October 22, 2007 - In a classic case of "be careful what you wish for", the bankruptcy reform bill passed by Congress two years ago is now a cause of some consternation for bankers. The bill, which was largely written by lenders, was promoted as a way to stop people from abusing the bankruptcy system. Lenders expected that once these so-called abuses stopped, the amount of money that they would be able to collect from debtors would increase substantially. But that has not been the case, and there is growing evidence that the new law may actually be hurting many lenders.

For years lenders claimed that many of those who filed for Chapter 7 bankruptcy - the type of bankruptcy that allows the courts to discharge all debts - should actually be forced to pay back all or a portion of what they borrowed using Chapter 13 bankruptcy rules. So they mounted a tremendous lobbying effort and managed to get a bankruptcy reform bill passed through Congress. The new law severely restricted the bankruptcy court's ability to discharge debt, and it put in place a litmus test for anyone trying to declare bankruptcy using Chapter 7. The bankruptcy court itself has virtually no leeway to take into account the individual circumstances of the filer.

What lenders expected from the new law, and what they have actually seen happen are two separate things.

For instance, lenders expected to see a significant decline in credit card delinquencies. For years, the percentage of percentage of customers who were behind on their credit card debt had hovered at around 4.5 %. Since the new bankruptcy law went into effect, that percentage has not changed.

The new law also prevents judges from adjusting the amount of money bankruptcy filers have to pay on their mortgages. Under the old law, bankruptcy judges had the ability to reduce or eliminate mortgage payments. They could order lenders to renegotiate loans. This change to the law was expected to help lenders. Instead, it may be having exactly the opposite effect.

Since bankruptcy judges can no long force a mortgage renegotiation for a primary residence, there is less money available to other creditors. The effect of this is that there is less money to be applied toward credit cards and other unsecured debts. It is also leading to more foreclosures among bankruptcy filers. Once a bankruptcy is filed using Chapter 13 rules, foreclosure proceedings do come to an end, but only temporarily. If the filer is unable to make mortgage payments during while his case proceeds through the bankruptcy court, his property may be foreclosed upon. This is having a direct impact on the number of bank-owned properties available for sale and is hurting real-estate markets nationwide.

Ironically, the law does allow judges to order the renegotiation of mortgages on business property and vacation homes. In theory, this would allow someone with two houses to have their primary residence foreclosed upon, but give them the ability to keep their second home.

The law has had an impact on the number of foreclosures filed. Today, they are running at about 50% of the number of filings under the old law. But the number is on the upswing and likely to continue to trend upward for the foreseeable future. One of the primary reasons that the number of bankruptcy proceedings are down may very well be because many consumers seen no advantages in filing for it.

It should be pointed out that the two most prevalent reasons for declaring bankruptcy have not changed. They are unexpected major medical expenses and unexpected job loss.  

by Jim Malmberg

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