BANKRUPTCY LAWS: The Need for Reform.

• Author: POMYKALA, JOSEPH S.

Bankruptcy filings surged to surpass 1,400,000 in 1998, another in a string of records. This occurred despite a robust economy, the longest expansion in post-World War II history, and the lowest unemployment rate in nearly two decades. Annual bankruptcy filings now more than double the number which occurred during the entire decade of the Great Depression.

The national bankruptcy rate has been rising eight times as fast as population, amounting to a fiftyfold increase in five decades. In 1998, there was one bankruptcy for every 68 U.S. households. Bankruptcy has become epidemic in some states. In Nevada, with one filing for every 39 households in 1998, it may have become a way of life.

Ninety-seven percent of bankruptcies are consumer filings. Business filings have actually fallen near the lowest level in two decades, while consumer filings jumped more than sevenfold. Why the surge? Debtor distress can not be blamed on the prosperous economy. Have consumers become more inept in their personal financial management? Have moral scruples about paying back debts declined? Perhaps a growing number of debtors are utilizing an overly generous legal system as a form of shrewd financial management.

The total amount of consumer debt has risen steadily along with the personal bankruptcy rate, but disposable income has increased, too. The debt service burden--the percentage of disposable personal income used to pay interest and principal--now around 17%, is about the same as a decade ago, while bankruptcy filings have doubled. The burden of debt has not gone up, but, since more debt is owed, more can be discharged, and the benefit of eliminating it via bankruptcy has increased.

The composition of consumer debt has changed. Credit card usage has risen dramatically. About 43% of non-mortgage consumer debt is unsecured revolving credit, compared to 14% in 1978. A 1978 Supreme Court ruling allowing banks to lend across state lines unaffected by state usury laws, coupled with a general deregulation of state interest-rate ceilings, gave birth to a quickly growing consumer credit card industry. Unsecured consumer debt is easily dischargeable in bankruptcy.

It is difficult to measure changing moral attitudes. Many believe that the stigma and embarrassment of bankruptcy has faded. Judge Edith Jones, a former member of the National Bankruptcy Review Commission, noted in Congressional testimony that "The current system of bankruptcy law permits any person to seek relief without demonstrating financial necessity. At one time in our history, filing bankruptcy was regarded as shameful, and filers suffered social stigma and permanently ruined credit. The shame and stigma are no longer compelling ... many filers now commence cases without ever having been in default on their debts. This suggests that bankruptcy is, to them, not a last resort, but a first resort. Many debtors are well-off and continue to be fully employed before and after filing bankruptcy. Lawyer advertising, do-it-your-self kits, and bankruptcy mills expand the pool of potential filers. Well-publicized celebrity bankruptcies, plus `water cooler' gossip about increasing filings, have tended to reduce bankruptcy to an acceptable alternative for personal financial management."

Legally discharging unpaid debts has become regarded more as a tool of smart financial management and less of an embarrassment. Oddly, some mortgage lenders recommend bankruptcy to remove high debt loads, enabling potential home buyers to qualify for loans.

Economists do not question why the bankruptcy rate is so high, but, rather, why it's so low. University of Michigan professor Michelle White estimates that 15.4% of U.S. households could benefit financially from filing, but less than a tenth of those households actually do so. More could benefit through strategic behavior prior to bankruptcy. If debtors convert nonexempt property to exempt--e.g., using cash to contribute to IRAs or paying off home mortgages--the percentage who could benefit rises to 17.5%, and to 22.6% if debtors move to states with higher allowed exemptions. Last-minute borrowing and spending sprees on the eve of filing could increase it even further. The mass of potential filings is a powder keg for the stability of financial institutions waiting to be tested in the next economic downturn.

One reason filings are not higher is the moral cost or stigma, a cost which may be declining. However, it is hard to rationalize some debtors valuing that more than the financial windfall. A sense of justice in voluntary repayment may not outweigh possibly erasing $50,000 of debt. The best explanation for why the bankruptcy rate is not higher is informational. Many debtors simply do not know of the...