with credit card debt is the broad middle class. The households in this class are most likely to have credit card debts and credit card debt to income ratios that are higher than those of low and high income households.
The American Bankers Association has reported on rates of delinquencies in credit card payments not seen in 15 years (3.48 percent), and well above the level during the 1991 recession. With debt at such a high level, even a small rise in short-term interest rates could have a very depressing effect on both consumer spending and even higher rates of bankruptcies.
Lender and Regulator ConcernsLosses to major consumer lenders are mounting. Although banks earned a record $52.4 billion in 1996, delinquent loans -- those with scheduled interest payments 30 to 89 days past due -- increased by 15.1 percent last year, according to the FDIC. Net charge-offs of credit card loans totaled $9.5 billion in 1996, accounting for 61.1 percent of all loan charge-offs. This was an increase of $2.7 billion from the $6.8 billion in credit card loans that banks charged off in 1995.
Visa U.S.A. reports that net credit charge-offs more than tripled in the 9 years between 1987 and 1995 and are projected to nearly double over the next several years. In 1995, bankcard industry losses resulting from personal bankruptcy filings increased 45 percent over the previous year, to $4.7 billion. Visa projects bankruptcy losses will exceed $9 billion by 1997.
An ominous new development is the "surprise" bankruptcy, filed by individuals who are filing for bankruptcy without first having a five or six month period of delinquency. Risk management professionals have reported that the similarities between "good" customers and those who file for bankruptcy are very alarming to lenders, who need to be able to differentiate between these borrowers. So even while the average delinquency ratios may be going up slowly, the charge-off rates are increasing faster, as consumers declare bankruptcy with little warning.
Confronted with rising losses on credit cards and more customers declaring bankruptcy, many
lenders are tightening up on consumer credit, according to a recent survey conducted by the
Federal Reserve. And last fall, the Office of
the Comptroller of the Currency (OCC) reminded national banks of the risks in preapproved
solicitations of credit cards and identified specific steps to address weaknesses in their credit card
portfolios. In an advisory letter the OCC identified the following weaknesses in some solicitation
The advisory letter said that the appropriate response to determining credit card portfolios
Yet such new restrictions on credit are unlikely to slow the growth in consumer bankruptcy filings over the next 12 months, given the lag time traditionally involved.
The continual increase in the consumer credit rates of default and percentage of charge-offs, when coupled with the surprise filings, are a potentially ominous sign that cannot be overcome by the comfort provided by the high interest earnings traditionally enjoyed by the consumer credit industry. It is worth recalling that the bad real estate loans which generated the savings and loan crisis did not fail overnight, but gradually created non-accruals and charge-offs to an unsustainable level.
The tightening of consumer credit is the most obvious, but perhaps the least palatable solution. Not only does the consumer credit industry enjoy high profitability, even with the filing rates; retailers have become "addicted" to consumer credit, particularly for the sale of large ticket items. There are, for example, few home electronics or appliance retailers who do not lead off their advertising with offers such as "six months, same as cash" or "no payments 'till next year".
Why Consumer Bankruptcies Increase During Each ExpansionConsumer bankruptcy filings reflect debt pressures on consumer best measured by the debt service payment ratios maintained by the Federal Reserve Board. These ratios measure the proportion of household income devoted to repaying consumer debt and mortgage debt each month. The record of bankruptcy filings shows this figure to be an accurate, though lagging, indicator.
As debt payments as a percentage of disposable personal income began to increase in 1983-84 and rose steadily until their peak in late 1989, bankruptcy filings were pulled up correspondingly. As the ratio began to fall (due to less consumer spending and reduced interest rates) from 1990 through the end of 1992, there was a subsequent decline in bankruptcies in 1993-94. But as consumer spending helped pull the economic wagon out of the 1991 recession there has been both a rise in the debt service payment ratio and a predictable (lagging) rise in personal bankruptcies.
This most recent consumer bankruptcy trend is consistent with the history of past economic expansions since the post-World War II era. Economic data show that while consumer bankruptcies rise during recessions, they increase even more dramatically during economic expansions. For example, between 1984 and 1990, consumer bankruptcies set records each year during the economic expansion that occurred then.
Consumer bankruptcies and household debt reflect broader trends in the growing supply of consumer and home mortgage credit over the last 20 years. While this increased availability -- the "democratizing" of credit -- has made consumers attain a higher living standard, it has clearly played a role in the rise in bankruptcies.
A recent survey of consumer debtors, conducted by Visa, showed that the number one reason for filing, cited by nearly 30 percent of respondents, was simply that they were overextended. Other major causes included the loss of a job, medical and health reasons, and divorce or separation. But while each of the latter causes may have been the "last straw" that led to a bankruptcy filing, the fact is that high debt loads create a kind of "at risk" population of consumers who are only an interrupted paycheck away from considering bankruptcy protection.
The ease and simplicity of the filing process, together with the lack of any meaningful stigma attached to being a Chapter 7 debtor, contributes to this phenomena. In addition, it is often easier for a recently-filed Chapter 7 debtor to obtain credit than one who is struggling to pay his or her debts.
Legal and Social Factors Have ContributedWhen Congress created the modern bankruptcy Code in 1978, it made bankruptcy a much more debtor-friendly law. Although the amendments to the Code have since attempted to rebalance the equities and provide more creditor protections, the basic pro-debtor framework remains. Bankruptcy provides a unique, automatic injunction against the world by the mere act of filing, with respect to nearly all legal and collection actions against the debtor. In most no-asset Chapter 7 liquidation cases -- the vast majority of consumer cases -- the debtor will never see a judge, is rarely examined by creditors and may never even set foot in a court before the case concludes with a permanent forgiveness of debts. That broad discharge, while providing the debtor's "fresh start", means that many creditors, particularly unsecured creditors, often receive no distribution at all in a bankruptcy case.
Though it was formerly true that debtors often had difficulty in reestablishing credit, intense competition in the consumer lending marketplace  has led to new credit being widely available to individuals without careful regard to their creditworthiness, even soon after they have discharged nearly all of their debts in a bankruptcy.
Also noticeable is a profoundly different perception toward bankruptcy, consistent with a larger secular change in attitude toward debt and personal responsibility. Unlike a generation ago, there is no shame in debt any more; the stigma associated with bankruptcy has largely disappeared. To cite but one example, virtually every major car dealer heavily advertises the availability of credit to finance cars for bankrupt debtors. Surprisingly, this is a good business decision by the dealer and the lender. The debtor will pay (and expects to pay) a significantly higher interest rate. In addition, the debtor has "cleansed" his or her balance sheet of credit card and retail credit accounts, therefore is ironically a better risk than a highly-leveraged debtor who is paying all of his or her bills.
Consumers are more aware of the bankruptcy option, made aware in part by a growth in lawyer advertising promising that you may be able to "keep everything" and "pay back nothing". A cultural milestone in the destigmatization of bankruptcy was recently reached with the advent of a brand new gameshow on Lifetime cable television called "Debt". Aired each night, the show features three consumers with high debts competing to answer questions on popular culture. The winner goes home with his or her debts paid off. The losers get a savings bond.
Potential Ways to Reduce Consumer Bankruptcy FilingsConsumer bankruptcies are likely to decline only when the need for this type of remedy declines or when the remedy itself becomes less attractive to potential users.
High yields on credit card loans, which have traditionally far outpaced loan losses, have spurred institutions to rapidly expand credit card lines of credit. High profits have attracted competition for new borrowers. The demographic changes in credit card underwriting, especially among lower income borrowers or new borrowers with no credit histories (e.g. students) should be carefully reconsidered and reversed, if possible.
The consumer credit industry has proposed a number of specific reforms aimed at striking a different balance between the right of honest debtors to receive a fresh start and abusive filings. Many of the suggestions are offered with the hope of encouraging greater repayment, such as by (a) providing that all initial consumer bankruptcies be filed under Chapter 13, where consumers agree to commit all of their disposable income to pay creditors over a three to five year plan period, or (b) by amending the Fair Credit Reporting Act to allow credit bureaus to report bankruptcies only during the limited time of the repayment plan, rather than up to 10 years, as is the case now. Other proposals are directed at limiting the scope of consumer bankruptcy relief, by (a) providing that debts incurred without a reasonable expectation or ability to repay would be deemed non-dischargeable in bankruptcy; (b) providing that all consumer debts and cash advances incurred within 90 days of filing be deemed non-dischargeable; and (c) by giving creditors greater ability to have a bankruptcy case dismissed for proven abuses.
The National Bankruptcy Review Commission, created by the Bankruptcy Reform
Act of 1994, has been studying ways to amend the consumer bankruptcy laws. Among
the proposals being considered are:
Significantly, however, as long as the consumer credit industry is willing to sustain high rates of defaults and charge-offs, and therefore provide easy credit to consumers who are already highly-leveraged and "at risk", there is little the Bankruptcy Code can do to effectively reduce the unprecedented rate of consumer filings.
Changes in the statute may lead consumers and consumer debtor lawyers to reconsider alternatives to bankruptcy. Consumer credit counseling should be encouraged as an alternative. And although lawyer advertising is a constitutionally protected form of commercial speech, consumers should be encouraged to educate themselves about alternatives to bankruptcy and should seek knowledgeable and ethical legal counsel, who will act in their client's best long term interest. One way to help distinguish among the best available consumer bankruptcy attorneys is through certification programs. The American Bankruptcy Board of Certification (ABBC) is one such organization that certifies consumer bankruptcy specialists, for the benefit of the consumer public.
The American Bankruptcy Institute appreciates this opportunity to submit this statement and looks forward to continuing to work with the Subcommittee and its staff.
Footnotes "The Consumer Impact of Expanding Credit Card Debt" Consumer Federation of America, February, 1997.[RETURN TO TEXT]