Unanticipated Consequences

  In the five months since the new federal bankruptcy law took effect, lenders and creditors have had something to smile about as filings initially fell as expected. But those smiles might soon turn to frowns as it becomes clearer that the new law will not have the desired effect of decreasing bankruptcy filings long-term.
  Indeed, signs are evident that filings will pick up. Seasoned observers worry that economic factors will collide this year to increase filings in the months ahead.
  Reports already have surfaced that individuals going for the now-required pre-bankruptcy credit counseling have so few financial resources they cannot afford the counseling fees, let alone to stay out of bankruptcy with the help of a counselor as the law's backers had hoped.
  Money Management International, a major credit-counseling group, told the Washington Post in January that only 4.5% of the 14,907 consumers it worked with since the federal law changed Oct. 17 had enough income to work out debt-repayment plans without going into bankruptcy. Less than 10% of those individuals, 42 out of 669, agreed to put together debt-repayment plans without resorting to bankruptcy.
  Further muddying the waters is the recent decision by the Internal Revenue Service to challenge the tax-exempt status of more than 30 leading credit counseling agencies that account for the vast majority of the credit counseling industry's revenues. Before that decision, the IRS had revoked the tax-exempt status of five agencies.
  Under bankruptcy laws, consumers can only receive counseling from tax-exempt or non-profit agencies.
  While the IRS charges that the agencies named in its action are funneling too much revenue into for-profit entities within their corporate structure or to their top executives, concerns have arisen that the action could severely limit the number of agencies certified to provide credit counseling.
  "These are large agencies that account for about 80% of the revenues generated, so in the short-term, it could affect consumer's ability to get counseling from qualified agencies," argues Allen Grommet, a senior economist at Cambridge Consumer Credit Index, an Agawam, Mass.-based organization that polls consumers monthly about their attitudes toward consumer credit.
  "The people who are most in need of counseling are lower-income individuals, which represent a large portion of Chapter 7 filings," says Grommet. "If they live in an area not served by a certified counseling agency, where are they going to get the counseling required under the new law?"
  The IRS is quick to point out that the agencies cited in its action have the right to appeal their tax-exempt status and that revocation of that status does not necessarily mean they will lose their certification to provide counseling under the new bankruptcy laws. The U.S. Department of Justice has jurisdiction over agency certification.
  Still, the definition of what constitutes a non-profit counseling agency appears to be falling more and more in line with what constitutes a tax-exempt agency, says Jeffrey Tenenbaum, a partner with Venable LLP, a Washington D.C.-based law firm that represents credit counseling agencies.
  "If an agency loses its tax-exempt status, lenders don't pay their share of the costs and the agency can't receive grants to keep operating," explains Tenenbaum. "Those funds account for about 50% of their revenues, and it will be tough to survive without that money since they won't earn enough from consumer fees under the bankruptcy law."
  One solution to extending the reach of certified credit counseling agencies in the wake of the IRS's decision is to offer consumers credit counseling by phone or via the Internet, something permissible under the bankruptcy law. Whether that will make a difference in persuading consumers to undergo counseling before filing for bankruptcy is unknown.
  Consumer bankruptcy filings hit a record high in 2005, surging almost 32% to top 2 million, according to a report by Lundquist Consulting Inc. of Burlingame, Calif. September's filings rose to record highs, averaging 9,000 per day, up 50% from 2004's daily average. In the week leading up to the new law, a record 315,000 bankruptcy petitions were filed, a figure that has plunged to about 3,500 per week, according to Lundquist.
  As of the end of January, bankruptcy filings were down about 10% since Oct. 18 compared with the same period a year ago, according to the American Bankers Association.
  The slowdown indicates, at least initially, that the law has achieved its objective: making people think twice about filing for bankruptcy, especially if the only aim is to discharge their debt by filing under Chapter 7, despite having the means to set up a repayment schedule under Chapter 13.
  Filings to Rise?
  The improved numbers, however, actually may be an aberration. Bankruptcy filings are likely to rise and even match 2005 levels in the coming months, say bankruptcy experts. They see a converging set of economic indicators that suggest a high percentage of consumers have the means to service their basic monthly financial obligations but little else.
  At the same time, economists and bankruptcy experts are keeping close tabs on changing market conditions that easily could push many consumers over the edge financially.
  Of chief concern are rising interest rates, increasing minimum credit card payments and ballooning consumer debt-to-income ratios.
  About 30% of bankruptcies filed normally are attributable to job loss and 46% because of overwhelming medical expenses, according to Celent Communications Inc., a Boston-based research and consulting firm.
  "There is a balancing act that will be taking place," says Dennis Moroney, senior analyst, bank cards, for Tower Group, the Needham, Mass.-based research and consulting arm of MasterCard International. "If interest rates rise too fast and wages remain stagnant for the most part, consumers that pay the monthly minimum on card bills and other loans are going to start to feel a cash flow pinch."
  Central to heading off this problem will be the actions of the Federal Reserve. Indications are that the Fed has one more rate hike on its agenda before it backs off about mid-year and determines whether the increased cost of funds is holding inflation in check without slowing economic growth.
  The first signs monetary policy has tightened too much will show up in the housing sector. If the housing market slows because of higher interest rates, concerns will shift to consumers who have heavily leveraged their home equity to pay off credit cards and auto loans and who are continuing to rack up credit card debt. Factor in the rise in the minimum monthly credit payment, and some bankruptcy experts fear the stage is set for a major conflagration.
  "In such an environment, all it would take is for a spark, like a sudden and sustained spike in energy costs, to ignite a firestorm of bankruptcy filings," says Joseph Prochaska, chairman of the consumers bankruptcy committee for the American Bar Association's business section. "It is a potentially precarious situation, and whether lenders and creditors can get through it unscathed is anyone's guess at this point."
  Bankruptcy experts agree that if lenders want the new bankruptcy laws to achieve the desired objective, they are going to have to cooperate with one another when working with consumers to create a manageable repayment plan outside of bankruptcy court. Doing that spares the consumer and the debtor related court costs. The savings incurred by the consumer can be put toward paying down debt instead.
  Whether this can be achieved is questionable, since many lenders are under pressure to reduce chargeoffs and bad debt, a reason they lobbied so hard for the new bankruptcy law.
  "The only way to encourage consumers to work out their financial problems outside of court is if all the lenders involved in a case consent to a repayment plan," explains Prochaska. "But if one lender decides they want a larger share on a monthly basis, which is quite possible, then it is not going to happen."
  Slow Response
  Counselors can only provide guidance and hope for the best. Just ask Catherine Williams, vice president of financial literacy for Houston-based Money Management Consumer Credit Counseling Services. Since the new law went into effect, the number of consumers voluntarily entering credit-counseling programs through Money Management to set up repayment programs has been miniscule.
  "The education aspects of the new law have been a little slow to get going," she says. "Education is a trailing variable in bankruptcy and debt management because, once a consumer leaves us, we have no idea what type of bankruptcy they will file for or whether they will complete the filing process."
  Says Jack Ayer, a resident scholar at the American Bankruptcy Institute, Washington D.C.: "Right now, about one-third of bankruptcy filings are being made by people who do not have legal representation. These cases are getting bounced out of the courts, and there is no indication as of yet what is happening to them next."
  The best guess is that these people are simply biding their time, hoping to juggle their debt problems as long as possible before filing for bankruptcy.
  Williams suspects that if the new law makes consumers feel Chapter 7 bankruptcy is not an option, many will opt away from counseling and attempt to play a shell game with creditors.
  Most consumers emerging from bankruptcy have a credit card within six months, according to bankruptcy experts. Lenders, however, need to keep in mind that consumers are obligated to notify their trustee of plans to take on more debt, such as a car or home-equity loan, or more credit, and that the trustee can reject those requests.
  This potentially sets the stage for lenders to be stymied in efforts to market to sub-prime credit risks by the very law they lobbied so hard to get passed. "Sub-prime lenders are going to have to be more conscious about who they solicit," says Grommet.
  In the meantime, lenders and creditors can enjoy their respite from bankruptcy filings because unless they adjust how they do business with debtors and sub-prime credit risks, it will not last for long.
  NEWS FLASH
  A New York judge recently ordered sub-prime credit card issuer Cross Country Bank to pay $9 million for engaging in what New York Attorney General Eliot Spitzer called deceptive credit card solicitation and abusive collection practices. Spitzer first accused the Wilmington, Del.-based bank in 2003 of offering cards with credit lines up to $2,500, but granting only about $400 to most of the consumers who responded, and applying most of that to bank fees. The lawsuit also accused the bank's affiliate, Glen Mills, Pa.-based Applied Credit Services, of harassing delinquent borrowers with illegal collection techniques that included obscene language and improper threats. In June 2004, state Supreme Court Justice Joseph Cannizzaro ruled in favor of Spitzer, saying Cross Country conducted fraud, false advertising and deceptive business practices. In December 2005, an appellate court upheld the ruling, and in January state Supreme Court Justice Thomas McNamara ordered the company to pay almost $8 million in penalties and $900,000 in restitution to thousands of New York consumers. Cross Country is appealing the case to the New York Court of Appeals, says bank attorney Howard Cayne. He argues that federal law establishes credit card disclosure requirements and that the bank was in full compliance with those laws.
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