The Impact of So-Called Reform of Bankruptcy Laws

A revolution in middle class life is around the corner. By next October, Americans who are in debt may no longer be able to make a fresh start if Congress fulfills its plan to have Pres. George W. Bush sign legislation that radically changes the bankruptcy laws in a way that bolsters the credit card companies, also known as banks.

The current bankruptcy law allows people to erase debts and have a clean start. That system leaves the credit card companies with nothing, and they don’t like that. But that principle does permit a middle-class person to regain his or her standard of living. In a nation increasingly governed by laissez-faire economic principles, the bankruptcy law is singularly humane.

The so-called reform now working its way through the House of Representatives, after Senate approval last month, will undermine the “fresh start” concept. It will introduce a means test requiring households with incomes over the New York State median of $42,432 to repay the debt over a five-year period.

If every debtor got into trouble by buying Prada wardrobes, it might make some sense to punish those owing money, but in fact, most people are bankrupted by unavoidable, in some cases life-saving, expenses.

Medical expenses account for a large portion of individuals’ debts. In a study for the journal Health Affairs, about 30 percent of the people questioned who filed for bankruptcy were ill or injured. They had health insurance but were nearly pushed to destitution by co-payments and deductibles for needed medical care. Many debtors in the survey had bills for services not covered by insurance.

As you might expect, the new federal legislation will not force debtors to reimburse credit card companies in the face of catastrophic medical expenses. But how will the bankruptcy judges know the difference between deadbeats and the person living through a medical emergency? The bankruptcy lawyer and the judge will examine the debtor’s finances in far greater detail than under the existing law.

In case you missed the implications of the previous sentence, let’s be clear—the new bankruptcy legislation will allow higher attorneys’ fees. Congress is also raising the filing fee by 17 percent, a tax increase of sorts. A new requirement will also add to the cost of declaring bankruptcy. Those declaring bankruptcy must seek credit counseling—at their own expense. Credit counseling agencies teach budgeting and control of impulse spending, helpful knowledge for binge spenders, but insulting to someone who happens to be broke and is living hand-to-mouth.

After all this preparation, the visit to bankruptcy court doesn’t bring relief—the bills must still be paid. The proposed law requires that the bankruptcy petitioner will have to enter into a five-year bill payment plan. Bill payments will come first and the amount of money left over for living expenses will be based on guidelines already in place in Internal Revenue Services collection practices. According to Jeffrey Morris, resident scholar at the American Bankruptcy Institute, single people will receive the smallest allowance, and under the language of the statute, contributions by a roommate for household expenses will be deducted from the petitioner’s allowable expenses. Therefore, a single person who splits the rent with a roommate will have to include the roommate contribution as income.

This is a radical departure from established practices of debt forgiveness. The concept of the fresh start is abandoned in favor of a government-sanctioned bill collection program.

I can speak with first-hand experience about bankruptcy. When Republican Gov. George Pataki first took office, the State Senate’s Democratic legislative budget was cut, giving me, a Democratic staffer, a second round of unemployment in about three years. I wanted to leave Albany and return to New York City, but my house was situated in the midst of a local crack war. The mortgage company wouldn’t accept the property, and instead moved to foreclose, so I declared bankruptcy. When the house was auctioned, nobody bid on it.

But I discovered something wonderful—for the first time in my life I was debt free. I vowed, and, somewhat to my surprise, kept the promise to never live on credit again.

Ironically, in the years since I declared bankruptcy, the credit card companies and mortgage brokers have flourished. It is hard to argue that my bad debts caused them serious injury. Bankruptcy made my life happier. To me, the concept of a fresh start is not a rhetorical flourish, but something that has lasted for eight years.

The present bankruptcy law was born of hard times. The 1970s was an era of stagflation—high inflation and economic stagnation. At its peak, the Federal Reserve set interest rates at levels approaching 20 percent. Today, that rate is less than three percent. The law was passed to alleviate the problems caused by bad debts. These debts kept increasing because the interest was added to the principal. Twenty-seven years ago, Congress and Pres. Jimmy Carter cut the Gordian knot and discharged all debts. This is the rationale behind the concept of a “fresh start.”

Moreover, the Federal Reserve, forecasting growing inflation, has hinted that it will raise interest rates every six weeks. The “fresh start” is ending just as interest rates are increasing. Could it be that we are starting another era where, as New York Law School Professor Karen Gross describes it, debt is like “quicksand—easy to get into and hard to get out of?”

The House of Representatives is expected to pass the Senate legislation this month, and that means anyone troubled by debt has until October to take advantage of the current law. This particularly painful issue is another wedge that will drive Americans further apart. As Harvard Law Professor Elizabeth Warren puts it, “All the money is on one side and all the hurt is on the other.”