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Can the bankruptcy mess be fixed?

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The bankruptcy bills that have muddled through Congress won't really fix the problems, experts say. Effective remedies will need to include things like consumer education, changed usury laws and improved health insurance access. Plus: steps that can reduce your risk.

By Liz Pulliam Weston

What’s remarkable about the bankruptcy reform bills proposed by Congress isn’t their strong, bipartisan support, or how close they’ve come to being law. The bills have passed both houses on three separate occasions since 1998, only to be vetoed or die in last-minute political squabbling.

What’s really remarkable about these bills is how few bankruptcy experts believe their reforms will actually work.

In interviews with more than two dozen bankruptcy judges, attorneys, trustees and academics, none said they believed the bills would:

Reverse the soaring bankruptcy rate.

Prevent more consumers from going broke.

Result in creditors being repaid significantly more.

Decrease the likelihood a bankrupt consumer would file again.

In its rush to force more consumers to take responsibility for their debts, Congress ignored most of the factors that have created today’s bankruptcy boom, these experts said.

“You can’t simply focus on the debtors,” summed up Brady Williamson, a respected corporate bankruptcy attorney who headed a federal commission on bankruptcy reform in the 1990s. “You have to focus on the creditors as well.”

Diversion to repayment plans

The centerpiece of the reform bills is means-testing for consumers, which is supposed to make sure that people who can afford to pay more of their bills actually do. Unless they can prove undue hardship, debtors who make more than the median income for their areas could be diverted into repayment plans instead of being allowed to wipe out their unsecured debts.

But the Congressional Budget Office estimates that only 5% to 10% of Chapter 7 filers -- somewhere between 58,000 and 116,000 of the total 1.2 million cases last year -- would be diverted. That’s because the vast majority of filers are too poor and won’t meet the median-income requirement.Check out your options.

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In Utah, for example, the median household income of filers was $24,000 for Chapter 13 filers and $16,500 for Chapter 7 filers, compared to a median household income in the state of over $45,000.

Even those who are diverted into Chapter 13 repayment plans may not end up paying their creditors much more cash. Critics of the bankruptcy reform bills complain the amounts the diverted debtors are allowed for living expenses may not be adequate. That, they say, would result in many being unable to meet their repayment obligations.

That’s true of most debtors in Chapter 13 repayment plans now. About two-thirds of these plans fail, often because the debtors are too optimistic about how much income they’ll make and what expenses they’ll face.

“Even one little bump in the road,” said bankruptcy expert Elizabeth Warren of Harvard University, “is enough to knock the cart over.”

Enter the Twilight Zone

Under the reforms, those who fail to complete their Chapter 13 plans could end up in a kind of Twilight Zone of debtors: unable to pay their debts or have them dismissed, they would return to being harassed by bill collectors they couldn’t satisfy. Some, critics contend, will simply “drop out” of the system by taking under-the-table jobs and forgoing bank accounts.

So what reforms would make a difference? The answers, according to bankruptcy experts, are more wide-ranging than you might think. Among them:

A return to usury laws. The effective end of usury laws in 1978 led to a massive increase in credit, including credit extended to troubled borrowers. Capping the amount of interest creditors can charge would force them to get smarter about the risks they take, contends Warren, co-author of “The Two-Income Trap: Why Middle-Class Mothers & Fathers Are Going Broke.”

Many families would have less access to credit, but according to Warren that’s not necessarily a bad thing. If these families have to pay two, three or 10 times the market rate for a loan, they probably are in no shape to afford that loan in the first place, she said.

Capping interest rates also would make it tougher for bankrupts to get credit again after filing. That would force many to learn how to live on cash and make bankruptcy more of a hardship -- perhaps deterring bankrupts from filing again.

Currently, bankruptcy filers are often offered credit cards before their cases have even closed, and many can qualify for high-rate mortgage and auto loans within months.

Better access to health insurance. Medical bills are a factor in one out of five consumer bankruptcies, and Warren’s research shows they are a direct cause of one in 10 filings.

By contrast, medical bills are a negligible factor in countries with universal health insurance. In Canada, for example, the consumer bankruptcy rate per capita is less than one-third that of the U.S.

The problem isn’t just the uninsured. As more employers shift the burden of insurance costs to their workers, many families are finding themselves unable to meet higher co-payments and out-of-pocket deductibles.

“I am seeing increasing numbers of elderly people who have suffered a medical crisis for which they had no insurance, but I am also seeing more people who have insurance, but the co-pays are eating them alive,” said Michael Baumer, an Austin bankruptcy attorney with 20 years’ experience. “I recently filed a case for two retired teachers who have health insurance and decent pensions, but between them they take 17 prescriptions and the co-pay is $20 per month per prescription." With doctor visits they pay a total of about $400 per month, "and that's if they don't have any problems which require them to get other care.”

Nothing short of universal insurance would end this problem, although almost any effort to extend coverage to the 43 million uninsured Americans would have some effect in curbing the bankruptcy rate.

Unified homestead exemptions. This provision may not prevent many bankruptcies, but it would make the process more fair, said Williamson, a member of the prestigious National Bankruptcy Conference, which studies bankruptcy reforms.

The U.S. Constitution in Article I, Section 8, gives Congress the power “to establish . . . uniform laws on the subject of bankruptcy throughout the United States.” Bankruptcy laws, however, vary widely by state, and nowhere are the differences more glaring than when you compare how much wealth people can shelter in their homes.

Florida, for example, has an almost unlimited homestead exemption, which is why it’s a favorite of millionaires, like O.J. Simpson, who want to avoid their creditors. Meanwhile, a poor family across the state line in Georgia would be at risk of losing its home in a bankruptcy filing.

“It’s exemptions like this,” Williamson stormed, “that are so outrageous they make a mockery of a system that is supposed to be uniform and nationwide.”

Better consumer education. Advocate groups like the Consumer Federation of America have long pushed for a law that would require credit card companies to tell their customers how long it will take to pay off a balance if only minimum payments are made, and how much interest the borrower is likely to pay.

In the last bankruptcy bill, lenders watered down this provision so that it required them only to tell borrowers how long it would take to pay off a generic $500 debt. Consumers who owe tens of thousands of dollars often would have a tough time doing the math to make that disclosure relevant to their lives. What’s needed, consumer advocates say, is personalized disclosures that could drive home the costs of carrying consumer debt.

The idea could be applied to any debt. When college students sign up for student loans, lenders should disclose how much the payments are likely to be by the time the student graduates. Students should be warned against total borrowing that would exceed the yearly salary of their first jobs.

Although student loans usually can’t be erased in bankruptcy, they frequently precipitate filings when graduates realize they can’t afford their rent, credit card payments and loans simultaneously.

“Student loans will become a crisis issue in years to come,” Austin attorney Baumer said.

Better Chapter 13 programs. Real bankruptcy reform could come on the local level if bankruptcy districts would improve their Chapter 13 programs, said Keith Lundin, a Nashville bankruptcy judge with 22 years’ experience.

Lundin’s district works closely with bankruptcy attorneys, judges and trustees to educate filers about money management and to create realistic Chapter 13 plans. These plans result in more money being returned to creditors, Lundin said.

“In Nashville, with three-quarters of a million people, $12 million a month is paid to creditors (through Chapter 13 plans),” Lundin said. “That’s more money than gets distributed (to creditors) in Los Angeles.”

Amounts paid to creditors (5 highest-paying states)

Total amount paid

to creditors in 1998 Per-case yield,

Ch. 13s only Per-case yield,

all consumer bankruptcies

Tennessee $303,424,262 $10,434 $5,867

Texas $255,751,205 $8,390 $3,692

Georgia $248,511,363 $6,563 $4,064

California $231,785,864 $6,252 $1,168

Florida $119,442,740 $6,782 $1,675

Source: “Bankruptcy by the Numbers: Measuring Performance in Chapter 13,” by Gordon Bermant and Ed Flynn, Executive Office for the U.S. Trustees; MSN research

Chapter 13 also can have benefits for the debtor. Consumers can typically hold on to property, like equity in a home or car, that they might otherwise lose in Chapter 7. More importantly for the “fragile consumers” that clog bankruptcy courts, though, is the ability to file a future Chapter 7 if necessary, Lundin said.

Those who get a Chapter 7 discharge are prevented from filing again for six years, while those who file a Chapter 13 can file for a Chapter 7 anytime.

“They can keep their (future Chapter 7) discharge for their medical disaster” or another financial setback, Lundin said. “They don’t waste their discharge, they keep their integrity and they learn something about managing money.”

Reduce bogus bankruptcies. Some people file Chapter 13 bankruptcies as a way to frustrate evictions or foreclosures, with no intention of following through on their filing. Because there is no limit on filing Chapter 13s, they can do this over and over in an effort to thwart their creditors.

Landlords and lenders can get the stay lifted, but typically have to go to court to do so -- something they say is often an unnecessary and unfair expense.

One easy way to reduce the number of such bogus filings is to change the “automatic stay” provisions that put foreclosures and evictions on hold. Rather than getting an automatic stay with each filing, a consumer who files more than once might be denied an automatic stay, or the stay might come with a 30-day expiration date, so that landlords and lenders don’t have to go to court to get it lifted.

Steps that can help reduce your risk

Obviously, some of these changes would be easier to make than others. And consumers can still play a big role in reducing their own risk for bankruptcy by taking the following steps:

Maintain financial flexibility. Running up big debts on credit cards and home-equity lines of credit leaves consumers vulnerable to the inevitable financial setbacks in life, such as job loss, income reduction, divorce and major illness. Using no more than 10% to 20% of your available credit will give you a cushion to use in case of an emergency.

Save for emergencies. Two-thirds of American households could not survive more than three months’ of unemployment without severe financial hardship. And 43% have less than $1,000 saved. Yet the average period of unemployment stretched for more than eight months in the last recession. Freeing up space on your credit cards and home equity line can serve as a stop-gap emergency fund, but most families will want to save a cash amount equal to at least three months’, and preferably six months’, worth of expenses.

Don’t go overboard on student loan debt. It rarely can be erased in bankruptcy, and many students find their debt loads allow them little room to save for a home or retirement once they’ve graduated. Don’t borrow more than about 75% of your first year’s salary.

Get health insurance, if at all possible. Some states offer bare-bones policies for low-income folks, or you might consider a high-deductible policy that requires you to pay more out of pocket but protects you against catastrophic medical bills.

Don’t overdose on mortgage debt. The burdens of homeownership are a leading cause of Chapter 13 filings, according to Warren and her fellow bankruptcy researchers, Teresa Sullivan and Jay Westbrook, authors of “The Fragile Middle Class: Americans in Debt.”

Lenders have greatly loosened their standards in recent years and will approve loans that eat up more than half of a borrower’s gross income, in some cases. It’s up to consumers to limit how much mortgage debt they take on.

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