The Failure of Bankruptcy Reform

(Cross-posted to The Atlantic Business Channel. From now on, I’ll repost many of the things I post there 24 hours later here; though you should click on the link and read it over there. In fact, if you aren’t already, you should be subscribing to their Business Channel – it’s a great feed of the daily business news.)

The goals of the 2005 Bankruptcy Reform were to both lower the number of those filing bankruptcy and also to increase the amount recovered post bankruptcy by forcing consumers into Chapter 13 bankruptcies. Seeing the latest data, it is clear that both of these goals have been failures – however the unique way in which they have failed is worth investigating, and it requires us to come up with a theory of the Sweat Box.

2005 Bankruptcy Bill, post-mortem.

First, let’s look at consumer bankruptcy filings.

This graph is taken from Option Armageddon here, and I’m going to let Rolfe call it like he sees it:

By the way, when economists talk about “pulling demand forward,” this is the kind of dynamic they have in mind. What Cash4Clunkers did to demand for cars, what the first-time homebuyer credit is doing for home sales, the Oct ‘05 law did to demand for bankruptcy filings — to a much greater degree.

More recently, bankruptcies have flat-lined around 120k per month. I suspect they will trend higher over the next few years as lower home values make it difficult/impossible to refinance debts using home equity. Obviously higher unemployment won’t help either…

Yes, it seems very clear that bankruptcies were high right before the reform went into place to take advantage of the old regime, and then dropped to reflect this move in demand. However the lag in time it has taken to get back to the old rates is important; we’ll discuss one reason the mean-reversion in this graph has taken some time in a minute.

Another goal though wasn’t just to drop the number of bankruptcies, but also to shift consumers from Chapter 7, which wipes your debt, to Chapter 13. Chapter 13 puts you on a payment plan, especially if you have high income relative to your debts, and thus allows greater recovery to those who are owed money. How has this transition gone?

From credit slips, we get this graph:

So the idea that we’d transition bankruptcy from chapter 7 to chapter 13 also has turned out to be a bust. In so much as the goal of the bill was to deter risky borrowing ex ante (and thus reduce filings) or increase bankruptcy payouts ex post (by moving people to chapter 13), it was a failure. Since lobbying is costly, if you were the CEO of a credit card or financial company, would have fired the team responsible for writing this for Congress?

Actually no, you’d give that team a giant raise.

Sweat Box

This is the argument Ronald Mann builds on in his provocative paper Bankruptcy Reform and The “Sweat Box” of Credit Card Debt. His argument is that the bankruptcy reform bill wasn’t about ex ante filing reductions or ex post recovery increases; it was about delaying the actual time it took to begin a bankruptcy claim. Many of the features of the bill, including ‘credit counseling’, raising filing fees, debt-relief agencies, etc. are designed to raise the time barrier between financial distress and the act of filing a bankruptcy. And what happens during that time? The person in question is paying triggered high-interest rates on credit card loans.

I’ve written about how the extremely high interest rates can’t be justified on financial engineering risk-measurement quantifications, and are more likely either a way to force consumers to pay off their loans immediately or soak them for what they are worth. Mann runs a quick number experiment (p. 18): Picture a distressed consumer with $2,000 in a credit card. If the cost of funds is 3%/year, interest is 18% for the first 3 months, 24% next three months, and 30% onward, minimum monthly payment is 2%, 2%+$50, and 2.5%+$50, for those time periods, and the borrower has a $40 fee every other month for whatever reason starting in the seventh month. Typical right? If the consumer pays this off for 2 years, the balance on the credit card is still $1,270, but if you look at the economic total (from the cost of capital) the loan has been paid off. I replicate this in a google spreadsheet here.

This is why keeping consumers paying off high fees and high interest for an extra year or two can be so profitable, and why it is worth all the lobbyist money even though the stated goals got lost in the shuffle somewhere. Stringing consumers along for another 2 years+ is a great business improvement, even if it doesn’t change a single other thing under equilibrium. And sure enough, it looks like the two years it has taken to get back to the previous numbers is reflective of this newfound, incredibly profitable, lag.

The Nudge

Considering that conservatives are hunting for his scalp, I’d hate to say anything that would position an argument to the left of Cass Sustein, co-author of the book “Nudge.” But I imagine this must be frustrating for those on the left looking at the numbers here. Here we have a part of the social insurance contract that is the bedrock of modern capitalism. We decide that shredding out a piece of it might make the lazy into more responsible people by giving them proper incentives and reducing moral hazard, while trickling down some basis points in credit card figures to the rest of us. A discipline and punishing of the poor through financialization. When the smoke clears years later, it turns out that it failed – there simply wasn’t efficiency to be gained here; all it did was make those already hit by adverse life events more leveraged and more desperate with little-to-no benefits to anyone outside shareholders of a few financial stocks.

And what is the response to this? Nudging. Now I am a big fan of nudging; Default settings do matter, and in so much as information is incomplete it can devastate market functions. But when it comes to rebuilding a social contract worthy of our country, can’t we do better than simply printing terms on a credit card sheet better? One can at least hope that Obama will help bring about a world where people do not go bankrupt because they’ve gotten sick, a major driver, maybe even the driver, of the first chart above.