The New Bankruptcy Law is 2 years Old: Have a Very Merry Sub-Prime Christmas

Leon D. Bayer

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Recent implosions in the sub-prime mortgage market have many borrowers thinking about bankruptcy. The bankruptcy law those borrowers and other financially distressed consumers are struggling to understand is a new law that took effect just 2 years ago.

There are three life altering events that seem to put people at a higher risk of filing for bankruptcy than anything else. These factors are unemployment, serious illness, and divorce. Suffer just one of these events and add to it a house payment that keeps adjusting ever upward, and it’s no surprise why people file bankruptcy.

Was there ever a time when you were late on a bill because you just didn’t have enough money to pay it on time? Most people have been there at some point in their lives and most of you survived it. One way or another, most of us manage to weather the storm with a bail out from family, a new job, or a big tax refund. But what happens when a personal money problem has grown into something so big that it has no solution? When things get that bad, you just might start thinking about bankruptcy.

Most of people who can’t pay their debts are not flakes. Most can trace their problem to a divorce, the loss of a job or a serious illness that caused them to stop working. These people didn’t choose that fate, and almost all of them incurred their debts during a time when they had the money to repay what they had borrowed. As we all find out, things in life can change. Very few of us are blessed with a perfect lifetime job, perfect good health, and a perfect happy marriage. The loss of just one of these pillars frequently brings devastating financial hardship, and leads many people down a path that eventually results in filing bankruptcy.

Filing bankruptcy usually brings people automatic relief. The pressure from bill collectors comes to an immediate stop, and in most cases, (called Chapter 7) the court will actually order the elimination of most debts. In

2005 approximately 2 million people filed for bankruptcy protection. Read on, and see why most of them chose that route.

In the early stage of a debt crisis, people are usually in denial that they have any problem, (probably a common human trait when any kind of personal problem looms). They may buy themselves some time by borrowing from "Peter to pay Paul," often transferring debt balances from one credit card to pay off another, because that keeps them "current" without actually making a payment that month. The problem with that strategy is that the debt never gets paid off; it just gets shifted to a different lender, often causing the debt balances to inch ever higher. In the later stage of a debt crisis, when a person’s available credit has run out, the game becomes a miserable struggle of juggling overdue payments and dodging the phone calls from creditors.

Observing this end game is like watching the death struggle of a bunny being crushed by a python. Bill collectors can sense when a debtor is sinking fast, and they sense they are competing against each other to coerce whatever limited money a debtor has left before another creditor has grabbed it. The strong arm tactics exerted by many bill collectors often become downright vicious at this stage of the collection process.

Despite laws banning hard ball collection tactics, the final collection assault is often a forceful combination punch that threatens the debtor with immediate fearsome legal actions, (garnishment of wages, seizure of bank account, car and other assets) combined with heaps of degrading personal abuse. There are very few people that can stand up to such pressure without an emotional meltdown, especially when the collector has you thoroughly frightened, you know you owe the money, you want to pay it back, and you just haven’t got it. This stage of the collection process leaves many a borrower holding their phone and weeping in tears of shame and frustration. This is the point when many debtors have simply had enough; they want the protection of personal bankruptcy.

Bankruptcy laws in the U.S. have evolved over time to provide a safe harbor where the "honest but unfortunate" debtor may be allowed to discharge most kinds of debts. The actual process entails a fairly complex legal inquiry that is conducted in a United States Bankruptcy Court. To describe this in very simple terms, the process takes place by demonstrating that one’s debts were incurred under honest good faith circumstances and that one is truly unable to pay back any of the money.

Debts that are owed for family support, taxes, and educational loans are generally not discharged and will usually remain owing. There is also a bankruptcy procedure, (called Chapter 13) that may allow someone to restructure most debts on new, better terms and usually with no more interest.

A complex new bankruptcy law took effect on October 17, 2005. The new law contains a "means test" to mathematically determine who is entitled to be forgiven of their debts, and who isn’t. The new law starts by dividing everyone into two classes: those who earn above the median level of income in the state where they live, and those who earn below it.

For those with an income below their statewide median and who have comparatively simple debt problems, a bankruptcy case generally works out to produce a result that is pretty much the same as what it used to be, (albeit with a lot more legal work and expense than there ever used to be.)

For those with an income above their statewide median, relief might still be granted but the bankruptcy calculus moves to a complex computation in which a combination of certain actual living expenses and certain hypothetical living expenses are subtracted from the debtor’s average income that was actually received during the previous six months. If the debtor shows a surplus of income under this formula, then the debtor may be required to give creditors all of their projected disposable income for the next 5 years.

On the surface, this process may look fair enough. Those who can pay something shouldn’t get a free ride. But in reality, the "means test" has some serious drawbacks as a gatekeeper for debt relief. For one thing, the eligibility process is anchored on a mathematical model of hypothetical living expenses. The use of hypothetical’s and a mathematical model to decide the outcome of justice does not uphold the principal of judging each case on an individual basis. Moreover, the hypothetical living expenses that the law imposes for conducting this "test" to determine someone’s ability to pay is mandated to be the exact same standards that the IRS currently uses as a collection tool against delinquent tax payers.

In addition to using certain artificial living expenses, the "means test" also artificially determines a person’s income. The test measures income that the debtor received over the previous six months. Someone who has just lost their job doesn’t have as much income now as they used to have six months earlier. A person who has suddenly lost a job or become disabled may be kept from filing what would have been a good faith bankruptcy case because the "means test" is imposed on their old income, not the income that they have now. Moreover, the variance in "means test" median income from one state to another can be huge.

The median income cutoff to avoid the "means test" for a single person living in Louisiana is currently $33,391. The median income cutoff to avoid the "means test" for a single person living in Connecticut is $53,876.

To make matters more complicated, within any particular state these anomalies grow even more pronounced. People having the same identical income and living in the very same state can have a completely different outcome in their bankruptcy cases. For instance, property owners get to reduce their disposable income by deducting the full amount of their actual monthly mortgage expenses; renters fare worse, because they only get a limited standard rent deduction instead of using what they actually pay.

In reality someone who is dead broke right now might still show "disposable income" under the means test. That is because the means test was formulated by the IRS as a collection tool to rationalize the gathering of income from delinquent tax payers, whereas modern American bankruptcy law was created for the opposite reason, which is to give people who have been "honest but unfortunate" a fresh start by eliminating insurmountable debt.

The current bankruptcy law was enacted at the behest of Big Money, namely the collection departments of the credit card banks and the major auto lenders who all wanted a bankruptcy law that would be too difficult for the average borrower to navigate. The idea was simple. Make the law too hard to understand, and people won’t be able to use it. Similar legislation was vetoed twice by President Clinton. In 2005, the Congress and the administration enacted this new law, effectively giving putting the fox in charge of the hen house.

Expert bankruptcy attorneys have been learning how to guide their clients through the tangle of new rules, regulations and complex forms that are now required for every case. The downside is that the process has become vastly more expensive and more time consuming on the people involved and on the court system than what it ever used to be. Those who brave the system without expert help are courting disaster. The best advice for people with a serious debt problem remains the most obvious; get the best legal representation that you can find. Filing bankruptcy is not something to be done on the kitchen table with a self-help booklet.

Economists know that accessible bankruptcy laws actually help an economy. This happens by creating an escape valve that allows troubled people to stay in the economic mainstream as self-supporting, tax paying consumers, (instead of dropping out under the pressure of never ending debt). It also fosters entrepreneurship, (risk taking) which creates job formation in new enterprises and grows the economy. If the cost of failure is too great, (permanent, inescapable debt), the economy stagnates from lack of new enterprise and small business expansion.

The current bankruptcy law is now two years old and it was bill collector’s dream come true. As the economy sinks, have yourself a very merry sub prime Christmas!