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One downside of the increased availability of consumer credit is an increase in the number of people who do not repay their loans, many of whom end up formally declaring bankruptcy. In an effort to curb this increase in bankruptcy filings, Congress passed and the President signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Recently, two workshops and two papers at the Federal Reserve Bank of Philadelphia were motivated by this legislation and the problem it addresses.
Thomas Durkin, an economist at the Federal Reserve Board, presented a workshop on the minimum payment disclosure that Congress hopes will help consumers make more educated borrowing decisions. At an earlier workshop, PCC Visiting Scholar Ronald Mann spoke about his forthcoming book that, among other things, discusses the role of credit cards in bankruptcy. Additionally, economic research by Wenli Li and Pierre-Daniel Sarte and by Robert Hunt examines how the new bankruptcy law has changed the relative attractiveness of the alternatives available to distressed borrowers, including Chapter 7 or Chapter 13 filings, credit counseling, and informal bankruptcy (that is, simply not paying bills).
The new bankruptcy bill, among other things, requires credit card issuers to include on customers’ statements a warning notice about making only minimum monthly payments. It also requires that issuers make available to consumers an estimate of how many months it would take to pay off certain credit card balances if only a minimum payment were made each month. Congress charged the Board of Governors with devising a methodology for making this payoff estimate and ensuring that the methodology is one that issuers can rely on to be in compliance with the law.
On May 22, 2006, the PCC hosted a workshop at which Durkin discussed his recent analysis of potential ways to make the payoff estimates required by the legislation. Durkin explained that creating a uniform methodology in an environment where issuers’ pricing strategies vary substantially is challenging. He finds that for consumers with similar balances and APRs, estimates of payoff time can vary by more than a decade, depending on assumptions made about how monthly minimum payments are calculated, how payments are allocated by balance type, and how finance charges are calculated.
While Durkin did not advocate that the Board adopt any particular methodology, he did explain that as a result of variations in issuers’ strategies, policymakers face a difficult task in implementing the statute in a way that provides consumers with accurate estimates.
A second workshop, led by Ronald Mann and based on a chapter in his forthcoming book on bankruptcy, examined the underlying causes of bankruptcy. However, Mann’s conclusions about what the problem is and how to solve it differ from those underlying the new law. Mann employs a number of cross-country comparisons to highlight connections between credit cards, debt, and bankruptcy. He argues that the most feasible way to reduce consumer bankruptcy is by taxing charged-off debt in order to decrease the incentive to lend to distressed borrowers. In his opinion, the new law, by contrast, will not reduce bankruptcy filings but will instead slow down the bankruptcy process for consumers, giving issuers more time to receive debt-servicing payments. Therefore, while Mann agrees that the surge in consumer bankruptcy is a problem, he does not think that making it more difficult for consumers to declare bankruptcy represents the full extent of needed change.
Given the focus on bankruptcy system reform, Li and Sarte’s recent research emphasizes that how the law is “tightened” matters. Li and Sarte’s paper “U.S. Consumer Bankruptcy Choice: The Importance of General Equilibrium Effects” focuses on the choice between Chapter 7 and Chapter 13 and the general equilibrium effects of different potential bankruptcy reforms. The authors developed a model to test three different policies: disallowing bankruptcy, tightening Chapter 7 through means testing, and tightening Chapter 7 by decreasing exemptions. Their model takes into account that changes to Chapter 7 will also affect the number of people filing for Chapter 13, and they note that wage garnishment under Chapter 13 can act as a disincentive to work. Li and Sarte’s model suggests that rather than tightening Chapter 7 through means testing, as the 2005 law purported to do, it would be better to do so by lowering the level of allowed exemptions under Chapter 7. While an important economic contribution, their paper also has a simple lesson for noneconomists, too: When you change one option, you change the relative attractiveness of other options, as well.
In the same vein, Federal Reserve Bank of Philadelphia Economist Robert Hunt has been researching industries tied to the alternatives to bankruptcy, which will also likely face change as a result of the legislation. Hunt identifies two possibilities for distressed borrowers outside of bankruptcy: ceasing to pay (informal bankruptcy), or attempting to renegotiate one’s payments to creditors through a debt management plan. These two possibilities are of particular interest to the Payment Cards Center because only about one-half of credit card chargeoffs are the direct result of a bankruptcy filing. When people stop repaying unsecured loans without declaring bankruptcy, their accounts are often eventually sold out or outsourced to an agency specializing in collections.
Hunt’s recent work on this industry builds on his Business Review article “Whither Consumer Credit Counseling?,” which examines the function of the credit counseling industry, its history, recent concerns about consumer protection, and the resulting developments. Hunt argues that consumers do not make decisions about whether to seek credit counseling, stop paying a debt, or file for bankruptcy in a vacuum. The characteristics of each of these options influence the relative attractiveness of the others.
Overall, changes to the bankruptcy system could potentially influence consumer choices about debt, and these choices could, in turn, influence financial institutions, credit counseling agencies, debt collectors, and the macroeconomy. Hopefully, the work of researchers on consumer debt and bankruptcy will continue to improve our understanding of how best to address the costs associated with consumers who cannot repay their debts.