Study: Law creates many too broke to file for bankruptcy

A decade after passage, reform law's impact is permanent insolvency


A decade after a federal bankruptcy reform law took effect, a new class of Americans has been created: the permanently insolvent.

They're too poor to file for bankruptcy protection, where the cost quadrupled under the law. Absent that protection, the insolvent are endlessly harassed by creditors and are more likely to lose their homes through foreclosure. Saddled with unrelieved debt, they cannot get a new credit card, most other forms of credit or a fresh start.

Bankruptcy law creates permanent insolvency

"The reform has generated a substitution, from formal bankruptcy to insolvency," said Stefania Albanesi, lead author of "Insolvency After the 2005 Bankruptcy Reform," a new study by economists at the Federal Reserve Bank of New York and Columbia University.

"Since insolvents are unable to repay debt, they are subject to collection actions and financial judgments and have difficulties obtaining unsecured credit," she said. "This is particularly bad for low income individuals, as they have little savings and sometimes rely on debt to face unforeseen expenses and the like."

The study, which was published in January and summarized this week in a Federal Reserve blog post, reached a variety of conclusions about the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005. Few of the economists' findings were encouraging for consumers.

  • The bottom lines of credit card companies, banks and other financial institutions have been nourished by the act, which was proposed by Wall Street interests, passed by Congress, and signed by President George W. Bush on April 20, 2005. It went into effect Oct. 17, 2005. "We cite research ... suggesting that profitability has risen for credit card companies as a result of BAPCPA," Albanesi said.
  • But consumers have suffered. Low income Americans, those most in the need of help, have been the most deeply damaged by changes that made it more difficult and far more expensive to file for protection under bankruptcy laws. "Our analysis suggests that the 2005 bankruptcy reform caused a decline in bankruptcy filings, which were replaced by a sizable rise in insolvency and foreclosure," the study's authors reported. "We show that insolvency is a state associated with a high degree of financial distress in comparison to bankruptcy. This consequence of BAPCPA is potentially welfare reducing for households."
  • Though it may not seem to matter if you are bankrupt or insolvent -- after all, you're broke either way -- the differences are profound for consumers, especially those struggling to begin anew.

"If you can't file for bankruptcy, you're between a rock and a hard place," said Kevin Weeks, president of the Association of Independent Consumer Credit  Counseling Agencies. "If you can't get that protection, you're stuck."

Here's why: If you file for bankruptcy, debt collectors must stop contacting you or garnishing your wages and, under a Chapter 7 or "fresh start" proceeding, many of your debts can be discharged.

So, you're broke, but you can start over again to restore your credit score and apply for credit cards, auto loans, a mortgage and other forms of credit, though the terms won't be ideal -- the bankruptcy may be on your public record for as long as 10 years.

But if you cannot file for bankruptcy, due to the newly elevated cost or newly complicated documentation requirements, you'll likely end up insolvent -- unable to pay your bills, unable to find shelter from creditors through the bankruptcy court, unable to start again.

Your credit score plummets, so you cannot qualify for new loans. Your home is not protected, as it would be under bankruptcy protection, so your mortgage may go into foreclosure and you are more likely to lose your house.

If you can't file for bankruptcy, you're between a rock and a hard place.

-- Kevin Weeks 
Association of Independent Consumer Credit  Counseling Agencies

"In bankruptcy, debts are discharged," Albanesi said, "whereas in insolvency, debts remain."

Said Weeks: "Quite simply, you're left in the lurch."

And there may be no way out -- because, unlike those who come under bankruptcy protection, your debts are never wiped away, so your credit score is perpetually dinged.

"The individuals who go bankrupt experience a sharp boost in their credit score after bankruptcy [discharges many debts]," the study reported, "whereas the recovery in credit score is much lower for individuals who do not go bankrupt."

The 2005 law was intended to discourage and reduce the number of personal bankruptcy filings by introducing a series of new, often burdensome steps. These included a "means" test, new anti-fraud measures that made attorneys responsible for the statements of their clients and mandatory credit counseling.

All of that substantially increased costs associated with filing for personal bankruptcy protection.

The study found that out-of-pocket costs for filing for Chapter 7 bankruptcy, the most common form of protection, soared from $600 before the 2005 law was passed to $2,500 just two years after it was passed. The average cost for a more complicated Chapter 13 personal bankruptcy rose from $1,600 to $3,500. In either case, these costs put the process out of reach for many consumers.

"The reform caused a large and permanent reduction in bankruptcy filings," the study's authors said.

According to data from the U.S. Bankruptcy Courts, nonbusiness bankruptcies plummeted from 1.56 million in 2004, the last full year before the new law was signed, to 597,965 in 2006, the first full year after the new law took effect.

Representatives of the banking industry and other financial entities say this shows that the bankruptcy law worked -- and is continuing to work as it should.

Bankruptcy protection is alive and well, and remains available for those in need.

-- Jeff Sigmund 
American Bankers Association 

"Bankruptcy protection is alive and well, and remains available for those in need," said Jeff Sigmund, a senior spokesman for the American Bankers Association, which represents the nation's $15 trillion banking industry. "These changes were designed to eliminate abuses and ensure the bankruptcy system is used fairly."  

At the same time, however, the new study found that diminished access to bankruptcy protection placed significant stress on many households and disproportionately affected low income Americans.

"We document that insolvency is associated with worse financial outcomes than bankruptcy," the study reported, "as individuals in this state accumulate collections, judgments, do not have access to new lines of credit and their credit score bottoms out."

"Since bankruptcy filings have declined mostly for low income individuals, our findings suggest that the 2005 reform may have removed an important form of insurance against negative income shocks and increased financial distress for this group," the federal and academic economists said.

The bottom line, according to the report: The law helped the financial institutions that lobbied for it. It did not help consumers -- and it harmed many of them.

"BAPCPA reduced credit card company losses and increased their profits," the study concluded. "However, there is little evidence that credit conditions for consumers improved."

See related: Court judgments for debt: Your options after the gavel

Published: February 24, 2015

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