Bankruptcy Abuse Prevention and Consumer Protection Act

How A 2005 Law to Prevent Bankruptcies Led to the 2008 Recession

couple in bankrutpcy
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The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 amended the U.S. Bankruptcy Code. It made it difficult to file for liquidation under Chapter 7 bankruptcy. As a result, more people filed for Chapter 13 bankruptcy which rescheduled payments.

The most controversial reform was a "means test." It compared debtors' incomes to the median state income. If it was higher, and debtors could make debt payments of at least $100 a month, they didn't qualify for Chapter 7 bankruptcy. They were assumed to have operated in "bad faith." That was only waived if they showed extreme special circumstances. 

The new law required that debtors prove there was no reasonable alternative to bankruptcy. All applicants were required to go through credit counseling before filing for bankruptcy. It must be through a federally approved program. The counseling created a repayment schedule. Debtors didn't have to follow it, but they had to show it to the bankruptcy court. During the bankruptcy proceeding, they had to return to counseling to learn good financial management practices.

The law made bankruptcy attorneys personally attest that all information was accurate. As a result, lawyers' fees went up.

Applicants had to be current on their U.S. taxes starting at least four years prior to filing for bankruptcy. If they stopped paying taxes, they could have their Chapter 7 status revoked.

Landlords could evict applicants even while they were undergoing the bankruptcy proceeding. The process used to protect applicants from eviction.

Proceedings also no longer protect applicants from driver's license suspensions, legal actions for child support, or divorce proceedings.

The law prioritized child support and alimony payments over other creditors.

President Bush signed the act into law on April 20, 2005. It applied to bankruptcy cases filed on or after October 17, 2005.

Why Congress Passed the Law

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.

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, were about 38,600 in 1999 and 35,000 in 2003.  

How the Act Led to the 2008 Recession

A report by the National Bureau of Economic Research said that the Consumer Protection Act could have helped cause the subprime mortgage crisis and the subsequent Great Recession. How? The law made it difficult to declare 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.

Before the 2005 law, homeowners could declare bankruptcy on their personal debt. It freed up funds to pay their mortgages and save their homes. With bankruptcy ruled out, homeowners were forced to use 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 health care. The Bush administration responded to the request of banks who said consumers were abusing bankruptcy to just avoid paying their bills. But medical costs were a commonly cited contributor to bankruptcies. When the Act prevented bankruptcy, those with chronic illnesses were forced to deplete all their assets to pay their medical bills. 

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

Despite the law, the 2008 Financial Crisis sent bankruptcies skyrocketing. 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 10 years. That prevented them from buying a house or obtaining credit. Both trends prolonged the housing crisis and recession.