The bankruptcy bill about to pass Congress arrives at an awkward moment: the tail end of a prolonged boom in consumer borrowing. From 1995 to 2000, Americans increased their personal debts by about 50 percent to roughly $7.5 trillion–a figure including everything from home mortgages to student loans. Now comes the bankruptcy bill, which would make it slightly harder for consumers to erase debts through bankruptcy. Although the bill is not especially harsh, it could perversely worsen the economic downturn.
We are already seeing signs of a pullback in consumer borrowing typical of a weakening economy. Worried about their jobs, consumers borrow less. Suffering losses from past loans, lenders tighten credit standards. In 2000, the growth of consumer loans slowed. For credit cards, growth dropped by half (from 13.3 percent in the first quarter to 6.7 percent in the last). Because consumer spending represents two-thirds of the economy, less borrowing reinforces the overall slowdown.
The question now is how much a new bankruptcy law might further darken the borrowing climate. At present, consumers can file under either Chapter 7 or Chapter 13 of the bankruptcy law. Neither eliminates secured debts: If you can’t pay your home mortgage or car loan, your home or car will probably be repossessed. But Chapter 7 eliminates many other debts–from credit card loans to medical bills (taxes and student loans aren’t forgiven; neither are alimony and child support). By contrast, Chapter 13 requires debtors to adopt a three-to-five-year plan to repay some debt (say, 40 to 60 cents on the dollar).
Surprise, people prefer Chapter 7. It covers about 70 percent of personal bankruptcies.
Chapter 7 dates from the federal bankruptcy law of 1898, says law professor David Skeel Jr. of the University of Pennsylvania, author of the forthcoming “Debt’s Dominion: A Political History of Bankruptcy Law in America.” The idea was to help impoverished workers–with little property and no prospects of repayment–get a fresh start. In 1938, Congress added the forerunner of today’s Chapter 13.
“Congress thought that debtors wanted to repay–that there was a stigma to bankruptcy and, if people could stretch out their payments, lots of people would take that choice,” says Skeel. “This was completely wrong.” Chapter 13 has never been popular. Over the years, both consumer borrowing and bankruptcy have been democratized. More people borrow, and more people go bankrupt. Between 1980 and 2000, personal bankruptcy filings rose from 287,570 to 1,217,972.
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Predictably, lenders–from banks to credit unions–blame abuse for part of the increase. Some borrowers use bankruptcy to escape debts that they could partially pay, it’s said. So the new bankruptcy bill decrees that borrowers with incomes over their state’s median income would automatically face Chapter 13. The bankruptcy court would estimate reasonable living expenses (for food, transportation, housing); if borrowers could then pay some of their debts, they would get a five-year repayment plan. In practice, this might affect 5 percent to 15 percent of people filing for bankruptcy. In 1998, the median income of people filing under Chapter 7 was roughly $23,000, about 59 percent of the median household income ($39,000). Divorce, job loss and medical bills are common reasons people stop loan payments. In normal times, this bankruptcy bill would be a big deal only for a small number of people.
But for the economy, these aren’t normal times. It is already straining under heavy debt burdens. Consider the explosion of “subprime” lending: loans to people with checkered credit histories (late payments, defaults, bankruptcy). The theory is that people’s circumstances change–they get a job, they remarry–and bad credit risks can become good. Since 1994, subprime mortgage loans have risen from about $98 billion (3 percent of mortgages) to $430 billion (almost 9 percent), says Mark Zandi of Economy.com.
A year ago, self-fulfilling euphoria was propelling the economy forward at an astounding clip. The danger now is that self-fulfilling pessimism will deepen the downturn. Under any circumstances, consumers’ rising debt load would threaten expansion. Mortgage partly ease the debt burden by lowering interest payments. But people also seemed to have used refinancings to borrow more.
The real pressures of high debt are now being compounded by scare psychology. “Drowning in debt,” says the cover story in the latest U.S. News & World Report. The bankruptcy bill sends a similar message: Be prudent; don’t overborrow. The message is about four years too late. Now it may simply amplify the growing gloom. This is not a bad bill, but it is certainly badly timed.