The 2005 Bankruptcy Law – A Help or Hindrance to the Economy?

Back in 2005, credit card companies were convinced – or at least tried hard to convince everyone else – that there was a bankruptcy crisis in the United States. Bankruptcy rates had doubled since 1980, they pointed out. 'Shopaholics' were charging everything under the sun and then declaring bankruptcy, forcing the credit card companies to eat their debt. They then had no choice but to pass these expenses on to consumers in the form of higher fees and interest rates.

In 2005, the major banks spent tens of millions of dollars lobbying Congress to make it harder for consumers to declare bankruptcy. Despite protests from lawyers, judges and law professors working in the system, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act. Insiders pointed out that the law was essentially written by the credit card companies; a single law professor and four credit industry lobbyists actually wrote the legislation.

Nearly everyone agrees that the laws made filing for bankruptcy more burdensome for debtors. Perhaps the most pernicious element, and the one the credit card companies fought hardest for, is the means test. The means test looks at your prior six months of income to determine whether you qualify for Chapter 7 bankruptcy. If your income is too high, you may need to increase certain expenses which qualify as deductions (much like tax deductions). If your income is still too high, you may need to file for Chapter 13 bankruptcy, which offers the same relief as a Chapter 7, but requires a payment plan. The Chapter 13 payment plan can last anywhere from 15 months to 5 years, depending on your particular jurisdiction.

A boon for the credit card companies and consumers who pay their debts, right? Well, certainly the credit card companies did well for a while– their profits rose thirty percent between 2005 and 2007. However, the decline in interest rates and fees they promised would accompany this never happened – in fact, interest rates and fees increased over this period. Things got so bad that Congress finally passed another bill last May, this one regulating industry practices: they set limits on credit card fees and interest rates and will require lenders to be transparent in their communications, starting in July of 2010.

More importantly, recent studies suggest that the new bankruptcy law may have contributed to the rise in foreclosures – costing the banks billions of dollars – and to the housing crisis in general. Now that many consumers mistakenly believed that bankruptcy was not an option, in many cases they simply walked away from their homes instead of declaring bankruptcy and continuing to make their mortgage payments. Feeling that they couldn't make both their mortgage and credit card payments, they may have opted to make neither. As foreclosure rates rose, slumping housing prices feel even further. Neighborhoods with a number of foreclosures went into deep decline. Banks lost money, the country slid into recession.

Does this mean that the bankruptcy law caused all of this? No, of course not. Many factors contributed to the recession, included the derivatives trading on Wall Street, the government trying to finance two wars without raising taxes, etc. However, it is clear that the idea that banks would pass on savings to consumers was unrealistic. It's also clear that removing consumer options resulted in financial decisions that ultimately hurt the banks as well as consumers. (Other studies argue that stringent bankruptcy laws discourage risk and entrepreneurship; it's no accident that many countries in the EU are loosening their bankruptcy laws during this recession.) The obvious conclusion is that Congress, and not the banks, should write laws. And that they should listen to the experts – in this case, the lawyers and judges involved in bankruptcy proceedings – instead of lobbyists with an agenda.

The good thing is that, in many jurisdictions, judges have construed the new law in favor of debtors. The means test is not bullet proof, and Chapter 7 is still a viable option for most consumers. And with the rising tide of delinquent mortgages, Chapter 13 bankruptcy remains the best way to save your family's home. Contact a bankruptcy attorney today and get the truth about bankruptcy.