Bankruptcies skyrocket as change in law looms
By Holden Lewis • Bankrate.com

A record number of people filed bankruptcy in April, May and June. Some were pushed --- by unemployment, divorce and sky-high credit card debts -- and some jumped, egged on by proposed changes in bankruptcy law.

From April 1 to June 30, more than 400,000 people and businesses filed bankruptcy. It was the first time that number had been surpassed in one quarter, and it represents a 24.5 percent increase over the number of filers in the second quarter of 2000, according to the American Bankruptcy Institute.

As recently as 1984, fewer than 400,000 people filed bankruptcy in an entire year. Now that number has been exceeded in three months.

Specifically, there were 400,394 filings in the second quarter this year, compared to 321,729 filings in the second quarter of 2000. Historically, the second quarter has the biggest numbers.

It looks like 2001 will see a record number of filings, surpassing 1998's 1,442,549 filings.

The numbers "are alarming, if not shocking," says Sam Gerdano, executive director of the bankruptcy institute.

Todd Zywicki, a law professor at George Mason University and an expert on bankruptcy, also calls the increase alarming and attributes it to several factors: a slight rise in joblessness, declining wealth because of drops in the stock market, and politics.

"Congress is on the verge of amending the bankruptcy code," Zywicki says, "and I've heard reports that bankruptcy attorneys around the country have been aggressively advertising, telling people that now is the time to file for bankruptcy, before reform passes."

James Caher, a bankruptcy attorney in Eugene, Ore., says he doesn't see a lot of advertising by his colleagues, but he says that bankruptcy attorneys have an obligation to tell their clients that it's probably better to file now rather than later because of impending bankruptcy reform.

Means testing
Congress wants to make it so onerous and grueling to declare bankruptcy that fewer people will even try. The House and Senate are ironing out differences in similar bills that they passed this year. If they pass a compromise bill and it's signed by the president, the law will take effect six months later.

Among other things, the bankrupty reform proposal would institute a "means test" to determine whether a debtor can declare Chapter 7 bankruptcy, in which the court forgives all debt that is not backed by collateral, or Chapter 13 bankruptcy, in which the debtor repays some or all debt during three to five years of court supervision.

About two-thirds of consumers file bankruptcy under Chapter 7. Those people kiss their credit card bills goodbye and get a fresh start. The credit card industry argues that more debtors should go into Chapter 13 instead and pay at least a portion of their credit card bills. The means test will push more debtors into Chapter 13.

Under the means test, if you have more than $100 a month left over after paying approved expenses (no cell phones, no restaurant meals, no nights out at the movies), you will be pushed into Chapter 13. Even if you net less than $100 a month after expenses, you can be pushed into Chapter 13 if you could pay 25 percent of your credit card balances over five years.

"We can't allow deadbeats to get away with stiffing creditors," Iowa Sen. Charles Grassley said in Senate debate. "That is why our bankruptcy bill is here. That is what it is all about: Imposing some responsibility on people who can pay their debts."

Giving debtors a taste of the whip
The bankruptcy reform bill:

• Spells out what is a reasonable amount to pay for food, clothing, transportation and housing, and requires the debtor to live within those guidelines unless there is a good reason not to;
• Makes it harder to shield assets by moving to Texas or Florida (or another state with a high homestead exemption) and buying an expensive house;
• Forces the debtor to pay the full cost of an auto loan or lose the vehicle to repossession, even if the vehicle isn't worth the outstanding balance on the loan;
• Requires debtors to complete courses in personal financial management before their debts are discharged in bankruptcy;
• Raises the priority of child-support and alimony payments;
• Places a $1 million cap on the amount in Roth and regular Individual Retirement Accounts that can be shielded from creditors;
• Protects money that has been put in education IRAs;
• Requires debtors to pay all charges made to credit cards in the three months before filing for bankruptcy;
• Makes it easier for landlords to evict bankrupt tenants who are behind on their rent;
• Lets creditors ask the court to dissolve the bankruptcy plan if a debtor is late in filing paperwork, such as copies of paycheck stubs and tax returns;
• Requires bank regulators to study whether credit card companies are offering credit indiscriminately, without regard to whether consumers can repay their debt and whether the resulting debt is contributing to bankruptcies;
• Requires credit card issuers to disclose how long it will take to pay off a balance if you pay just the minimum every month, and prohibits the issuer from closing your account just because you pay off the balance every month and don't pay interest.
• Instructs the Federal Reserve to find out whether people are going bankrupt because of credit card debt amassed in college.
• Penalizes creditors that refuse to negotiate a payment schedule with a credit counseling service.

Rumblings from the lab
In some ways, the proposed law is a social experiment. It requires several agencies to study the law's effects and report them to Congress. Chief among the experiments is a requirement that debtors abide by Internal Revenue Service guidelines that detail what constitutes reasonable spending. Congress wants a report in two years that describes how the guidelines affect debtors and bankruptcy courts.

The IRS guidelines describe reasonable expenses for food and clothing, transportation and housing. Some guidelines are nationwide, and some are applied by region or county.

According to the guidelines, it is reasonable for a single person earning $1,000 a month to spend $198 on food and $43 on clothing, while it is reasonable for a single person earning $4,000 a month to spend $325 on food and $129 on clothing. They say it is reasonable for a family of three in Dallas to pay $1,135 a month for housing and utilities and for a family of three in Peoria to pay $856 a month.

The guidelines allow a family in Dallas that has one car to spend $337 a month on car payments, fuel, insurance and other transportation expenses, while a family in Peoria that has one car can spend $231 for the same expenses.

There is disagreement over what these standards mean. The IRS lumps housing and utility expenses together, but bankruptcy courts prefer to separate them because it matters whether someone is paying a mortgage or renting.

And what about the guidelines for transportation expenses? Some debtors are making payments on cars, while others own paid-for cars that will have to be replaced soon. Should those debtors fall under the same guidelines? And what if a car has to be fixed, but the repair cost exceeds the guidelines? Is it fair to allow someone in Dallas to spend $106 more a month on transportation than someone in Peoria? No one in Congress has answered these questions.

Relaxing in the sunshine
When people complain about deadbeats who abuse bankruptcy law, they often tell anecdotes about wealthy scofflaws who move to Texas or Florida, buy a big ol' expensive house on a golf course, wait a few months and declare bankruptcy.

It happens all the time, because Texas and Florida (and Iowa, Kansas and South Dakota) have unlimited homestead exemptions. That means a bankrupt debtor can keep his or her primary residence, no matter how valuable it is.

The proposed law would put a national cap of $100,000 on the homestead exemption. The cap would apply for two years after the purchase of a house. Under this plan, creditors could force the sale of a bankrupt debtor's house. The owner could keep the equity up to $100,000 and creditors could get the rest.

The two-year limit means that if a wealthy scofflaw managed to move to one of these states, buy a mansion and hold off creditors for more than two years before declaring bankruptcy, he might be able to keep the house.

Remaining upside-down
Auto lenders hate a part of the bankruptcy code that allows bankrupt debtors to keep a car without making all the payments on the loan. So they persuaded Congress to change it. The upshot is that people who owe more than their cars are worth will not fare well.

For example, let's say your car's Blue Book value is $3,000 and you're paying $250 a month for it with 20 more payments to make. You owe $5,000 for a car that's worth $3,000. Under current law, you could declare bankruptcy, give your auto lender $3,000 and keep the car. Not so under the revamped law. You would have to make the 20 payments, just as you had promised you would make -- or allow the car to be repossessed.

IRA cap
In general, bankruptcy law protects pensions and retirement savings. No matter how much money you have in your 401(k), creditors can't touch it if you declare bankruptcy. In the past, Individual Retirement Accounts were treated the same way, but not under bankruptcy reform.

Under the new bankruptcy law, the first $1 million saved in IRAs will be protected from creditors. Any amount over that is fair game for the debt collectors. What if you changed jobs and rolled your 401(k) money into an IRA? Money in IRAs that comes from rollovers from 401(k)s would be protected from creditors.

The law prevents creditors from grabbing money saved in education IRAs, which are savings vehicles to pay for college.

The kids are all right
Bankruptcy reform does offer a few gestures toward consumers. The law says that "it is the sense of Congress" that "certain lenders may sometimes offer credit to consumers indiscriminately, without taking steps to ensure that consumers are capable of repaying the resulting debt." It orders the Federal Reserve to study whether that's true, and whether credit card issuers' policies contribute toward consumer bankruptcies.

Torres snorts in derision at that part of the legislation. "A study on the Hill is a way of saying, 'We've got to have cover, that we're concerned about this issue, but we're not going to do anything about it,'" he says.

The law calls for yet another study, this time one on whether people are going bankrupt because of credit card debt they amass in college. Legislators rejected a couple of amendments that would have reined in the activities of credit card companies on college campuses. One would have capped credit limits for college students at $2,500 per card and strengthened parental supervision.

Another amendment would have required credit card issuers to verify income before they could issue cards to applicants under age 21, or to get a parent to co-sign or to require the young applicant to get financial counseling first. That measure was defeated, too.

Another pro-consumer measure in the bill requires credit card companies to tell customers how long it would take to pay off their balances if they make only minimum payments. For example, a monthly statement might be required to say that making a 2 percent monthly payment on a balance of $1,000 at a 17 percent interest rate would take 88 months.

What must be especially alarming to credit card lenders is the rise in Chapter 7 filings, up 30.3 percent in the second quarter this year compared to the same period last year. In Chapter 7 bankruptcy, the filer's debts are forgiven, and credit card companies take the biggest hit from Chapter 7s.

Chapter 13 filings, in which the filer gets to keep the house or car in exchange for repaying debts partially or in full, went up 11 percent.

-- Posted: Aug. 24, 2001