Originally published at OnMoney.com, a division of the online broker Ameritrade.
We've all heard the stories about high-flying real estate developers, financiers and con-artists in Texas or Florida, who went bankrupt and yet somehow managed to hold onto their multi-million dollar homes.
We've seen the stories in the newspaper about the rising tide of bankruptcies, and how shameless middle class Americans are emulating these high-fliers, making use of antiquated bankruptcy laws to painlessly disengage from their obligations.
It sounds unfair on the face of it, and America's financial services industry wants to put an end to it. That's why financial services companies spearheaded the drive to enact The Bankruptcy Reform Act, which Congress passed and sent to President Clinton for his signature last December. Clinton vetoed the bill, claiming that it was unfair to average folks who fell on hard times.
But now -- The Bankruptcy Reform Act is b-a-a-a-ack! It's on the D.C. fast track.
The coalition of unions, consumer and women's groups who have been fighting the bankruptcy law are just about out of ammo. Both houses of Congress are expected to pass the measure this week, and President Bush has said he's ready to sign it into law.
"I hope this bill does make bankruptcy more embarrassing - and more difficult," says Senator Charles Grassley, a Republican from Iowa, who clearly hopes to reform America's views on bankruptcy.
But some fear the bill does not go far enough.
"I think it is a marginal, kiss-your-sister kind of bill," laments Senator Phil Gramm, Republican from Texas. "We watered it down to please the Democrats. The decision has been made to try to pass it as is."
Several prominent Democrats are outspoken advocates of the new bill. Senator Joe Biden of Delaware, Senator Dianne Feinstein of California and Senator Robert Torricelli of New Jersey all believe that consumers are "abusing" current bankruptcy laws.
"What every American needs to understand is that somebody is paying the price," says Torricelli. "I believe this is the equivalent of an invisible tax on the American family, estimated to cost each and every American family $400 a year."
Bankruptcy experts and consumer groups, on the other hand, say the bill is too tough on average Americans and won't curb the worst abuses of high-flyers who will still get to keep their multi-million dollar trophy homes in Sunbelt havens.
"This is the harshest bankruptcy bill to come before Congress in years," says Travis Plunkett, Legislative Director of the Consumer Federation of America.
So what's the bottom line on this legislation? Will it curb the high-fliers and restore a sense of financial morality to America's trailer parks and suburbs? Or did Bill Clinton have a point, after all?
Bottom Line on the Bankruptcy Bill
Most Americans who file for bankruptcy have neither assets nor cash flow to pay creditors and do so as a last resort. Most of these folks are not high-flying risk-takers with 5,000 square foot houses and multiple luxury cars, whose latest schemes have exploded, leaving them with only their offshore bank accounts, McMansions, and jewelry. The vast majority of those who file for bankruptcy do so after the loss of a job, a contentious divorce, or in the wake of massive, unexpected medical expenses.
According to Todd Plunkett, legislative director of the Consumer Federation of America, one of the groups opposing the change in the law, the average person applying for bankruptcy has an annual income of $20,000 and is running a credit card of $18,000. These are hardly the rich "convenience" debts of high-flyers who have crashed and burned through their own cupidity or stupidity.
The "reform" will make bankruptcy applicants go through a means test, giving credit card companies a much better chance to seize basic assets such as the homes and cars of people who are floundering in debt. Of course these unfortunates will now require costly lawyers to deal with the reams of new paperwork required.
The Bankruptcy Reform Act would treat a bankrupt person's credit card debt like it would treat failure to pay child support.
As Time points out in a lengthy investigative article on the topic, "MasterCard and an unmarried mother would compete for the same limited pool of cash. And the law would create hurdles intended to discourage or prevent people from filing for bankruptcy protection."
Under the existing law individuals and families can file under Chapter 7, where a trustee oversees the selling of what assets may exist. This is the most popular form of going bankrupt.
Proceeds are then divided up among creditors. But most outstanding debts don't have to be paid, which means charges such as credit card debts and doctors bills are not paid. But there are some debts that have to be paid under Chapter 7: student loans, child support, alimony, and taxes.
Most importantly, there is a safety valve in all this to ensure the person doesn't suffer penury. Retirement accounts and pensions can't be touched.
In practice most people don't have much of anything left. The Executive Office of U.S. Trustees in a 1997-98 study of Chapter 7 bankruptcies, said, "by the time they filed, they had little if any capacity to repay."
This finding indicates that if the purpose of the Bankruptcy Reform Act is to extract more money from bankrupts it is likely to be a non-event.
Although Morgan Stanley Dean Witter analyst Kenneth Posner estimates that the new bill could boost credit card issuers' earnings by 5% a year, a Creighton University study funded by the nonpartisan American Bankruptcy Institute found that only 3.6% of bankrupts could afford to pay any more under any circumstances.
Twenty First Century Debtors’ Prison
There is another procedure for people who can pay back a bigger hunk of debt, Chapter 13. With Chapter 13, the debtor agrees to pay a percentage of his income to a trustee who in turn pays creditors during a 5-year period. Unfortunately, the vast majority of Chapter 13 filers end up unable to meet their obligations.
No matter. The Bankruptcy Reform Act will force more and more potential bankrupts into Chapter 13 rather than Chapter 7, by means of the means tests described above. In addition, the bill will simply remove bankruptcy as an option for many folks.
These individuals will be subject to:
*garnishment of wages
*multiple collection actions
*repossession of personal property
*permanent credit black-listing that will make it impossible ever to buy a home
The folks denied any form of bankruptcy protection will be “faced with what is essentially a life term in debtor’s prison”, according to Brady Williamson, a law professor at the University of Wisconsin, who was chairman of the National Bankruptcy Commission in 1995.
Oh, and as for those high-flyers who somehow go broke and keep their mansions? The Bankruptcy Reform Act won’t touch ‘em. If you live in Texas or Florida, and file for bankruptcy under state law, you can keep your home no matter how much it’s worth. The reason for this inequity? States’ rights, say Congressional supporters of the Bankruptcy Reform Act. It has nothing to do with a double standard – one class of bankruptcy for the rich and another, much more savage approach for average Americans.
The bill’s history
Financial industries came up with studies to show the need for the Bankruptcy Reform Act, including one financed by Mastercard International and Visa that claims every American family foots the bill for bankruptcies to the tune of $400 annually.
Industry advocates claim there is “growing statistical evidence" that more and more Americans are using the bankruptcy laws as a dodge, to avoid paying debts even though they can pay back something.
This is said to be a hidden tax for all American households and in effect, provides “welfare benefit without a means testing." Bruce Hammond, COO of credit card issuer MBNA told a 1998 congressional hearing, “Despite an extraordinarily strong economy, personal bankruptcy filings in the U.S. have skyrocketed in recent years. During 1997, there were more than 1.3 million personal bankruptcy filings, an all-time record and nearly a 19% increase over the number of consumer bankruptcy filings in 1996. By comparison, the number of consumer bankruptcy filings in 1980 totaled 287,570. This means that the number of consumer bankruptcy filings in 1997 represents an increase of more than 360% since 1980."
These claims were reiterated and given added weight by important members of Congress, some of whom had received hefty campaign contributions from the credit card industry – members like Bill McCollum of Florida who received $225,000 from the credit industry and New Jersey Senator Robert Torricelli. He received a $150,00 contribution from MBNA.
Consumer groups have pretty much shredded the industry claims. They point out, for example, that bankruptcies actually have been declining, dropping by 12 percent from the record high in 1998.
That could change during the Bush downturn of 2001. Bankruptcy filings in January of this year rose 15% over the number recorded a year ago.
The industry calls the bankruptcy changes a “reform," when, in fact, it amounts to nothing more than a textbook case of special interests at work. The industry spent $5 million on lobbyists headed by Lloyd Bentsen, the former Democratic senator from Texas and Treasury Secretary in Clinton’s first term, and Haley Barbour, head of the Republican National Committee. To grease the skids for the lobbyists the industry poured $20 million into political contributions. Time reports it included a $200,000 contribution to the National Republican Senatorial Committee, by that 800-pound gorilla of credit cards, the giant MBNA Corp.
Bankruptcy and Subprime Borrowers
There's more to bankruptcy reform than meets the eye.
The new bankruptcy law is a major gift to all lenders who routinely make large numbers of loans to the so-called "subprime" market, consisting of individuals with poor credit records or having too little income to normally qualify for a credit card.
Since most of the profits to be made from credit card debt come from late fees, it is in the short-term financial interest of both bank and non-bank credit card issuers to enable marginal borrowers to maximize their debt. Of course, this strategy runs the risk that the borrowers will simply be unable to make even minimum payments, and then want to file bankruptcy.
The Bankruptcy Reform Act will enable the issuers of this "sub-prime" debt to extract the extra dollar from those unfortunates who fail to make the monthly nut. And that same bill will strike fear into these sub-prime borrowers, who will, consequently, make greater efforts to placate lenders under any circumstances.
The new bankruptcy bill will embolden lenders to relax today's loose credit standards even more - to take more risks in other words. And these loans are already plenty risky.
People who a couple of years ago would routinely get turned down on their applications, are welcomed today with open arms, offered initial interest rates of 3 percent (and even lower in some cases) for loans that can run up to $15,000 or $20,000. A sub prime borrower typically today may have 3 or 4 cards with lending limits of upwards of $10,000.
Of course, what the cardholders soon learns is that one missed or late payment sends the interest rate soaring to 18 percent or more. And most of the low rates shoot upwards after an initial period of 3 to 6 months or so. Thus, the cardholders can easily be overwhelmed by debt, and where they might once have turned to bankruptcy to regroup or hold on to basic assets, under the new regime assets such as a car or a house will be up for possible seizure by the credit card issuer.
Under the old bankruptcy statutes, the lenders would have a hard time getting at the house, and would have to stand in line with other creditors while the borrower first attended to taxes or alimony or child support. But no more.
Now the credit card holder will have to hire lawyers and spend a lot of time bucking new rules. Bottom line is that credit card companies, armed with sophisticated corporate debt collecting divisions, can take anything you own, including house and car, leaving you destitute, like the people living in the poor house of the 19th century.
The subprime market is huge. It consists of people living on the margins of the working middle class, along with elderly who face enormous medical bills and women who find themselves trying to fend off credit card companies from taking their alimony or child support payments. For minorities who have historically faced discrimination or red-lining by banks and other financial institutions, the sub-prime lending institutions have provided a tenuous grip on middle class life.
Traditional banking institutions and the creators of a new, parallel, and largely unregulated banking industry that has been created by finance companies, credit card issuers and other nonbank financial institutions are currently locked in a death struggle for this potentially lucrative but dangerously risky market.
Nonbank lenders offer credit cards, of course, just like banks. And an array of other products geared for this lucrative but risky market -- things like "pay day" loans, in which a working person can get an advance on his pay check by signing a check post-dated on pay day at an interest rate that runs as high as 400 percent. Workers who take out payday loans barely keep up, and often roll them over to keep their heads above water.
They make loans to people in anticipation of tax refunds, which are offered by used car dealers and tax preparer companies. The trick here is for the tax preparer company to charge fees for preparing the tax forms, and fees for electronic tax filing required by all clients.
Different studies suggest that close to 20 percent of people between 50 and64 used one of these sub prime outfits to cash checks.
There are car title pawns, which make loans against your car. And there are high interest mortgage lenders.
Where these businesses were once finance companies, they have increasingly been taken over by major corporations. Ace Cash Express, Inc, of Irving, Texas has 900 offices and is listed on NASDAQ(check). It cashes checks, sells lottery tickets, runs bill payment and money transfer services and offers payday loans.
Moreover, the credit card guys are a Trojan horse for home equity lenders. Faced with a big balance and a high interest rate on the credit card, an individual can turn to the lower interest home equity market to pay off the card, thereby running up the home equity loan to the max, and placing the house up for grabs.
The Parallel Banking System, Greenspan and You
The Bankruptcy Reform Act will give the architects of the nonbank lending system a green light to expand their product lines and market their products more aggressively, so this rapidly growing parallel banking system will get a major boost and should grow even faster.
So what difference does that make to those of us who pay our bills and have savings accounts, 401(k)s and investment portfolios?
Well, if you care about the safety and soundness of the financial system, and if you want Alan Greenspan to have the power to move markets when markets nosedive (as they are doing today), then it could matter a great deal to you.
You see, this parallel banking system operates outside the constraints of federal regulators such as the Federal Reserve Board, and it is growing at the expense of traditional, federally regulated financial institutions.
In 1979, banks and thrifts accounted for 52 percent of all financial sector assets, but by 1999, depository institutions had seen their share dwindling to 22 percent.
"This rise in nonbank financial activity means that more lenders are operating without rigorous regulation of their market practices or their financial soundness," explains Tom Schlesinger, Director of the Financial Markets Center, a public policy research group located in Philomont , Virginia.
"Banks now have to forage for riskier, higher yielding credits to keep pace with their less-regulated, lower-cost rivals," Schlesinger continues. "That dynamic helps feed credit bubbles in some sectors and almost inevitably increases the possibility of credit-quality problems in a downturn."
Many nonbank lenders maintain lines of credit at banks, so during an economic slowdown, any problems incurred by nonbank lenders would automatically feed into the traditional banking system, creating problems there as well.
The growth of nonbank financial activity and the relative shrinkage of the financial sector also hamper the Fed's ability to control aggregate credit growth and conduct effective monetary policy.
You see, bank reserves remain the Fed's primary tool for implementing monetary policy. The last few months, for instance, the Fed has been providing more liquidity to banks, through lower rates, while encouraging them to make fewer loans. This increases bank reserves, which increases the safety and soundness of the banking system at a time when an economic downturn and flat to plummeting stock markets could create big problems for banks who have made bad loans to telecom companies or made bad bets on credit derivatives.
When banks were the primary lenders to corporate America, the Fed's actions would have immediate consequences for the broader economy. But now corporate America relies upon money markets for financing much more than banks.
As the Fed's traditional toolkit loses its effectiveness, the Fed must hammer the economy with bigger, more abrupt policy changes to affect the demand for credit - having essentially lost its ability to affect the supply of credit directly.
That's one reason why the recent Fed rate cuts have not yet turned around the incipient Bush economic downturn, the inventory drawdown or tech spending plans of major corporations, or the plunging Nasdaq index. Another reason is that Fed rate cuts take a year or more to affect the real economy, but that's another story.
The Fed's need to make ever more dramatic policy changes feeds market volatility and compounds another aspect of the shrinking banking system problem - a growing number of net-creditor households rely on yields from these volatile assets to service their debts.
Between 1979 and 1999, deposits declined from 25 percent of all household financial assets to a mere 10 percent today.
"The result is greater fragility for the entire American financial system," argues Tom Schlesinger of the Financial Markets Center. "And the long-term answer is leveling the regulatory playing field upward - including a system of reserve requirements for all financial intermediaries."
But that type of strong medicine for nonbank lenders is not on George W. Bush's agenda and it's not on the agenda of the Democratic opposition.
Instead, Republicans and Democrats alike are focused on making it easier for bank and nonbank lenders alike to extract more profits from average Americans so they will flourish in an increasingly risky, volatile and fragile American financial system.