How Much Debt Should Creditors Forgive?

Concerned about the skyrocketing number of consumer bankruptcies, Congress is considering whether to make it more difficult for Americans to walk away from their debts.

Banks, credit unions, and other lenders say they expect to be hit with a record 1.3 million bankruptcies this year, up from 182,000 in 1978. Creditors complain that a significant number of these are people who could still afford to shoulder some of their financial obligations - and that the current system makes it too easy for them to escape paying what they owe.

Bankruptcy lawyers and many consumer groups say current law represents the nation's historic emphasis on an individual's right to a fresh start. They say the real problem is the creditors and their relentless marketing of credit cards.

It's an issue that involves personal responsibility, economic efficiency, and the pressures to spend in a consumer-oriented society. And it touches every American who has a checkbook. Lenders say their bankruptcy-related losses cost the average household some $400 a year in higher prices and interest rates.

"The remarkable increase in consumer bankruptcy over the last two years is particularly alarming," writes the congressionally appointed National Bankruptcy Review Commission in its recently issued final report. "It warrants prompt attention from Congress...."

The Constitution expressly gives Congress the power to write US bankruptcy law. But it wasn't until 1898 that lawmakers established a formalized system, creating federal bankruptcy courts and many of the procedures in use today. Congress passed major reforms in 1938 and 1978, and amendments in 1984.

The American approach to bankruptcy is unique: It tries harder than in most countries to balance fairness to creditors with a fresh start for debtors.

But those twin goals are often in conflict. Now Congress is looking at whether a new balance between them needs to be struck.

Lenders complain that today's laws made it too easy to file and that the US has developed a relatively relaxed societal attitude toward bankruptcy.

The most frequently cited horror story is the case of Paul Bilzerian, a multimillionaire who sank millions into a Florida mansion and then filed for bankruptcy to avoid debts after a fraud conviction. Even relatively expensive homesteads are protected from creditors by Florida law.

Controversial report

Public debate on the subject was launched late last month, when the review commission established in 1994 presented its findings. The commission recommended more than 170 changes in bankruptcy law, such as establishing a uniform nationwide homestead exemption, allowing debtors to keep $20,000, requiring repayment of credit-card debt incurred within 30 days, and extending bankruptcy protection to student loans.

The findings were immediately controversial. "They have not discouraged people from going into bankruptcy, except for those who repeat," says Sen. Charles Grassley (R) of Iowa.

But Stephen Brobeck of the Consumer Federation of America finds the commission report worthwhile. "Creditors were not happy with those recommendations because they did not deny consumers ... access to Chapter 7 bankruptcy," he says. Under Chapter 7, a debtor does not make repayment on debts. That's why creditors prefer Chapter 13 bankruptcy, which sets up a program for partial repayment.

Ideas from Congress

Congress is responding to prodding from creditor groups with proposals to make bankruptcy more difficult. A bill sponsored by Reps. Bill McCollum (R) of Florida and Rich Boucher (D) of Virginia would require debtors to file under Chapter 13 if they make more than 75 percent of the median family income and can pay $50 a month on 20 percent of their unsecured debt.

But Mr. Brobeck says creditors' groups are on a futile quest: "They are not going to substantially increase their recovery through bankruptcy reform, because you can't squeeze water out of a stone." He says the typical family that files for Chapter 7 bankruptcy earns less than $20,000 a year and has more than $17,000 in credit-card debt.

Senator Grassley and Sen. Richard Durbin (D) of Illinois have introduced an alternative that tries to strike a balance between protecting against debtor abuses of the system and creditor bullying of debtors. It would require debtors to file under Chapter 13 if they can repay 20 percent or more of their debt. The bill would also establish an alternative dispute-resolution system.

Brobeck calls the Grassley-Durbin proposal "a sincere effort to correct abuses in the system." But he says it does not adequately protect moderate-income households with huge debts.

The explosion in bankruptcy, Brobeck says, is "the tip of the iceberg of growing financial insolvency in typical American households." He blames credit-card companies that aggressively market to families who can't really afford more credit: Some 2.8 billion cards will be offered to consumers this year.

"Both halves of the bankruptcy equation can and should act more responsibly," Durbin says.