A previous post outlined Professor Zywicki’s position, which boiled down to its essence is this:

- A lenient law (the 1978 Bankruptcy Reform Act) led to Chapter 7 bankruptcy becoming too easy.

- This led to a gradual decay in personal morality reflected in an increased willingness to walk away from one’s bills, and a reduction in social stigma as more people filed.

- The reform law that passed the Senate (finally) tips the scales back properly towards personal responsibility.

I believe that Professor Zywicki’s analysis, and the legislation that reflects this analysis, is flawed for four reasons:

1. By saying it hasn’t changed much, it makes a factual error in ignoring the explosive growth of consumer debt in the past 12 years.

2. It fails to look at how the growth of subprime, unsupportably aggressive, and sometimes predatory lending have contributed to putting financially uninformed people in jeopardy.

3. It fails to consider how lenders have changed their tactics towards borrowers in trouble, making many bankruptcies a near self-fulfilling prophecy.

4. Perhaps most importantly in terms of the current legislation, it utterly fails to deal with moral failures of the financial services industry in the past 12 years or so, and by doing so, lets the industry off the hook for its share of the problem. (Note: Prof. Zywicki invoked “morality” first, so now it’s fair game.)

1. Consumer (Non-Mortgage) Debt HAS Grown–a LOT

Zywicki claims that over the past 50 years revolving debt (e.g., credit cards) has substituted for installment debt (e.g., car loans), and that the overall levels of consumer debt have not changed much during that time.

This is the graph that he uses:

Now I have to wear reading glasses, but even without them I can still see that BOTH revolving AND non-revolving debt increased significantly starting in about 1993, from (following the blue line) about 16% to about 22%. That is no small increase.

Further, this graph masks the “payment-size problem.” The percentages here are calculated by dividing monthly required payments by monthly income. The required payments for credit cards (the infamous “minimum payments”) that are typically 2% of the outstanding balance at first substituted for installment debt (from the 1960s until 1993). But starting in 1993 they started piling up on top of installment-debt payments, which are usually a much higher percentage of the outstanding balance. Total balances owed (as opposed to required payments) have therefore gone up to an even greater extent during the past 12 years than the graph indicates.

To look at the situation properly, you really should push the green revolving and the blue total lines a lot higher by using “reasonable” payments against card balances (4%-5%) instead of the minimums. Now stay with me here–doubling the payments on revolving credit to reflect reasonable instead of minimum payments would change the percentage of income that “should” be devoted to revolving payments (the green line) to about 18% of income in 2003 and 2004 and the total reasonable payments against all debts (the blue line) to about 31% for those years. Also, note that we’re only dealing with payments here; interest rates, which have gone down in the past 12 years, are irrelevant to this graph.

So something must have started happening in 1993 that went beyond what I’ll call the “consumer morality effect” that Zywicki cites as THE reason for the bankruptcy explosion. Just to make things easy, let’s concede the “consumer morality effect” (even though I really don’t-see the first UPDATE below) for the period from 1978, when the law changed, until 1993 (15 years would appear to be plenty of time for consumer morals to decay, don’t you think?). Some might argue that the 1980-1983 recession was unusually harsh and heralded a partial dismantling of the safety net, but we’ll ignore that for the moment.

Let’s look (the graph is from one of Zywicki’s papers):

Bankruptcies (including Chapter 13s) went from roughly 3 per 1,000 families in 1978 to about 9 per 1,000 in 1993. You can even see that in 1994 and 1995, per-family filings went down, perhaps indicating that the “consumer morality effect” was (excuse the term) maxed out.

What happened from 1995 until now to increase filings to 14 or 15 per 1,000? See Points 2 and 3.

2. The Rise of Subprime, Unreasonably Aggressive, and Predatory Lending.

Let’s be frank: lenders have been reckless during the past 12 or so years.

Here’s just some of what has happened:

- New subprime mortgages grew from $40 billion in 1994 to $332 billion in 2003 (go Here, and look at Page 7 of the October 29, 2004 report [Page 10 sequentially], for a graph that contains most years). About 10% of all new home loans were subprime. The 2003 subprime figure would represent well over 2 million loans if the average amount loaned were $150,000.

- Subprime and “near prime” vehicle loans, which can have rates as high as 14%-25%, and again which basically didn’t exist in the early 1990s, are a significant percentage of all car loans. Subprime vehicle loan volume was $23.8 billion in 2002, up from $2 billion in 1994.

- Payday lending, which in all but the rarest of circumstances is purely predatory, and which again basically didn’t exist in the early 1990s, has grown to at least 14,000 nationwide locations (plus the Internet). That’s more locations than McDonalds.

All of these represent lending that ignores most normal underwriting standards. This lending, which can only be described as irresponsible (dare we say “immoral”) has been the main force driving the rise in bankruptcies from the mid-1990s until now.

Yes, this is tough to prove but in light of the following I would think someone has to DISprove it:

In June of 2003, almost 6% of subprime mortgages were over 90 days delinquent (vs. less than 1% of conventional mortgages). A rather large PDF with this info is here

Folks, these are foreclosures or bankruptcies waiting to happen. And how many more were “only” 60 days or 30 days past due, with foreclosure and/or bankruptcy just around the bend?

3. The disgraceful deterioration in how borrowers in trouble are treated.

Zywicki cites distant impersonal banks as opposed to the local and personal ones of the past as a reason why consumers don’t feel too badly about walking away from debts. I would submit that lenders carry much more blame here for the tattered relationship:

- The average late fee has gone from roughly $13 to $33 in the past 10 years. $39 is not at all unusual.

- In the same time period, the average overlimit fee has gone from roughly $13 to $30. (Aside: The only way to go over the limit is for finance charges to put you there. Any attempt at an overlimit purchase gets stopped. So other than to rake in “gotcha” money, why do these fees even exist? Oh, and did I tell you that one incident of going over the limit will normally generate TWO overlimit fees?)

- If your credit score is sliding, you can just about forget about forgiveness for being one day (or one hour) late with your payment.

- “Universal default” means that if you’re late with any lender, you’ll be treated as late with all of them, and probably get smacked with penalty rates by all of them. Penalty rates now average over 26%.

- Finally, lender “fair-share contributions” to credit-counseling agencies have declined sharply in the past few years, and lenders are less willing to lower rates and reduce balances for those who go into counseling.

The total effect of all of this heavyhandedness has been to cause more of what the lenders are complaining about (bankruptcies) to occur, and has led many otherwise reasonable to people to say “The heck with them. We’re filing” (actual language used was cleaned up).

4. Because of Points 2 and 3, the financial industry is at least as morally responsible as consumers for the current situation, and probably moreso.

This final point simply ties back to what I wrote when I first posted on the topic a little over a week ago:

One of my core beliefs is that if you are in business and conditions give you a chance to rip off the uninformed without penalty, you still don�t do it. “It’s their fault for being so stupid” doesn’t cut it. There will always be opportunities to shortchange the ignorant, but anyone with a “do unto others as you would have them do unto you” outlook on life would not capitalize on ignorance.

The financial industry, like the moneychangers in Biblical times, have totally failed the “do unto others” test. (You know, the “moral” standard that the Professor Zywicki has told us almost all Chapter 7 bankruptcy filers are failing.) Passing the Bankruptcy “reform” legislation in its current form will let them avoid current and future accountability for the lending mistakes they made.

I will suggest what I would do to try to fix the system to rein in lenders and (to a lesser extent) consumers, and ask for ideas from readers, in a future post.

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UPDATE: Just to be clear, I personally DON’T think (but can’t prove) that the rise in bankruptcies from 1978 until 1993 (from 3 per 1000 to 9 per 1000) was entirely (or even mostly) due to the “consumer morality effect.” I don’t deny its existence, but the other factors that Zywicki dismisses, especially divorce, could very well have played a more important role. Divorces with large amounts of unsecured debt, especially situations where one spouse stuck the other with unmanageable debts leading to bankruptcy, were virtually unheard of until high-limit credit cards got into the hands of the majority of the population, which didn’t happen until mid- to late-1970s. I also noted that the severity of the 1980-1983 recession and the slight weakening of the social safety net that followed it (to name just one example, unemployment benefits becoming taxable) may have contributed to the 1978-1993 rise.

Professor Todd Zywicki of The George Mason University School of Law has been one of the principal proponents of the “it’s too easy and it shouldn’t be” line of reasoning that has been the impetus behind that Bankruptcy “Reform” law that has passed the Senate and will be considered in the House beginning this week.

The Cliff’s Notes version of Zywicki’s position, for those who don’t want to read the whole post (remember, this is HIS position) is:

- Bankruptcy laws, which was already pretty lenient, became unreasonably lenient in 1978.

- The lenient 1978 law led to:
— aggressive attorney advertising.
— a realization on the part of many that they could be better off after a Chapter 7 bankruptcy filing than they were before.
— (gradually) a decay in personal morality over paying one’s bills.
— (gradually) a reduction in the social stigma involved in bankruptcy.
— an increased willingness to stiff the big, bad, impersonal out-of-town bank.
— collectively, the steep growth in bankruptcy filings.

- Creditor lobbyists, long ineffective at making their case in Washington, are finally being heard.

- When it’s passed, the Bankruptcy “reform” law (finally) sets things right.

To prove his point, much of Zywicki’s other research attempts to disprove possible other causes. So he systematically eliminates a number of other potential factors (with some paraphrasing): debt service and household net worth (even in the lowest income quintile); housing costs; divorce; and illness, unemployment, and other financial shocks.

He does a very good job–almost, but his two major omissions pull the rug out from under his arguments. That’s for the next post.

__________

(end of Cliff’s notes–For those who read on, you may experience wailing and gnashing of teeth)

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Bankruptcy legislation first became a permanent feature of the landscape in 1898. The only major rewrite of bankruptcy law, the one Zywicki say made filing (Chapter 7) “easy” (others might argue, “less creditor-friendly”), occurred in 1978.

Zywicki argues that how we got to the alleged “easy” situation was due to a number of political factors (from his paper “The Past, Present, and Future of Bankruptcy Law in America”–PDF download is at the bottom of the linked page):

- Until recently, bankruptcy lawyers and their lobbyists have worked diligently to defend their position and have used their technical expertise to cleverly craft rules that favor them and the growth of their business, even when creditors seem to have the upper hand politically.

- Again until recently, the financial services industry has NOT been an effective lobbying group.

- The general public (called “repayers” because they end up “repaying” debts not collected through higher prices and less availability of credit) have not had, and really still don’t have, an effective voice at all.

- So-called progressive ideology from early in the 20th century through today’s consumer advocacy groups has favored debtors over creditors.

Now the landscape has changed (and Zywicki thinks this is a good thing–the italics on “moral” are HIS):

“Congress is animated by a new political ideology of ‘personal responsibility’ that serves as a counterweight to the traditional prodebtor ideology….The personal responsibility ideology sees consumer bankruptcy as primarily a moral issue, rather than an economic issue.”

“….Consumer bankruptcy filing rates (should be) viewed as a crisis of the American soul, rather than a mere matter of economic policy. Put simply, there is no economic explanation for the upsurge in individual bankruptcy filings in the late-1990s, an era of unprecedented prosperity, low interest rates, low unemployment rates, and soaring levels of individual wealth. Given the anomaly of economic prosperity combined with the staggering rise in bankruptcy filings, many have concluded that the problem is social and spiritual, rather than economic.”

“(in the changed environment) Despite …. intense lobbying efforts, bankruptcy professionals have been unable to replicate their previous successes in turning the reform process to their advantage.”

“(meanwhile) for the first time in recent memory creditors as a group have been able to overcome their collective action problems to lobby effectively for their interests.”

“Promiscuous consumer bankruptcy laws were just one of the many social experiments of recent decades that have proven contrary to human nature and the needs of successful societies. The movement toward greater accountability in consumer bankruptcy represents a necessary step of social self-correction after a period of chaos and revolution.”

Prof. Zywicki’s position now being established, his other work (example here (PDF download is at the bottom of the linked page) is meant to disprove all other conventional-wisdom causes for the rise in personal bankruptcies:

- debt service, payments vs. income (even in the lowest income quintile), which he shows hasn’t gone up much.

- household net worth (even in the lowest quintile), which has grown across the board.

- consumer revolving and non-revolving credit, which he claims has remained stable on a combined basis.

- housing costs, for which he says the effect of their increase has been offset by the presence of more two-income families.

- financial shocks like unemployment, downsizing, divorce, health problems, and lack of health insurance, for which he claims no correlation with bankruptcy filings.

He gets a lot of it right, but his omissions are glaring. They’ll be discussed in the next post.

David Broder opines in the WaPo today and the NY Times has a longer analysis piece.

Since Prof. Todd Zywicki, one of the main academic supporters of the “reform” bill, is quoted today in NYT, and since I will critique his positions shortly, let’s go to his two paragraphs from there because the mask is off (bold added; link is to second page where Mr. Z’s quote is; link requires registration and free access with registration goes away after roughly a week):

But Todd J. Zywicki, a professor at George Mason University School of Law, said that financial distress cannot explain the surge in personal bankruptcies in the 1990’s. They were not preceded, he said, by equally steep increases in unemployment, divorce or health-care costs.

Professor Zywicki has a number of theories on why bankruptcies have increased, but if asked to rank them, he said that the No. 1 would be “the generosity of the bankruptcy code - it makes it so easy.”

Here’s hoping that Prof. Zywicki’s “easy” characterization becomes to the bankruptcy debate what “a bunch of guys in their pajamas” was to the blogs during RatherGate.

Besides the paperwork, which I would characterize as anything but easy based on this (link is to Texas info; procedures are nearly uniform in all 50 states), here are some other “easy” aspects of bankruptcy:

- You have a black eye on your credit reports that will stay there for 7-10 years.

- It will affect your ability to get a job in many professions, and may cause you not to be able to keep your job. A healthy percentage of employers pull credit reports when you apply, and in certain cases they can pull them at will. Many employers, rightly or wrongly, conclude that if you can’t take care of yourself financially, they don’t want you to be around their assets.

- It will affect your vehicle and homeowner’s insurance rates in most states. Sometimes it takes an accident or a claim to trigger a big increase, sometimes it simply happens at renewal time.

- Utility companies, wireless providers, and the like will impose deposit requirements.

That’s just the hard financial stuff (most of it). These common psychological consequences explain why people try to avoid bankruptcy:

- Divorce, especially when one person contributed more to the problem than the other. In many cases, the offending spouse, so to speak, knows that the marriage is probably over if they file, and does everything possible to avoid it.

- Negative impact on extended family relationships, especially if some of the extended family isn’t getting paid back what was borrowed.

- Negative impact on work and social relationships.

- At the risk of getting into personal psychology (if you don’t like this one, fine, just acknowledge the other three), because of the other items, there can be negative psychological effects, potentially to the point of depression or suicide.

All of the “hard” and “soft” reasons identified, plus the sense of honor that most people try to live by, are reasons why, if anything, people avoid filing for bankruptcy and, in many cases, delay the inevitable longer than they should.

I’m sure everyone has a story of someone who took bankruptcy as the easy way out, but it’s long way from there to concluding, as Prof. Zywicki has, that there has been a pervasive breakdown in willingness (not the ability, the willingness) of people to walk away from their obligations in the past 20 years. I’m not buying it. This cannot be the whole explanation. Something else is involved.

More to come that will first describe the Professor’s positions and then argue against them.

Unbeknowst to me, Apache stopped running sometime last night (what, sleeping is prohibited?)

It’s up now, and the site’s working. A way to force Apache to restart periodically is being investigated.

Apologies for the outage.