Bankruptcy Reform Gave Creditors Too Much

By Michelle J. White
Special to's Think Tank Town
Monday, August 21, 2006; 12:00 AM

Last fall, following years of intense lobbying by the credit card companies, Congress passed the "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005" (BAPCPA). While U.S. bankruptcy law was very debtor-friendly prior to BAPCPA, it has become much more pro-creditor today.

Bankruptcy law must balance two conflicting objectives: helping debtors who experience adverse shocks by discharging some of their debt, and promoting credit availability by enforcing the obligation to repay.

Discharging some debt when adverse shocks occur is valuable because it reduces the decline in debtors' consumption, thus providing partial consumption insurance and reducing the costs of debt. These costs include debtors' illnesses turning into disabilities because they cannot pay for medical care, debtors' families becoming homeless because they cannot pay rent, and debtors' children dropping out of school in order to work, leading to lower earnings as adults.

However debt forgiveness in bankruptcy harms future borrowers by reducing credit availability and raising interest rates. The obligation to repay in bankruptcy and state-sanctioned procedures for enforcing it are intended to reduce those costs.

It's useful to divide bankruptcy filers into two groups: opportunists and non-opportunists. Non-opportunists file for bankruptcy only if they suffer adverse shocks that substantially reduce their ability-to-pay -- they are the people for whom bankruptcy debt relief was intended. Opportunists, in contrast, file for bankruptcy even when they have not experienced any adverse shock. They also plan in advance to maximize their gains from bankruptcy by borrowing as much as possible and filing even when they have high ability-to-pay.

Prior to BAPCPA, opportunistic debtors commonly used such strategies as acquiring additional credit cards and charging more on each card, converting non-exempt wealth to exempt by paying down their mortgages or renovating their homes, moving to states like Texas and Florida that have unlimited exemptions for home equity, and sheltering assets by putting them in trusts.

The large credit card lenders lobbied for bankruptcy reform on the grounds that many bankruptcy filers are opportunists and reforming bankruptcy law would discourage opportunism. But the new bankruptcy law mainly discourages filings by non-opportunists.

Under bankruptcy law pre-BAPCPA, there were two separate bankruptcy procedures, Chapters 7 and 13. Most unsecured debt was discharged under both. Debtors who filed under Chapter 7 were obliged to repay only from their wealth above an exemption level, while debtors who filed under Chapter 13 were obliged to repay only from their post-bankruptcy incomes. Debtors were allowed to choose between the two procedures, so that they could choose to repay from whichever source they did not have.

Under BAPCPA, both bankruptcy procedures have been retained, but debtors' right to choose between them has been abolished. To file under Chapter 7, debtors' incomes must now pass a "means test" that requires that their incomes be below a cutoff level that is based on median family income in their state. If their incomes are above the cutoff, they must file under Chapter 13 if they file for bankruptcy at all. Debtors who file under Chapter 13 must use all of their incomes above a consumption allowance for five years to repay. BAPCPA also instituted new requirements that more than double the costs of filing, from less than $1,000 to around $2,500. It also reduced the amount of debt that is discharged in bankruptcy, lengthened the minimum period that must elapse between filings, and required debtors to undergo credit counseling and take a debt management course.

The main effect of those changes is that non-opportunistic debtors will avoid or delay filing for bankruptcy because they cannot pay the high costs of filing, or their gain from filing is smaller, or they are ineligible to file. Creditors gain because they now have longer to collect penalty interest rates and fees and more opportunity for garnishment of debtors' wages.

For opportunistic debtors, the impact of BAPCPA is mixed. BAPCPA made it more difficult to use some of the most popular bankruptcy planning strategies -- debtors can no longer move to Florida and use its unlimited homestead exemption unless they move more than two years before filing, and debtors can no longer shelter assets by renovating their homes unless they do so more than three years before filing. But opportunistic debtors can still use trusts to shelter assets in bankruptcy and BAPCPA provides a new bankruptcy exemption for up to $1 million of assets in tax-sheltered individual retirement accounts ($2 million for married couples who file). Opportunistic debtors can also pass the means test and qualify for Chapter 7 even if they have high incomes, by spending more on categories that increase their consumption allowances.

Under BAPCPA, fewer non-opportunistic debtors will file for bankruptcy because they cannot afford the high costs of filing. Those debtors will be worse off because they have less consumption insurance. But opportunistic debtors will continue to find bankruptcy worthwhile as long as they plan in advance and have good lawyers.

Michelle J. White is professor of economics at the University of California, San Diego, and research fellow for the National Bureau of Economic Research. Her article "Abuse or Protection?" will appear in the fall issue of the Cato Institute's Regulation Magazine.

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