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New Bankruptcy Law Hurts Consumers and Lenders, Report Finds

Foreclosures, credit card debt increase in wake of changes to law

By Martin H.Bosworth
ConsumerAffairs.com

July 22, 2008

According to research conducted by Mike Simkovic, a former James M. Olin Fellow in Law and Economics at Harvard Law School, "after [the] 2005 bankruptcy reform went into effect, both personal bankruptcy filings and credit card company losses sharply declined."

At the same time, while upfront annual fees on credit cards have been all but eliminated, "Fees have been climbing and becoming less transparent over the years, and there is no evidence that [the] 2005 bankruptcy reform reversed this trend...over-limit fees and late fees have been climbing since well before bankruptcy reform, and that this trend continued after [the] 2005 bankruptcy reform."

Simkovic's paper, "The Effect of the 2005 Bankruptcy Reforms on Credit Card Industry Profits and Prices," compiled data from government, industry, and consumer resources to paint a picture of the lending landscape for debtors and creditors after the passage of the bankruptcy laws. According to Simkovic, industry consolidation in the credit card market enabled the top card issuers to avoid losses from "price wars" by reducing rates to attract new customers.

"The credit card industry might also be able to avoid price competition because of complex, multi-tiered pricing that can make it difficult for customers to comparison shop," Simkovic said. "These fees and interest rates—complex in their own right—are presented in a form that is difficult to understand. Customers faced with such complex pricing systematically miscalculate and underestimate the cost of credit card debt."

Simkovic referenced a 2006 report from the Government Accountability Office (GAO) that found not only that bank fees and penalties are continuing to rise for card holders, but that credit card disclosures and explanations of fees are deliberately written in manners that make them hard to understand. The GAO also recommended in a separate report that credit card issuers use existing technology to customize card disclosures to individual cardholders, particularly those with high balances or frequent late payments.

"The fact that after bankruptcy reform, interest rates and fees continued to rise and grace periods continued to fall, even though credit card companies reaped tremendous gains from declining bankruptcy losses demonstrates that the credit card market is not price-competitive," Simkovic said. "This lack of price competition explains why the benefits of bankruptcy reform accrued exclusively to credit card lenders and were not shared with the average American family, and why...bankruptcy reform was a failure."

Negative Impact

Another effect of the bankruptcy laws is the increase in foreclosures and defaults by mortgage holders who can't afford to make payments on their homes. According to David Bernstein, "The more stringent bankruptcy code, by restricting financial relief available under the bankruptcy code and by increased the costs of filing bankruptcy, appears to have increased the number of individuals walking away from their homes, their mortgages, and their other financial obligations without seeking the protection of the bankruptcy court."

Bernstein, an economist at the U.S. Department of the Treasury, created and filed the "Bankruptcy Reform and Foreclosure" paper as a private citizen. Bernstein examined the changes to bankruptcy filing under the new laws, including the establishment of a means test to determine the filer's available income, and the higher costs of filing and paperwork.

Under the new law, most individual filers would not qualify for Chapter 7 bankruptcy, which allows for the liquidation and erasure of most debt. Instead, they would be forced to file under Chapter 13, which requires regular payments of at least some of their debt to creditors.

According to Bernstein, the more stringent requirements of the new laws may be causing homeowners to "walk away" and let their homes go into foreclosure rather than attempt to file for bankruptcy. The restrictions on bankruptcy filings and subsequent increase in foreclosures puts downward price pressures on neighborhoods where many homes are in default or foreclosed upon, he said.

"One of the great lessons and ironies associated with [the new bankruptcy law] is that the new law by increasing the dollar value of assets susceptible to default has weakened many of the financial companies that sought the more stringent bankruptcy code," Bernstein said.

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