Bankruptcy Abuse Prevention and Consumer Protection Act

How It Helped Create the Great Recession

couple in bankrutpcy
The average bankruptcy filer is a middle-aged couple. Photo: Simon Potter/Getty Images

The Bankruptcy Abuse Prevention and Consumer Protection Act was a law designed to reduce bankruptcies. At the time, legislators thought bankruptcies were being used by consumers to simply avoid paying their debts. Most of the debt at the time was credit card debt.

They also wanted to protect companies and individuals from being forced into bankruptcy by creditors.That used to occur via a petition for involuntary bankruptcy.

There are three advantages of bankruptcy. First, those in debt could hold off the collection efforts of creditors. Second, they could have unsecured debts simply written off. Third, they could get their debt reorganized and interest payments reduced on secured loans.

Legislators were concerned because individual bankruptcies had risen from 1.3 million in 1999 to 1.6 million in 2003. Business bankruptcies, on the other hand, remained 38,000 per year. 

President Bush signed the Act into law on April 20, 2005.  It required that debtors prove there was no reasonable alternative to bankruptcy. They must also prove they were unable to pay, and they had made good-faith efforts to resolve the debt problem.

The most controversial reform was a "means test." It compared debtors' incomes to the median state income. If it was higher, debtors were not allowed to declare bankruptcy. They were assumed to have operated in "bad faith." That was only waived if they showed extreme special circumstances.

(Source: Roxane DeLaurell and Robert Rouse, "The Bankruptcy Reform Act of 2008: A New Landscape," The CPA Journal, November 2006.)

How the Bankruptcy Act Helped Cause the Great Recession

A report by the National Bureau of Economic Research (NBER) said that the Bankruptcy Prevention Act could have helped cause the subprime mortgage crisis and the subsequent Great Recession.

How? The law made it difficult to declare bankruptcy. Before that, homeowners could declare bankruptcy on their personal debt, freeing up funds to pay their mortgages and save their homes. With bankruptcy ruled out, homeowners relied on their home equity to pay bills.

First, homeowners were forced to take equity out of their homes to pay back their debts. Before the Act was passed, the home was protected from creditors, even under bankruptcy. Homeowners could declare bankruptcy on their personal debt, freeing up funds to pay their mortgages and save their homes. After the Act, people became more desperate to pay bills. Mortgage defaults rose 14%. In addition, 200,000 more families lost their homes, each year after the Act was passed. 

Second, people became enslaved by the cost of healthcare. The Bush Administration responded to the request of banks who said consumers were abusing bankruptcy to just avoid paying their bills. However, the number one cause of bankruptcies was healthcare costs. But if bankruptcy is prevented, then those with chronic illnesses must deplete all their assets to pay their medical bills.   (Source: Wenli Li, Michelle J. White, Ning Zhu, Did Bankruptcy Reform Cause Mortgage Default to Rise?

NBER, May 10, 2010)

Thaty is supported by earlier data. In the three months before the Act was passed, there were 667,431 bankruptcies (Q4 2005). This plummeted to 116,771 the first quarter of 2006. It was just 155,833 in the second quarter.

Three years later, bankruptcies doubled. In the second quarter 2009, 381,073 people were forced into bankruptcy. By then, homeowners could no longer rely on home equity to pay their bills. They lost their home, and still had to declare bankruptcy. Such a dramatic increase in such a short period of time shows how many families folded in the face of unsustainable debt.

Higher bankruptcies couldn't have come at a worse time for the economy. Vendors who no longer received payments eventually went bankrupt themselves. That created more unemployment. Although families who received bankruptcy protection were temporarily saved from crushing debt, it stayed on their credit report for ten years.

That prevented them from buying a house or obtaining credit. Both trends prolonged the housing crisis and recession.

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