BANKRUPTCY AND CREDIT

Every society must resolve the tension between debtors and creditors, especially if the debtors cannot pay or cannot pay quickly enough. Many of the world's religions have condemned lending money for interest, at least among co-religionists. In traditional societies, money lenders, although necessary for ordinary commerce, were often viewed as morally suspect. The development of a robust capitalism was based upon raising capital by paying interest or dividends, and so it has been important for capitalist societies to develop institutions and mechanisms for handling debt and credit.

The inherent tension between creditors and debtors turns upon the creditor's claim to justice as the property owner and the debtor's interest in fairness in the terms of repayment. To be sure, lenders sometimes used their position to create social control mechanisms such that debtors often could never work their way out of debt. Such arrangements as sharecropping and the use of the company store often tied laborers to employers through the bonds of debt. With some exceptions, states and legal regimes upheld property rights against the claims of the debtors.

Through the years, societies have sanctioned creditors' use of slavery, debt-prison, transportation to debtors' colonies, debt-peonage, seizure of assets or garnishment of wages to control debtors. Most such methods, however, work to the advantage only of the first creditor or the most aggressive creditor to demand payment. Bankruptcy, as used in the United States and a number of other countries, provides a means for resolving not only the debtor-creditor conflict but also the potential conflict among creditors.

Bankruptcy is a very old concept. The word itself comes from an Italian phrase meaning "broken bench," because a bankrupt merchant's work bench would be broken by his creditors if he could not repay the debt. In the United States, each state has laws governing debtor-creditor relations, but the enactment of bankruptcy statutes is reserved to the Congress by the U.S. Constitution. United States bankruptcy occurs in the federal courts and is regulated by statutes enacted by Congress. Special bankruptcy courts are located in each federal judicial district, and specially appointed bankruptcy judges oversee the caseload. Bankruptcy decisions may be appealed to the federal district court and subsequently to the federal appeals court and the U.S. Supreme Court.

Bankruptcy is technically different from insolvency. Insolvency refers to a financial situation in which a person or business has liabilities that exceed assets. To be bankrupt, the debtor must file for bankruptcy protection in the federal court. Although the overwhelming majority of individuals filing for bankruptcy are also insolvent, occasionally a solvent business will file for bankruptcy because of anticipated liabilities that will exceed its assets. An example of such a bankruptcy is that of pharmaceutical manufacturer A. H. Robbins, whose Dalkon Shield intrauterine device (a contraceptive) was judged the cause of many injuries and some deaths among women who used it. As the financial judgments against the company mounted, its management sought the protection of the bankruptcy courts. Bankruptcy allowed the company to hold its creditors at bay for a period of time to allow the company to propose a financial settlement.

THE ROLE OF THE STATES

Although bankruptcy is a federal matter, states also have laws to govern debtor-creditor relations. Each state's debtor-creditor laws are affected by its history and by the debt conventions that are part of its history. Before becoming a state, for example, Georgia was a debtor's colony. Before the Civil War, debtors in such southern states often fled harsh debt-collection laws by going to Texas, indicated by "G.T.T." in sheriffs' records. Texas has traditionally retained pro-debtor statutory provisions, especially its generous exemption.

An exemption is the property that a debtor may keep despite bankruptcy or a judgment for nonpayment. The federal bankruptcy statutes recognize the right of state law to prescribe exemptions. There is also a federal exemption, but state legislatures may require their citizens to claim only the state exemption, which in some states is smaller than the federal exemption. State exemption laws vary widely, with some states allowing a substantial exemption and other states exempting very little property. Even a generous exemption law, however, is not a guarantee that a debtor will keep a lot of property. A home is not exempt if there is a mortgage on the home, and other goods are similarly not protected from a secured creditor if they have been used as collateral for a debt.

The states with a Spanish heritage often followed the Spanish tradition that a bankrupt's family should have the means to continue to make a living. Thus, the state laws of Florida, Texas, and California, for example, have traditionally been liberal in permitting debtors to keep their homesteads and some other assets, such as the tools of their trade and current wages. Other states exempt items that are believed necessary for the family's well being, such as children's school books, certain farm equipment, sewing machines, and funeral plots. There is a recent trend toward substituting dollar limitations for exemptions instead of listing specific items of property.

The state exemption is the principal determinant of the resources a bankrupt debtor will have following the bankruptcy. The rest of the debtor's postbankruptcy status depends upon the type of bankruptcy the debtor declares.

TYPES OF BANKRUPTCY

Bankruptcy may be entered either on a voluntary or on an involuntary basis. U.S. bankruptcy law arranges several ways by which debtors may voluntarily declare bankruptcy. Either individuals or corporate actors, including incorporated and unincorporated businesses, not-for-profit agencies, and municipalities may declare bankruptcy. The law makes special provision for the bankruptcies of railroads and stockbrokers. Creditors may in some circumstances initiate an involuntary bankruptcy. Only a small proportion of all bankruptcies is involuntary, and nearly all of those cases are targeted toward a business.

The Clerk of the Bankruptcy Court classifies each case filed as a business bankruptcy or a nonbusiness bankruptcy. These distinctions are not always clear-cut. As many as one in every five "nonbusiness" debtors reports currently owning a business or having recently owned a business. Moreover, many of the "business" bankruptcies are small family-owned enterprises. Whether classified as business or nonbusiness, the bankruptcy of a small business owner typically affects the family's welfare as well as that of the business.

Individual, noncorporate debtors typically have two choices in bankruptcy: Chapter 7 liquidation or a Chapter 13 repayment plan. In a Chapter 7 case, the debtor's assets over and above the exempt property will be sold and the creditors will be paid pro rata. Creditors with secured debts (those debts with collateral) will be allowed to have the collateral. All remaining debt will be discharged, or wiped away by the court. The debtor will not be able to file a Chapter 7 bankruptcy again for six years.

The Chapter 13 repayment plan is available only to individual debtors with a regular source of income. There are also other legal limitations, such as maximum limits on the amount of debt owed. The debtor files with the court a plan for repaying debts over a three-to-five year schedule. The debtor must report all income to the court, and must also include a budget that provides the necessities of rent, food, clothing, medical treatment, and so on. The difference between the budgeted amount and the monthly income is the disposable income, which becomes the amount of the monthly payment.

The Chapter 13 petitioner must pay to a trustee, who is appointed by the court, all disposable income for the period of the plan. The debtor gets to keep all property. The trustee disburses the funds to the creditors. For a judge to confirm a Chapter 13 plan, the unsecured creditors must receive more money through the plan payments than they would have received in a Chapter 7 liquidation. At the conclusion of the plan, any remaining debt is discharged. Following this discharge, the Chapter 13 petitioner is also barred from further Chapter 7 bankruptcies for six years.

About two of every three Chapter 13 filers do not complete the proposed plan. Although the Chapter 13 may provide some benefits to the debtor—for example, he might have time to reorganize his finances—once plan payments are missed the court may dismiss the Chapter 13 and the debtor loses the protection of bankruptcy. Repayment plans such as Chapter 13 were begun by bankruptcy judges in northern Alabama before Congress wrote them into law. Even today, Chapter 13 is disproportionately popular in some judicial districts in the South. About one-third of all nonbusiness bankruptcies are filed in Chapter 13.

Some debts survive bankruptcy, regardless of the chapter in which the bankruptcy is filed. Child support, alimony, federally-backed educational loans, and some kinds of taxes are among those effectively nondischargeable in Chapter 7. Creditors may also object to the discharge of a specific debt if the debt arose from certain misbehavior, including fraud and drunkenness. Creditors may also object to the discharge generally on the grounds of debtor misbehavior, including hiding assets, disposing of assets before the bankruptcy, and lying to the court. A judge may object to a debtor filing in Chapter 7 if the judge believes that the filing represents a "substantial abuse." A Chapter 13 plan must be filed in "good faith."

For persons with substantial assets and for businesses there is an additional choice, Chapter 11, also called a reorganization. In Chapter 11, a debtor business seeks the protection of the court to reorganize itself in such a way that its creditors can be repaid (although perhaps not one hundred cents on the dollar). Creditors are given an opportunity to review the plan and to vote on its acceptability. If a sufficient number of creditors agree, the others may be forced to go along. In large cases, a committee of creditors is often appointed for the duration of the Chapter 11. Reorganizations may provide a means to save jobs while a business reorganizes.

In recent years, critics have charged that undoing business obligations has become an important motive for companies to reorganize under Chapter 11. Various companies have been accused of trying to avoid labor contracts, to avoid product liability, or to insulate management from challenges. These strategic uses of bankruptcy are potentially available to solvent companies. Although strategic uses of bankruptcies by individuals probably occur, most studies have found that the individuals in bankruptcy are in poor financial condition, often with debts in excess of three years' income.

There is also Chapter 12 bankruptcy, another type of reorganization specifically for farmers. It was introduced in 1986 and in most years between one and two thousand cases are filed in Chapter 12.

Federal law permits the fact of a bankruptcy to remain on a credit record for ten years, but the law also prohibits discrimination against bankrupt debtors by governments or private employers.

BANKRUPTCY TRENDS

The number of business bankruptcies remains relatively small, usually fewer than 75,000 in a year, with exceptions in a few years. The number of nonbusiness bankruptcies, however, has generally risen for about two decades, from about 313,000 in 1981 to 811,000 in 1991. Nonbusiness bankruptcies passed the millionmark in 1996, and by 1998 there were more than 1.4 million nonbusiness bankruptcies in the United States.

Embedded within the general increase in bankruptcy are substantial regional variations in filing rates that seem to follow the business cycle. Some analysts believe that bankruptcy is a lagging indicator; that is, some months after an economic slowdown, bankruptcies begin to rise as laid-off workers run out of resources or small business owners find they cannot remain in business.

Each bankruptcy affects at least one household, and one estimate puts the average number of creditors affected at eighteen. Some creditors, such as credit card issuers, are affected by numerous bankruptcies within a single year. Some bankruptcies initiate a chain of events: The bankruptcy of a single business may lead later to the bankruptcies of employees who lost their jobs, of creditors whose accounts receivable were never received, and of suppliers who could not find new customers. Creditors often argue that the rising numbers of bankruptcies cause them costs that are then passed on to all consumers in the form of higher interest rates.

A bankruptcy may be filed either by a single individual or jointly by a couple. Since the early 1980s, there has been a sharp increase in the proportion of bankruptcies filed by adult women. Several studies indicate between one-third and one-half of bankruptcies are now filed by women. Over half of bankrupt debtors are between the ages of thirty and fifty. Their mean occupational prestige is approximately the same as that of the labor force as a whole, and their educational level is also similar to that of the adult population. The proportion of immigrants in the bankrupt population is approximately the same as their proportion in the general population. There are conflicting findings about the extent to which minority populations are overrepresented or underrepresented in bankruptcy. Despite their educational and occupational levels, however, the median incomes of bankrupt debtors are less than half the median income of the general population.

CAUSES OF BANKRUPTCY

Much of what social scientists know about bankruptcy comes from reviewing the bankruptcy petitions filed in courts, and from interviewing judges, lawyers, clerks, and others who work in the bankruptcy courts. Information about the causes of bankruptcy, however, typically comes from interviews with the debtors themselves. Because many debtors are ashamed of their bankruptcies, and because American debtor populations are geographically mobile, interview studies often have somewhat low response rates. For learning the cause of a bankruptcy, however, there is probably no substitute for asking the debtor.

Debtors often report "inability to manage money" or "too much debt" as the reason for their bankruptcy. In probing a little deeper, however, researchers have found five major issues involved in a large fraction of all bankruptcies: job problems, divorce and related family problems, medical problems, homeowner problems, and credit card debts.

Many debtors have been laid off completely, lost overtime, or had their hours of work or their pay rates reduced. Some debtors have had long periods of unemployment; others have lost their jobs because of the closure of the plant or the store where they worked. The job loss causes an unplanned loss of income, and this fact in turn often creates a mismatch between the petitioner's debt obligations and the ability to meet those obligations. During the recession of the early 1990s, when many industries were downsizing and otherwise restructuring their labor forces, about two in every five bankrupt debtors reported a job-related reason for bankruptcy.

Divorce and other family problems may result in lower incomes for the two ex-spouses (especially the ex-wife). Moreover, in most divorce settlements the debts are also divided, and the debt burden may be too great for one of the ex-spouses. Sometimes an ex-spouse will file bankruptcy knowing that any jointly-incurred debts discharged by the bankrupt spouse will have to be paid by the other ex-spouse. Although alimony and child support cannot be discharged as debts, for custodial parents who do not receive the payments the financial consequences may be grave. Similarly, for parents who must make the payments, a reduction in other debts may make the payments more possible. Finally, it is harder to support two households on the income that used to support just one household. For all of these reasons, the recently divorced may find themselves in bankruptcy.

Medical problems may lead to higher debts if the debtor is uninsured or if insurance is insufficient to pay for needed medical procedures, pharmaceuticals, and professional services. Medical problems may at the same time lead to lower incomes if a person is too ill or injured to work. Either way, a spell of illness or an automobile accident may push a previously solvent person into a situation in which debts are no longer manageable. Medical problems rise in frequency as a reported cause of bankruptcy for adults aged fifty-five to sixty-four, years in which medical problems may increase but before Medicare coverage becomes available.

Earlier efforts to examine medical debts as an indicator of the causes of bankruptcy showed medical debt to be a fairly insignificant cause, whereas direct interviews of debtors are more likely to reveal medical issues as causative. There are reasons to believe that the debt indicators underestimate this reason for bankruptcy. Insurance will often pay medical providers but will not replace income, so that debts to hospitals or physicians might not appear in the records even though the illness or injury is nevertheless the reason that the debtor cannot repay debts. Moreover, some medical providers accept credit cards, so that the medical expenses are hidden within credit card debt. And some debtors will make efforts to pay off their medical creditors first for fear of being denied services. On the other hand, there may be some overestimate of the impact of medical issues in interviews, because respondents may believe a medical reason may be seen as a socially acceptable cause for bankruptcy.

Bankrupt debtors are somewhat less likely to be homeowners than the general population, but a substantial number of homeowners file for bankruptcy, often to prevent the foreclosure of their mortgage. Chapter 13 permits homeowners to pay the arrearages (missed payments) on their mortgage along with their current payments. Home ownership may also be an issue for a worker who is transferred to a different city and buys a second home before the first home is sold. Equity is the portion of the home's value for which the homeowner has made payment. The recent proliferation of home-equity loans, which allow homeowners to use the equity in their homes as collateral, has also put homes at risk even if the payments on the principal mortgage are current. Small business owners are often required to use their homes as collateral for business loans, which means that a failing business may also entail the threat of the family losing its home. Home-equity lending is being extended to a number of other situations, including college loans and credit cards, with the result that many Americans are risking their homes, often without realizing it.

A final reason for bankruptcy is large credit card debts, often at high rates of interest. All-purpose cards (such as Visa, MasterCard, and American Express) are now used for many consumption purposes, including payment of federal income taxes, payment of college tuition, and many goods and services, with the result that credit card debt is assumed for many different purposes. Most ordinary living expenses can now be charged with a credit card, so that interpreting a high credit card debt is difficult. High rates of interest accelerate the credit card debt quickly. Credit card debt is the fastest-growing reason for bankruptcy being given by debtors.

BANKRUPTCY MYTHS

Empirical studies have refuted a number of myths about bankruptcy. One such myth is that some people file for bankruptcy again and again. Several studies have been unable to confirm this myth, but there are a number of people who are unsuccessful at Chapter 13 who eventually file Chapter 7. These people have not really repeated bankruptcy, because they have never received a discharge from their debts in their Chapter 13 filings.

Another myth is that large numbers of bankrupt debtors have high debts because of alcoholism, drug abuse, and gambling. Although most empirical studies have identified a few isolated cases in which one of these problems plays a role, the great increase in bankruptcy numbers cannot be attributed to a great increase in addictive behavior.

A third myth is that there is widespread abuse of the bankruptcy process because many debtors could allegedly pay all of their debts. Most studies of the repayment possibilities for the debtors find that the debtors are unable to repay their debts, even if their families live on very modest budgets (such as the model low-income budget of the U.S. Bureau of Labor Statistics). The few studies that have found debtors able to repay have often eliminated from repayment whole categories of debt that the debtors themselves cannot eliminate. There are, however, documented cases of fraudulent or abusive use of bankruptcy, some of which are prosecuted by the government as criminal matters.

STRUCTURAL SOURCES OF BANKRUPTCY

Several changes in American financial life have contributed to the imbalance of debt with income and may have increased the numbers of people who file for bankruptcy.

Consumer credit has been available for decades, principally as a means to help households finance a large purchase over a period of time. Individual sellers extended credit, often on the basis of personal knowledge of the borrower and the borrower's ability to repay. Later, banks, credit unions, and personal finance companies helped finance the purchase of homes, cars, and small appliances. These institutional arrangements offered more protection to the seller and made a personal acquaintanceship less important in the lending decision.

The development of credit cards, with preapproved credit limits, allowed consumers to buy a large variety of goods or services on credit, not just large or expensive items. It was not just the invention of the credit card, however, but some later developments in its use that have changed consumer financial patterns in a way that may have influenced higher bankruptcy rates.

First, beginning in the late 1970s, most states repealed their laws making usury an offense, and Congress made state usury laws largely ineffective. Usury, the charging of excessive interest, was formerly regulated by the states, most of which set limits on the maximum amount of interest that could be charged to borrowers. With the repeal of these laws, high rates of interest—some as high as 20 percent or more—could legally be charged. Prior to this time, such high rates of interest were usually defined as criminal and were associated with loan-sharking and the lending practices of organized crime.

Second, credit cards became a major profit center for many banks, especially because of the high interest rates that could be charged. Marketing of credit cards mushroomed. New markets, including relatively low-income families, became the targets of sophisticated mail and telephone campaigns. Even though many of the families might not be able to repay everything they charged, the large interest payments made the lending profitable. Credit cards are now extensively marketed to young people, especially college students, who are relatively unfamiliar with financial matters.

Third, credit devices proliferated to include gold and platinum levels, cash advances, and many other features that were both profitable to card issuers and attractive to card holders. Sometimes card holders did not understand how these features worked; for example, many card holders did not realize that there is no grace period for repaying a cash advance, and the interest rate on a cash advance is often higher than the rate for purchases.

Fourth, merchants who accepted credit cards enjoyed increased business because the buyers did not have to carry a large supply of cash. Advertising by stores and restaurants increasingly emphasized the acceptability of credit cards, so that the advertising for goods and services reinforced the advertising of the credit card issuers. Meanwhile, the credit card issuers provided protection against nonpayment to the merchant who accepted a credit card, and they also provided some protection for the card-holder against the fraudulent use of the cards.

Fifth, a major restructuring of the U.S. economy occurred at the beginning of the 1990s, in which millions of workers were laid off or could find only contingent jobs. Many of these workers found credit cards to be a convenient way to maintain consumption levels and their family's lifestyle even though their expected income stream was interrupted.

These trends contributed to an increase in the numbers of people who had high debt-to-income ratios. Some people incurred high levels of debt, often at high interest rates, and simultaneously experienced declining or stagnant income. While not every person with a high debt-to-income ratio filed for bankruptcy, those who did file for bankruptcy had very high ratios. Changes in the American economy during the decade of the 1990s probably influenced the increase in the number of bankruptcies. In particular, the increasing indebtedness of Americans closely tracked the rise in bankruptcies.

Rising Indebtedness. The economic changes of the 1990s, in addition to the well-entrenched borrowing for home mortgages, car purchases, and college expenses, have resulted in an increase in consumer credit outstanding from 298 billion dollars in 1980 to 1,025 billion in 1995. Thus, while the U.S. population increased by 16 percent, indebtedness increased by 244 percent. These are nominal dollars, but even accounting for inflation (constant dollars) the debt burden doubled. During this same time frame, mortgage lending increased by 223 percent, from 1,463 billion dollars in 1980 to 4,724 billion dollars in 1995. Credit card debt, which was only 81.2 billion dollars in 1980, had increased by 351 percent to 366.4 dollars in 1995. Thus, while there was an increase in all forms of indebtedness, credit card debt—which began from a smaller base—showed the largest percentage increase.

Industry sources estimate that in 1990 there were 1.03 billion credit cards in circulation in the United States, and that by 2000 a projected 1.34 billion cards will be in circulation. In 1990, these cards accounted for 466 billion dollars of spending and resulted in 236 billion dollars of debt. By 2000, the projected spending is 1,443 billion dollars, with 661 billion dollars as debt.

In its survey of how consumers use credit cards, the Board of Governors of the Federal Reserve System reported that 54.5 percent of the sample always paid off the balance on their credit cards each month. Another 19.1 percent sometimes pay off the balance, and the remaining 26.4 percent hardly ever pay off the balance. It is from this latter group that the credit card issuers run the greatest risk of eventual nonpayment but also have the possibility of earning the greatest amount of interest. About 30 percent of the consumers earning less than $50,000 a year "hardly ever" pay off the balance, compared with only 10.5 percent of those who earn more than $100,000. Over 35 percent of the consumers under the age of thirty-five hardly ever pay off their balance, compared with 10.5 percent of people over the age of seventy-five.

Credit cards alone do not pose a major financial problem for most people, even for those who maintain a balance; the median balance is about $1,000, with a median charge of $200 a month. For those people with larger balances, however, and with interest charges and sometimes penalties and late fees added to the principal, indebtedness may become a serious problem. And although facing this problem can be postponed by making small monthly payments, the balance can quickly become too large ever to be handled on most salaries.

The ubiquity and convenience of credit cards has led to their growing use for additional purposes: as a form of identification, as security for returning rented cars and videotapes, and—perhaps ironically—as an indicator of creditworthiness for additional extensions of credit.

INTERNATIONAL CREDIT ISSUES

Besides the indebtedness of the individuals in a population, there is also growing concern about other forms of indebtedness. Many countries, especially those with less developed economies, have borrowed large sums of money from more developed countries. The repayment of these loans, and the terms that are demanded, have provided a source of tension between the richer nations and the poorer nations. International agencies such as the International Monetary Fund often prescribe austerity measures to help a country meet its repayment obligations.

The development of transnational corporations has also raised issues of which set of debtor-creditor laws govern transactions that may span several countries. Debtor-creditor laws and the laws of insolvency and bankruptcy vary dramatically from country to country, and an important issue in international commerce is how to handle problems of nonpayment. Many of these issues remain highly contested and largely unsettled.

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Teresa A. Sullivan