Judiciary HomepageConsumer Bankruptcy and the Credit Industry
Testimony of
Vern McKinley
Attorney
Regular Policy Contributor to the CATO Institute
Before the Subcommittee on Commercial and Administrative Law
Committee on the Judiciary
U.S. House of Representatives
March 10, 1998
Thank you for the opportunity to testify on the issue of consumer bankruptcy and the credit industry. My name is Vern McKinley and I work as an attorney for a federal financial regulatory agency. I also write regularly for the CATO Institute on financial and regulatory issues.
My first experience with the federal bankruptcy system was during the mid-1980s. I examined banks for the Federal Deposit Insurance Corporation in Texas during the banking crisis of that period. A review of the loan portfolio was a vital part of each examination and it was not uncommon for an examination team to review a number of loan files of borrowers who had filed for bankruptcy. My experience with bank credit issues was also developed working on the research staff of the Board of Governors of the Federal Reserve and as a financial analyst for the Resolution Trust Corporation. Prior to my current position, I worked as an attorney in private practice and had the opportunity to work pro bono for an indigent borrower facing financial difficulties. Finally, I have spent much of the past year researching the issue of consumer bankruptcy and the dramatic rise in the number of consumer filings. The final product of that research is an article published in the current issue of CATO Institute's quarterly magazine, Regulation. This article is attached as an appendix to my testimony along with a companion article by Joseph Pomykala which appears in the same issue. My remarks today are largely based on my article that appears in Regulation.
Background-The Constitution grants Congress the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States." Like the Commerce Clause, this power was intended to facilitate the free flow of interstate commerce, as summarized in The Federalist No. 42:
"The powers included in the THIRD class are those which provide for the harmony and proper intercourse among the States…to wit: to regulate commerce among the several States and the Indian tribes; to coin money, regulate the value thereof, and of foreign coin;…to establish a uniform rule of naturalization, and uniform laws of bankruptcy…The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed into different States, that the expediency of it seems not likely to be drawn into question."
Bankruptcy law has evolved from a means to facilitate collection of debts to a means to facilitate evasion of debts, as it provides an attractive opportunity for consumer filers to cleanse themselves of debt. The pronounced rise in consumer filings over the past twenty years is well-documented. I believe this increase is primarily due to the extraordinary benefits available from filing, the foremost of which is a discharge of debts. The following issues have been the primary focus of attention of those attempting to explain this rise.
Economic cycle/joblessness-If bankruptcy were truly a system that focused its relief on those suffering from economic dislocation, as some argue, then one would expect that when economic times are bad, filings would rise and when economic times are good, filings would fall. In fact, the opposite has been true over the last 20 years since the last major overhaul of the bankruptcy laws. Over this period there have been two lengthy economic recoveries. During both of these recoveries, four to five years into the business cycle, filings increased dramatically, ultimately to record levels. This is the phenomenon we are seeing today as during relatively good economic times with the unemployment rate below 5%, we have a record number of filings year-after-year. This pattern also occurred during the late 1980s, as filings reached record levels year-after-year, even as the unemployment rate drifted downward to slightly over 5%.
Medical Bills and Divorce-One major reason cited by filers for filing bankruptcy is large medical bills. Since such a large portion of medical bills is paid by third party providers, health care consumers have little incentive to contain health care costs, leading to enormous debts for the uninsured or underinsured. Fixing the system is important, but is independent from the analysis of bankruptcy. Many filers also blame divorce for their decision to file, but it is likely not the cause of the recent surge in filings since the early 1980s. Although the divorce rate rose steadily throughout the 1960s and 1970s, it has flattened throughout the 1980s and 1990s.
Easy access to debt, especially credit cards-A recent report by the Consumer Federation of America places the blame for the recent increase in bankruptcies on "aggressive credit card marketing by issuers, chiefly banks, who have increasingly been targeting low and moderate income households." The Consumer Federation's solution to the rise in bankruptcies is to impose a limit on the availability of consumer credit, through legislative means if necessary.
Of course, being in debt is a necessary condition for filing bankruptcy. But, placing the blame for the increase in consumer bankruptcy filings on non-mortgage debt, as many self-appointed consumer groups have done, may be misguided. Consumer credit debt service burdens, what one researcher calls "a truer measure of the ongoing financial obligations that households face [than the debt-to-income ratio]," are at roughly the same level as they were 30 years ago (Paul C. Bishop, Federal Deposit Insurance Corporation, "A Time Series Model of the U.S. Personal Bankruptcy Rate." C. Alan Garner, Federal Reserve Bank of Kansas City; "Can Measures of the Consumer Debt Burden Reliably Predict An Economic Slowdown?"). On the other hand, mortgage debt service burdens have trended upward over this same period. In a number of ways, from the mortgage interest deduction to the creation of mortgage-related government sponsored enterprises, to the programs of the Federal Housing Administration, the Congress has strongly encouraged consumers to take on this mortgage debt. This encouragement of mortgage debt has been with the support of many of the same groups that have encouraged a tightening of non-mortgage debt.
The recent expansion of non-mortgage credit availability to lower-income households is actually a positive development. It is especially encouraging because it has been accomplished without the heavy-handed federal incentives that have accompanied increases in mortgage debt. Any legislative effort to restrict consumer access to non-mortgage credit would have the government dictate to consumers and creditors how to make credit decisions. This would be a dangerous step toward a system of government credit allocation. Restrictions on debt tend to have the greatest adverse impact on marginal credit risks.
Reduced Social Stigma-It is difficult to measure this decreased stigma, but one indicator is the sheer number of people filing, as there have been ten million filings over the past twenty years. Other indicators of a reduced stigma are the fact that surveys show roughly half of filers learn of the bankruptcy option from friends or family and the willingness of consumers to file bankruptcy more than once. The ease of filing clearly plays a role in both of these indicators.
The Lawyer's Role-Coinciding with the recent increase in bankruptcy rates was a 1977 Supreme Court case that protected advertising by attorneys as commercial speech under the First Amendment. Prior to that time, many states forbade most types of lawyer advertising. Television expenditures for legal advertising over the twenty year period since that ruling have increased dramatically from a few million dollars per year to approximately $100 million per year (Diane Ellis, Federal Deposit Insurance Corporation-"The Influence of Legal Factors on Personal Bankruptcy Filings").
The role that attorneys play in the increase in filings is self-perpetuating and biased toward an ever-increasing level of filings. Furthermore, attorneys and their subordinates essentially hold a monopoly position regarding the provision of bankruptcy services and can utilize unauthorized practice of law statutes to maintain this monopoly position. Existing financial incentives encourage a high-volume, full-time bankruptcy practice, what some call a "very routinized practice." As the number of attorneys practicing in this area has increased, it has drawn others to the practice. As additional attorneys are drawn into the practice of bankruptcy, the search for consumers who may benefit from filing intensifies. This search for potential filers has apparently not reached a point of saturation. Although about 1% of filers currently file, one researcher argues that at least 15% of U.S. households would benefit financially by filing for personal bankruptcy (Michelle J. White, University of Michigan-"Why Don't More Households File for Bankruptcy?").
Changes in Demographics-There is also evidence that the aging of the baby boom generation has contributed to the recent increase in bankruptcy filings. The prime years for bankruptcy filing are the peak borrowing years of age 24 to 54. The percentage of the American population in this category has increased from 34 percent to 44 percent over the last thirty years.
Changes in Legislation-The Bankruptcy Reform Act of 1978 ("1978 Act") moved the bankruptcy laws in a pro-filer direction. As discussed in the attached article by Joseph Pomykala, the 1978 Act is simply part of a historical evolution that has been characterized by a continued ratcheting up of the attractiveness of filing in the form of expanded eligibility, property retainage and access to discharge. The impact of the 1978 Act, combined with the previously-discussed impact of expanded attorney advertising, has had startling results. For the twenty years prior to the implementation of the 1978 Act, bankruptcies trended upward from roughly 100,000 filings per year to 200,000 filings per year, a yearly rate of increase of less than five percent per year. Also during that twenty year period, each time filings increased by more than 15 percent in a year it was during an economic recession. For the nearly twenty years since the 1978 Act went into effect, bankruptcies trended dramatically upward from 200,000 filings per year to 1.35 million filings in 1997, a 12 percent rate of increase. During this time, as noted previously, many of the largest year-to-year increases in filings have occurred in the midst of strong economic recoveries.
Who Pays the Price for Bankruptcy?-To the extent that borrowers are getting debts discharged that they have the ability to repay, they are externalizing their debt problems, even to parties who were not part of the original credit transaction. This is a direct cost of maintaining the current bankruptcy system. Although the precise allocation of costs between these parties is uncertain, it is likely that these costs are absorbed by:
Creditors-because of the imprecision of the borrower screening process, creditors may not always be able to pass these costs on to debtors in the form of higher fees or interest rates.
Bad debtors-as information and modeling of the credit allocation process becomes more sophisticated, creditors will more effectively be able to screen borrowers, identify potential filers, and potentially passing on some of the costs of bankruptcy to debtors who are most likely to file.
Good debtors-because the credit screening process is not now, nor will it ever be perfect, some of the costs of bankruptcy may be passed on to good debtors in the form of higher rates and fees. However, because the competition for very strong debtors is intense and some of these debtors are easily identifiable, it is unlikely that these very strong debtors absorb much of the costs of bankruptcy.
A less obvious cost of the current bankruptcy system is that lenders, in reaction to borrowers' increased willingness to file, have tightened their lending standards, especially related to credit cards. This tightening was pronounced in early 1997 (Federal Reserve Senior Loan Officer Opinion Surveys-January, May 1997). As a result, marginal debtors, some of whom would more easily secure credit in a system without quick and easy bankruptcy, are being denied credit.
The Right Course-To restore the bankruptcy system to its Constitutional purpose of facilitating the collection of debts in interstate commerce, all consumer debtors should commit to a plan where a share of future income and a share of current assets are committed to repaying creditors. If the debtor expects no income over the plan period, and has no assets to liquidate, then, and only then, should an immediate discharge be granted. Even under these stricter limits, discharge should be limited to once in a lifetime. Because bankruptcy would become an exercise in financial planning, non-attorney providers, such as accountants and financial planners, should also be allowed to prepare bankruptcy plans.
I would ask that my testimony and attachments be placed in the record. Thank you for the opportunity to appear before you and I will be pleased to answer any questions you may have.
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