Monday, January 5, 2009


In one of my previous posts I suggested that the problems we confront are not simply tied to what's happening in the housing market, and the unscrupulous financial practices that led to the real estate market boom and bust. For this reason I argue that simply throwing a trillion dollars at the banks will not be enough to get our economy moving again. In addition to undoing bad legislation, one of the biggest challenges Barack Obama confronts is how to get American consumers spending, thus creating demand and job growth. The problem is that American consumers are swamped by debt and burdened by stagnant wages. I describe what's happening in Chapter 2 of my book, The Myth of the Free Market: The Role of the State in a Capitalist Economy (Kumarian Press, March 2009), which I reproduce here.

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When personal bankruptcies in the United States hit 1.5 million in 2002 and then went to 1.6 million in 2003, one of the goals of the US Congress was to find a way to reduce the number of bankruptcy filings. This led to bankruptcy reform legislation in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).

After climbing to 2 million bankruptcies in 2005, filings dropped to 600,000 in 2006. The problem was solved, right? Think again. Bankruptcy filings rose to 822,590 in 2007 and were on pace to reach 1 million at the end of 2008. What explains the surge in bankruptcy filings? Several developments are at work here.

First, Congress catered to the interests of the financial industry but failed to address the principle causes of bankruptcy. Second, the industry raised fees and reduced grace periods after the BAPCPA was passed. Finally, the credit card companies lent people even more money after 2005 because it became more profitable to do so.

According to noted bankruptcy attorney Leon D. Bayer, in addition to making it more difficult to file for personal bankruptcy, the 2005 legislation didn’t wipe out the reasons people file for bankruptcy. More than 90 percent of all personal bankruptcies are filed for three reasons: job loss, divorce, or catastrophic illness. There’s little that Congress can do about these life events.

Because no provisions were made in the BAPCPA to work with people who are hit by these real-life incidents, debtors soon found that the notion of “broke and in debt” was no longer good enough. The newly divorced, the medically recovering, and the unemployed would have to wait until they hit distressed debtor status to qualify for bankruptcy. Debtors, after all, had to be taught a lesson. This helps explain why military personnel in the National Guard were not given special consideration either. A deadbeat is a deadbeat according to the industry—there are no exceptions. And Congress agreed.

So, rather than addressing the underlying causes that lead to bankruptcy in America, the 2005 legislation simply deferred and, more realistically, compounded the situation for those confronting uninvited financial problems.

Now, you’re probably scratching your head and asking why legislators didn’t anticipate this. It’s a good question. To start, we must acknowledge that the biggest supporters of the 2005 legislation were the credit card companies. They aren’t run by dummies. Some may get greedy, which compels them to make dumb decisions as a group over time, but the companies are not run by inherently dumb people. The executives in the credit card industry saw that bankruptcy filings were going through the roof in 2005. They also understood that there was an economic bubble waiting to burst. So they moved to protect themselves and their “fee and penalty” gold mine (fee income accounted for 31 percent of industry profits in 2001, whereas total income from late fees jumped from $1.7 billion in 1996 to $7.3 billion in 2003 ).

To be sure, the industry knew that the vast majority of Americans filing for bankruptcy were placed in their situation by uninvited life circumstances—job loss, divorce, or illness. But the details of their lives were viewed by disengaged industry lobbyists as being as “unfortunate” as they were unimportant. Like the Vegas strip, the goal of “The House” (the credit industry) is to get people in the door, at the table, and to keep them there. If they’re not at the table, you can’t get debtors, no matter what their circumstances, in the fee and penalty cycle. So the industry went to “their muscle” (i.e., Congress) to make it more difficult for debtors both to qualify for bankruptcy and to discharge their credit card debt. And they got their wish.

Then, in spite of promising that consumers would benefit from the legislation (because fewer losses would accrue to the creditors), the industry immediately reduced grace periods, increased interest rates, and hiked late and over-limit fees (among others). Because the industry already had “universal default” authority, which allows the industry to hike rates on a clients account if the client is late making a payment on a competitor’s account, the industry prepared itself for even greater profits. Profits for the industry jumped from about $30 billion per year in 2005 to almost $40 billion in 2007. But the reasons for record profits after 2005 can’t be traced simply to increased fees, higher rates, and shorter grace periods.

By helping the credit card industry reduce bankruptcy filings after 2005, Congress ensured that the companies would have fewer losses and more earnings (although I’m not sure whether favorable legislation that generates more income for an industry counts as genuine “earnings”). With more money at hand, the industry, incredibly enough, lent more. You would think that they would have learned a lesson from being just one year removed from record bankruptcies—and the fact that Americans had a savings rate that was effectively zero. Think again. In 2007, according to Laurent Belsie at the National Bureau of Economic Research, the credit card companies did the following:

[They] started lending more, even to consumers with bad credit. Credit card debt increased more quickly during the past two years [2006–2007] than at any time during the previous five years.
Comfortable in the knowledge that it was more difficult for borrowers to enter into bankruptcy proceedings, the credit industry determined that it was in their financial interest to lend more. Teaser rates, cashable checks, and other industry gimmicks filled our mailboxes. And why not? By raising the bar necessary to file for bankruptcy, the industry knew that fees, penalties, and other charges would add significantly to their client’s debt load. According to Robert D. Manning, author of The Credit Card Nation, all of this is a good thing for the industry because

In the old days, the best customer was someone who could pay off their loan. Today the best client of the banking industry is someone who will never pay off their loan.
Keeping distressed debtors in the game longer can make for fatter profits. But there is something else at work here. The industry is increasingly bundling credit card debt into debt contracts. And why not? The credit card companies have hundreds of billions of dollars that are owed to them by consumers. Rather than maintain a debt of, say, $6,000—which most middle-class Americans can’t pay off in the immediate term—it’s much easier to bundle and sell the debts that are owed to investors who are looking for income streams, with interest.

Because the debt is secured by the payments of the credit card holder, the debtor becomes the “collateral” paying the debt—hence, a collateralized debt obligation (CDO). And, with the 2005 BAPCPA to maintain debtor compliance, credit card debtors become government-enforced collateral.

The practice of selling credit card CDOs has become so profitable that, by the end of 2007, “one-third of Capital One’s $151 billion in managed loans had been sold as securities.” This figure is sure to grow. After home equity loans came to a crashing halt in 2007 and 2008, consumers have been forced to rely on their credit cards more and more, often just to pay their mortgages. This helps explain why the credit card industry opposed the 2008 Credit Card Holder’s Bill of Rights (HR 5244), which, among other things, imposed industry restrictions on questionable fees, sudden rate hikes, and payment time frames.

These developments explain why the 2005 BAPCPA has become such a moneymaker for the credit card industry. The harder it is for someone to pay off his or her credit card debt, the longer it will be before the debt is paid. And debt that can’t be repaid, or repudiated, becomes a continuous source of industry income.

Julie L. Williams, chief counsel of the Comptroller of the Currency, explains what’s happened: “Today the focus for lenders is not so much on consumer loans being repaid, but on the loan as a perpetual earning asset.” Put another way, the bankruptcy bill of 2005 turned personal misfortune and consumer debt into yet another income stream for financiers and Wall Street.

Without addressing conditions in the economy, the three primary causes behind bankruptcy, or what the industry has done to entice clients, the BAPCPA does much to violate the integrity of market capitalism while undermining the spirit of Adam Smith’s order of nature and reason.

- Mark

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