Blog sponsored by Bankrupt-Law.com


Michelle J. White, Special to washingtonpost.com's Think Tank Town,
washingtonpost.com


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.


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.