Bankrupt Profits: The Credit Industry's Business Model for Postbankruptcy Lending

• Author: Katherine Porter
• Position: Associate Professor of Law, The University of Iowa
• Pages: 04

Associate Professor of Law, The University of Iowa. Angie Littwin, Ronald Mann, and Elizabeth Warren provided helpful comments on this Article, and Melissa Jacoby, Dr. Deborah Thorne, and Jay Westbrook offered useful feedback on an early draft. Tai Duncan and Brian Locke provided research assistance.

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Introduction

The recent reform of America's bankruptcy law favored the interests of creditors. In the two years since the reform, obtaining consumer bankruptcy relief has become more expensive, time-consuming, and difficult.¹ These legal changes were motivated by a perceived need to reduce the incentives and ability of consumer debtors to "overborrow" and then seek relief from the bankruptcy system.² The credit industry aggressively promoted this "strategic behavior" model of bankruptcy, which focuses on consumers' personal responsibility for financial outcomes. In the credit industry's view, many bankruptcy debtors were prodigal spenders who accumulated debts through irresponsible financial activity. The credit industry assailed bankrupt families for lacking the moral conviction to repay their debts. Bankruptcy was proffered as an easy way out that attracted consumers who were intent on gaming the credit system.³ The credit industry convinced Congress that curtailing bankruptcy relief was sound social policy;⁴ such reforms were needed to dampen prodigality and encourage consumers to make prudent financial decisions. Page 1372

The competing model of causation focused on the role of adverse financial events such as job loss, illness, or divorce in causing financial distress and bankruptcy filings.⁵ The adverse-events model posits that most families fail to pay their debts because of an external financial shock-not because they lack moral fiber or borrowed with no intention of repaying. This view focuses on macroeconomic and social trends, rather than individual consumers' decisions, to understand the rise in bankruptcy filings. Advocates of the adverse-events model note that America offers families a relatively weak, and declining, social safety net to help them cope with adverse financial events.⁶ The expansion of consumer credit in recent decades has left families more highly leveraged and less able to weather financial shocks.⁷ If the adverse-events model is correct, creditors' lending practices and the scope of social programs are necessary loci for reforms aimed at reducing the incidence of bankruptcy.

During the bankruptcy reform process, the strategic-debtor and adverse-events models competed for policymakers' attention. Opponents of reform repeatedly cited empirical data on the causes of bankruptcy and harped that the strategic-debtor model was more a matter of perception and politics than documented empirical reality.⁸ Nonetheless, the strategic- debtor model dominated the public discourse and was the leading justification for reducing the availability and scope of consumer bankruptcy relief. This focus on debtor behavior led to bankruptcy reform that intended to alter the incentives for and practices of consumers.

As a consequence, the credit industry's lending decisions were not subjected to the same scrutiny as debtors' borrowing decisions. Nor were lenders held to the same moral standard as debtors for evaluating the appropriateness of their financial practices. Creditors' strategic behavior, and the consequences of their lending activities, were not an integral part of the debate over bankruptcy reform.⁹ The financial practices of creditors Page 1373 were never closely examined, perhaps in part due to the difficulty of obtaining proprietary lending data. The fragmented regulatory framework for consumer lending also hindered efforts to identify problems in the consumer-credit market. Further, theoretical scholarship has emphasized the law's role in shaping debtors' incentives, rather than evaluating how creditors react to bankruptcy laws. These factors combined to shroud the realities of consumer-credit marketing and lending. The amount of consumer credit obviously had mushroomed in the past decade. However, the blame for the increased bankruptcy rate accompanying this credit expansion was put squarely on the shoulders of consumers rather than creditors. This focus on debtors has distracted scholars and lawmakers from examining how lenders contribute to financial distress and from considering how bankruptcy law influences creditor behavior.

This Article analyzes original empirical data from the first-ever detailed longitudinal study of bankrupt families. This novel postbankruptcy vantage point offers a fresh perspective on the credit industry's beliefs about the causes and consequences of consumer bankruptcy. The findings document how the credit industry responds to consumer bankruptcies, exposing the credit industry's bankruptcy rhetoric to empirical challenge. If even a modest proportion of bankruptcy debtors are untrustworthy deadbeats whose immoral or strategic behavior harms creditors, the credit industry should be reluctant to lend to these families. These families have self- identified themselves as "profligates" by filing bankruptcy, thereby giving lenders hard, public evidence that they borrowed and did not repay. Even after bankruptcy, these families will have ample opportunity to avoid repaying new postbankruptcy loans. Indeed, the credit industry's portrayal of bankruptcy debtors suggests that these families are skilled at evading collectors, hiding assets, shielding income from garnishment, and relying on state laws, such as exemptions, to prevent legal action. Faced with this knowledge, lenders should eschew bankruptcy debtors. Creditors should purge these families from their solicitation lists, and when approached by these families, demand security for any loan.

In fact, the data show the opposite. This Article's key finding is that creditors repeatedly solicit debtors to borrow after bankruptcy. Families receive dozens of offers for new credit in each month immediately after they receive a bankruptcy discharge . Some offers specifically target these families based on their recent financial problems, using bankruptcy as an advertising lure. Other credit offers issue from the very same lenders that the families could not repay before bankruptcy. While not every lender will accept a "profligate" bankrupt as a customer, debtors report being overwhelmed after bankruptcy with a variety of credit solicitations from many sources. Lenders Page 1374 offer families most types of secured and unsecured loans. Creditors' widespread efforts to lure bankrupt families into new borrowing relationships stand in stark contrast to the credit industry's portrayal of itself as the victim of these families' strategic behavior.

In addition to credit card solicitations, most families report receiving offers for car loans, second mortgages, live checks, and other credit lines. Two paradoxes emerge. First, debtors report more difficulty in obtaining secured loans than unsecured loans. This outcome is surprising, as collateral is thought to mitigate credit risk.¹⁰ Despite bemoaning the risks created by immoral and strategic borrowers, many lenders do not bother to secure loans to bankrupt families. Second, debtors who chose chapter 13 (repayment) bankruptcy ("Chapter 13") instead of chapter 7 (liquidation) bankruptcy ("Chapter 7") have fewer opportunities to borrow. Rather than signaling to creditors that a family is a "responsible" borrower, repaying a portion of its past debts actually hinders a family's access to future credit. Creditors' actual behavior contradicts the industry's purported policy goal- articulated in the debate leading up to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005-of channeling more families into Chapter 13 instead of Chapter 7. On the whole, the credit industry treats former Chapter 7 bankruptcy debtors as valuable customers, seeking to profit by loading these families with new debt immediately after bankruptcy.

The vast opportunities to borrow after bankruptcy belie the credit industry's assertions that it is harmed by the immoral or strategic behavior of bankruptcy debtors. When the empirical data are juxtaposed against creditors' rhetoric in support of restricting bankruptcy relief, the gulf between creditors' actions and words is enormous. Despite their disparagement of the character of bankrupt families, lenders actively solicit them as future customers. This empirical evidence suggests that the credit industry takes one view of bankruptcy debtors to Congress, the media, and the public, but itself literally "banks" on a different view of bankruptcy debtors. While the data are not conclusive on bankruptcy causation, creditors' interest in lending to bankrupt families is consistent with acceptance of an adverse-events model of bankruptcy. If the adverse-events model is correct, creditors need not refrain from soliciting bankruptcy debtors as future customers because a discharge of debts in bankruptcy reflects the occurrence of an exogenous event that caused severe financial hardship. Thus, a vast majority of bankruptcy filers are neither immoral individuals who chronically fail to honor their obligations nor strategic actors who are intent on evading repayment of their debts using legal protections or strategies other than bankruptcy. The strong overall pattern Page 1375 of credit offers to bankruptcy debtors suggests that creditors themselves reject the strategic-debtor model of bankruptcy.

Creditors' targeted...