Research

Mortgages, credit cards and the new bankruptcy code

The new, tighter U.S. bankruptcy code has not only made it harder for people to erase their debts and easier for creditors to get more of what they are owed, it also has made bankruptcy statistics a less relevant and reliable economic indicator, according to Dawn McLaren, a research economist at the W. P. Carey School of Business.

2006-11-08

The new, tighter U.S. bankruptcy code has not only made it harder for people to erase their debts and easier for creditors to get more of what they are owed, it also has made bankruptcy statistics a less relevant and reliable economic indicator, according to Dawn McLaren, a research economist at the W. P. Carey School of Business.

The main thrust of bankruptcy-code revisions that took effect in 2005 is to force people who are deemed able to do so, to make at least some payment toward their debts under Chapter 13 reorganization, while the rest of their debts are erased.

Although most households still may declare Chapter 7 bankruptcy under the new code's means-test provisions and receive a discharge of all debts -- a fresh start -- more people now must file for Chapter 13 bankruptcy, a process lasting up to five years.

Unusual patterns

In her "Mortgages, Credit Cards, and the New Bankruptcy Code," article in the November 2006 Western Blue Chip Economic Forecast, McLaren, an analyst with the JPMorgan Chase Economic Outlook Center at the W. P. Carey School, cites an unusual pattern in bankruptcy filings for the four quarters ending June 30, 2006. For instance, hurricane-battered Louisiana saw a decrease of 18.7 percent in bankruptcy filings, a larger decrease than in Arizona, where McLaren describes job growth as stellar.

"There was a surge at the end of last year and a drop at the beginning of this year, as laws have been tightened to make bankruptcy a less attractive option for consumers," McLaren writes.

McLaren notes that this came on the heels of new requirements in minimum amounts due on revolving credit card accounts, which is an attempt to motivate consumers to pay off debt faster.

"Because small minimum payments ensure that Americans never pay off their balances if only the minimum is paid, the law was modified to require banks to charge a minimum payment sufficient for the person to pay off their balance in their lifetime. This made banks double the usual minimum payment compared to what it had been prior to the change in the law," McLaren says.

"All of this adds up to a breakdown in the correlation between bankruptcy rates and consumers' financial well-being," McLaren writes. "This means that bankruptcy filings cannot currently be used as a dependable predictor of upcoming turning points in the economy. Bankruptcy rates could, prior to the change in the law, provide a gauge of Americans' debt circumstances. Were people able to get by on their earnings or were their finances sufficiently strained for them to seek court protection from creditors?"

Debt-fueled consumption has helped to maintain consumer demand so far in the 21st century, a trend that began its uptick in the mid-1990s and has intensified with the low-interest housing-price boom that has allowed many households to use their mortgages as an ersatz ATM.

"With the housing boom that occurred in many metro areas across the United States offering homeowners a chance to supplement their spending by tapping into their assets, the percentage of people with second mortgages and home equity loans can shed some light on households' financial situation," McLaren writes. Citing numbers from the Office of Federal Housing Enterprise Oversight, she notes that among Western states -- where housing prices are way above the national average -- only Colorado is not showing double-digit growth in home prices over the year ending in the second quarter of 2006.

Citing the Federal Reserve, McLaren says the Household Debt Service ratio is approaching record levels, touching 14 percent in late 2005 and continuing to increase in 2006.

"This ratio climbed throughout the economic good times of the 1990s, only leveling after the last recession instead of dropping as it had after previous recessions," McLaren writes. "During the 2001 recession, consumer spending was a key component in keeping the recession shallow and short. Most of all, consumers -- lured by incentives -- kept buying cars, even in the face of faltering job growth."

McLaren's article further notes: "The American consumer has come to depend on the accumulation of debt, especially with the decline in real wages over the last year."

In an interview, she elaborates: "When inflation is low, real wages don't suffer as much. We've had a big bump up in inflation -- 4.5 percent now versus 2.5 percent a couple of years ago. This eroded real wages and pushed them into the negative."

New rules

Under the new bankruptcy provisions, people check whether the monthly average of their past six months of gross income is below the median income for their state; if it is, they may file Chapter 7. Under the second stage of the bankruptcy means test, some people whose incomes are slightly higher than their state's median income may still be able to file Chapter 7, depending on allowable expenses that can be used in the calculation. Others go to Chapter 13 reorganization. Financial counseling is a required part of the road back to solvency for undisciplined consumers.

Homestead provisions of the 500-page bill, signed into law by the president April 20, 2005, took effect immediately. The rest of the provisions were effective by Oct. 17, 2005.

McLaren says that since the 2001 recession, the economy has continued to expand, along with job growth, outside the hurricane-damaged Gulf states and the auto-dependent state of Michigan.

"Does this mean that the debt service ratio will be whittled away and the change in the bankruptcy laws will not matter?" she wonders. "Or will the next business cycle be much harder on consumers than the last?"

And, besides affecting consumers, the new bankruptcy law most likely will have a ripple effect on small-business people and the self-employed, including independent contractors.

Alan N. Resnick, professor of bankruptcy law at Hofstra University School of Law and a co-editor of "Collier on Bankruptcy," was quoted at Law.com as saying that new provisions will come to bear on non-bankruptcy cases involving pensions, worker incentives, severance packages and single-asset real estate ventures.

Since the breakdown in the correlation between bankruptcy rates and consumers' well-being, is there a new way to measure their financial status, a way that will be comprehensible to the public?

"I think we have to pay more attention to people's real wages and the percentage of disposable income used for debt service payments," McLaren responds. "Unfortunately, the latter is not available on a statewide or metro-area basis within a reasonable time to be useful. Its availability on a nationwide basis, however, can be useful as a proxy. Another useful measurement is foreclosures, but then there are not much data easily available to the general public for that."

Is McLaren willing to go ahead and predict that the next business cycle indeed will be much harder on consumers than the last?

"No matter what the depth of the next business cycle, it will be harder on consumers either at the time or in the future," McLaren says. "Bankruptcy is no longer the option it used to be, and debt service payments are very high. With real wages declining, even a shallow recession is likely to make consumers feel worse than they did during the last recession."

Bottom Line:

• New bankruptcy provisions make it harder for individuals and households to erase all their debt.
• Subsequent decreases in bankruptcy filings do not mean fewer consumers are in financial trouble.
• Increases in home values have further fueled consumer debt.
• It remains to be seen if the debt service ratio will decrease and whether the new bankruptcy law will help reduce it.

Economics