Bankruptcy Reform and Credit Card Losses

In 2004, when more than 1.6 million households were filing for bankruptcy, the credit card default rate was 4.09%.  The credit card lenders claimed that bankruptcy cost every American family $400 in discharged debt.  In 2005, the default rate jumped when more consumers filed for bankruptcy in anticipation of the new bankruptcy amendments.  Now that burst of consumer bankruptcy filings is over, and the bankruptcy filing rate is less than half that of 2004.  But the credit card default rate is right back where it was in 2004.

CHARGE-OFFS 2006
                 Jan 06: 6.05%
                 Feb 06: 4.73%
                 Mar 06: 3.75%
                 Apr 06: 3.95%
                 May 06: 4.24%
                 Jun 06: 4.19%
                 Jul 06: 3.99%
                 Aug 06: 3.95%
                 Sep 06: 4.15%
                 Oct 06: 4.09%
                 Nov 06: 4.19%
        Source: CardData (www.carddata.com)

Fake Numbers

In this morning's New York Times, David Leonhardt declares that “the official numbers on house prices—the last refuge of soothing information about the real estate market on the coasts—are deeply misleading.”  The reality, says Leonhardt, is much worse that the official stats show.That's bad news for the consumer, particularly for the homeowner who has purchased any time since the big real estate run up that started in about 2000. 

But it also raises an interesting question for scholars who make data an integral part of their work:  how could the numbers be off?  Leonhardt focuses on two factors.  1) The sales data reflect only the prices for houses that sold, not for the many, many more houses that are sitting on the market unsold.  2) The data are not for all houses, but only for a subset of the market.

These are not small differences.  Officially, Boston prices are up about 1%.  Leonhardt says that local experts report that the number is down 20%.  The official Boston index, however, excludes all mortgages larger than $417,000.  The last point knocked me over.  If the drop (or rise) is not uniform across different price levels, then the data have been off all along.

The first problem (sales data reflect only prices for houses that sold) should straighten itself out over time because the big, unsold inventory will begin to push those prices down.  Of course, so long as the inventory is big, there is more downward price pressure coming up. 

But the second problem says there is a systematic kink in the data that is little known and whose impact is almost impossible to measure.  That revelation sends a shiver down my spine.  How many other take-it-for-granted numbers have this kind of twist?

Changing Perspectives

Since the early 1980s, most of the proposed changes for consumer credit have been aimed toward making the market work better by giving the consumer more information.  The credit industry has resisted mightily, including fighting to the death over such modest proposals as disclosing the length of time it would take to pay off a card.  Sure, there were some academics who argued that more disclosure was useless (no one can understand the current disclosures), but better disclosures seemed to be the only possible improvement in a world dominated by faith in the perfection of markets. 

Yesterday might be a good day to mark on the calendar.  A new voice rose to say that it is time to talk about new regulations on credit cards.  Senator Carl Levin, D-MI, spoke at a conference on debt at the Center for American Progress.  As he celebrated Ronald Mann's book, Charging Ahead!, the senator went on to say:  “Education . . . I’m afraid, isn’t going to be enough.” Stressing the need for new legislation and regulation, he continued, “Without that club, without that stick, we’re not going to see reforms coming.”

More Bloodsucking

Bob Lawless picked up on the West Virginia former Supreme Court Justice who had his fill of a rigged arbitration system.  The judge's article, "Arbitration and Goodless Bloodsuckers," didn't hold back. 

Now there's another voice in the chorus.  My colleague, Harvard law professor Elizabeth Bartholett, testified under oath in a deposition for a consumer who is suing to avoid on a lawsuit to getting sent to arbitration.  Betsy explains how once she ruled against a credit card company, all her pending cases against that company were sent to someone else, with notes to the consumers that she had a "scheduling conflict."  The rules of the game don't seem hard to figure out:  Keep only the arbitrators who rule only for the credit card companies. 

What is a Fact?

I was teaching Carnival Cruise Lines to my first-year contract students.  This is the Supreme Court opinion holding that a forum selection clause in the fine print on the back of a cruise line ticket binds a customer who bought the ticket near her home in Washington state and was injured on the cruise to travel to Flordia to sue.  As we discussed the opinion, a student explained that the clause is good for everyone (except the woman who was injured) because, quoting the Court, "passengers who purchase tickets containing a forum clause like that at issue in this case benefit in the form of reduced fares reflecting the savings that the cruise line enjoys."

Is this a question of fact or of law?  "Fact, of course," said the students.  So I asked how this fact could be proven.  What followed was a wonderful, multi-student discussion of maginal pricing, elasticity of demand, etc.  Even as I pressed on the presumptions underlying the deductive model--fully informed parties, competitive markets, low transactions costs, etc--the students hung on to their model.  They were smart and sophisticated in their arguments, but the bottom line was that they "proved" the fact of lower costs deductively by appling what they saw as immutable economic principles. 

When I pointed out that this lovely conversation was all about theory and not fact, they were resistant.  So I reversed and asked what the plaintiff might offer as proof to show that the justice was wrong.  Much silence followed.

I finally filled in the blanks, suggesting some empirical tests--ticket prices for companies that do/don't use such clauses, changes in pricing before/after such clauses are used, evaulation of whether cost is large enough to be reflected in price, etc.  They got the idea and had some good suggestions

What struck me, and the reason I bring it to this group, is how these very bright students seemed to believe that deductive logic produced a "fact" that they could not or would not challenge.  Perhaps my class was abberational, but it made me wonder about how we are educating our students, both before and during law school.  Is it all about deduction, with nothing left over for reality?   

I speculate that my contracts class includes several future law teachers and future policy makers, many future community leaders and a lot of future voters.  If the deductive logic of economics is all-controling, then empirical work--indeed, empirical questions--will always remain at the intellectual and political margins. 

The class reminded me that empirical scholarship is important, but empirical teaching may be more important.  These students are our future. 

Murder Mystery

I’ve been reading “The Strange Death of Academic Commercial Law,” by Larry Garvin.  The piece is a cheerfully ghoulish description of how few people are teaching and writing in commercial law and how the field is aging.  He reports some telling statistics to back up his claims. 

My quibble with Larry is just a quibble: Hey, bankruptcy is part of commercial law (Larry counted only the UCC courses).  Including bankruptcy would improve the teaching and scholarship stats considerably.  Similarly, there is some new action in consumer law and e-commerce that might also be omitted from Larry’s calculations. 

No Big Chapter 11s

Remember 1984?  Terrible clothes, big hair, westernwear on dimestore cowboys?  That was also the last time Chapter 11 filings were lower than they are right now.  I'd heard some grumbling, but Lynn LoPucki sent me the data from his remarkable Bankruptcy Research Database (BRD).  Amazing.  (The numbers are in the continuation.)

With record sales of junk bonds, these companies are not deleveraged and somehow better able to withstand economic shocks.  So what's going on?  I have three theories, but I could be overlooking something.

1)  Bankruptcy law is well-settled, so businesses now do private, non-bankruptcy bankruptcies in which everyone gets slightly better than their likely Ch 11 payouts. 
2)  A few hedge funds are controlling all the action, calling the reorganization shots privately and making credible threats that there will be no DIP financing, which makes bankruptcy look very unattractive to a debtor who is in the clutches of the funds.   
3)  Companies are refinancing and refinancing, until they eat up all their assets--a strategy that keeps them out of bankruptcy for now, but that will promote more crashes in the future. 

Other ideas?

Consumer Law Scholarship

I noticed that a consumer education journal has put out a call for papers, both policy pieces and empirical research that might inform those who do consumer education.  Because many of the folks who read this list care a great deal about consumer law but are not located in the same academic space as the people who do consumer education issues, I thought I'd pass along this opportunity.

Anyone who is interested should get in touch with Dr. Angela Lyons at [email protected]. 

I can't quit without noting the different scholarly traditions.  The manuscripts should be no longer than twelve pages, double-spaced, including text, references, tables, and figures.  After so many years of writing for law reviews, I can barely clear my throat in twelve pages--and that takes about forty footnotes.

How daring to think about writing short pieces that get right to the point. 

The Cap Survived

The Talent-Nelson bill to limit interest rates on lending to soldiers to 36% just passed the House-Senate Conference.  Katie Porter wrote about this earlier.  When the House and Senate come back to vote on the Defense Authorization bill, the cap will be in there—and there can be no more amendments.   The only choices are to vote yes or no.

Mark this day on your calendar:  Usury rates are back.  The circumstances are limited, and politics may be driving the outcome.  But Congress finally said, at least in this limited circumstance, “Enough is enough.”  Credit issuers everywhere—from payday lenders to credit card companies to home mortgage issuers—felt a slight disturbance in the force.

Soon it will be OK to roll an elderly person with a 400% interest rate, or a Hispanic worker, or a college student, but not someone in the military.  How long will that last?

Distress or Strategy

One of the most contentious debates of the past two decades has been the argument over the reasons for increases in bankruptcy filings.  Some believe  consumer debtors file for bankrutpcy largely because they have run out of other options following significant financial disruptions, such as job loss, medical problems and family break up.  Teresa Sullivan, Jay Westbrook argued this position in Fragile Middle Class based on 1991 studies of the families that filed, and Tyagi and I add more data using 2001 Consumer Bankruptcy Project in Two-Income Trap.  Fay, Hurst & White analyzed PSID data on the general population and concluded that debtors were more strategic, filing when it was economically rational to do so and not when triggered by other events.  (Fay, Hurst, White, The Household Bankruptcy Decision, 92 American Economic Review 706 (2002))

Now comes Jonathan Fisher at the Bureau of Labor Statistics with a new paper that analyzes the same PSID data White and her coauthors used.  He has several interesting findings, but two are highly relevant to the financial-distress versus clever-strategy debate.  The first is that people do not file when they could best maximize their benefits.  If debtors behaved like the rational maximizers beloved by all economists, then they would have filed for bankruptcy at least a year earlier, according to Fisher.  Instead, they held off, kept paying and filed only later.   What held them back--stigma?  Fisher suggests that they filed only when it was clear that they were in a deep enough hole that things were never going to get better. 

Fisher also noted that the clever-strategy folks have a problem with the fact that about 17% of the population would benefit from bankruptcy, but only about 1.5% actually file.  But Fisher made an interesting observation about the benefit-but-not-file group:  they were in a lot better financial shape than the benefit-and-file group.  While Fisher doesn't push any conclusions about this, the finding is consistent with a picture of debtors who do not want to file for bankruptcy, no matter how attractive bankruptcy might seem to an economist.  Instead, these people file only when the pressure from their creditors are greater and the likelihood they can ever pay these debts off is smaller.

The PSID data pose substantial challenges for both White and Fisher.  For example, there is gross under-reporting of bankruptcy filings (.42% in PSID when national rate was .89%). This means either the sample isn't representative of Americans generally or people are concealing their bankruptcy filings even as they fill out PSID questionnaires.  ("Bankruptcy?  Me?  No way!") 

The paper has many nuggests, but the headline finding goes right to the question about who uses the bankruptcy system.   

Bad News and Bankruptcy

One of the most contentious debates of the past two decades has been the argument over whether  consumer debtors file for bankrutpcy largely because they have run out of other options following significant financial disruptions, such as job loss, medical problems and family break up.  Teresa Sullivan, Jay Westbrook argued this position in Fragile Middle Class based on 1991 studies of the families that filed, and Tyagi and I add more data on the the point using 2001 data in Two-Income Trap.  Fay, Hurst & White analyzed PSID data and concluded that debtors were more strategic, filing when it was economically rational to do so and not when triggered by other events.  (Fay, Hurst, White, The Household Bankruptcy Decision, 92 American Economic Review 706 (2002))

Now comes Jonathan Fisher at the Bureau of Labor Statistics with a new paper that analyzes the same PSID data the earlier economist team used.  Fisher has several interesting findings, but two are highly relevant to the negative-event/strategic debates.  The first is that people do not file when they could best maximize their benefits.  If debtors behaved like the rational maximizers beloved by all economists, then they would have filed for bankruptcy at least a year earlier.  Instead, they held off, kept paying and filed only later.   Fisher concludes that something else held these people back (could it be stigma?).  He suggests that they filed only when it was clear that they were in a deep enough hole that things were never going to get better. 

Fisher also noted that White has a problem with the fact that about 17% of the population would benefit from bankruptcy, but only about 1.5% actually file.  But Fisher made an interesting observation about the benefit-but-not-file group:  they were in a lot better financial shape than the benefit-and-file group.  While Fisher doesn't push any conclusions about this, the finding is consistent with a picture of debtors who do not want to file for bankruptcy, no matter how attractive bankruptcy might seem to an economist.  Instead, these people file only when the pressure from their creditors are greater and the likelihood they can ever pay these debts off is smaller.

The PSID data pose substantial challenges.  For example, there is gross under-reporting of bankruptcy filings (.42% in PSID when national rate was .89%). This means either the sample isn't representative of Americans generally or people are concealing their bankruptcy filings even as they fill out PSID questionnaires.  ("Bankruptcy?  Me?  No way!") 

The paper has many nuggests, but the headline finding goes right to the question about who uses the bankruptcy system.   

The Next Medical Bankruptcy Candidate

I noted a small blip in a story by Rick Lyman at the New York Times about the newly released census data.  It seems that another 1.3 million people lost health insurance between 2004 and 2005.  That brings the 2005 total to 46.6 million Americans without health insurance.

I figure that pretty much all the poorest Americans already had no health insurance.  The latest 1.6 million most likely represent a continuing expansion of the uninsured middle class.

With "medical bankruptcy" having entered the lexicon in the past year, this new stat makes me pause to think about risk.  I just did an interview about this with Karen Springen at Newsweek.  On the research side, papers with Melissa Jacoby and Debb Thorne (both on this blog) and David Himmelstein and Steffie Woolhandler (both Harvard Medical School) show that health insurance is no guarantee that someone won't end up in financial collapse following a serious medical problem.  But insurance makes a difference on where the tipping point occurs.  For the uninsured, the $11,000 hospital bill following a slightly dodgy appendectomy spells financial doom.  For the insured, it may take a more serious round of surgery and rehab after a bad fall to hit that same $11,000 in uninured costs out of a total bill of $50,000.  Of course, either group can be beaten up financially by time lost from work.  This is all just a question of vulnerability by degrees.

With the changes in the bankruptcy law making many people feel that the option has become too expensive or too difficult to accomplish, what will happen to the 1.6 million newly uninsured?   Many won't get sick, and others who get sick won't seek medical care.  But for some, modest medical problem will put them in a financial hole from which they can never recover.  If they don't go to the bankruptcy courts, what will happen to them? 

Disclose, Disclose, Hide

All my professional life, I have heard that there are three rules of bankruptcy:  "disclose, disclose, disclose."  Worried about a conflict?  Disclose it. Want to make a payment? Disclose it.  Starting a new business initiative? Disclose it.  In fact, I thought disclosure was the quo for the quid of the automatic stay and other bankruptcy-induced protection.  Evidently I was misinformed.

Gretchen Morgensen reported in the New York Times yesterday that Delaware bankruptcy judge Kevin Carey ruled that the Werner Company, a ladder maker, wouldn't have to disclose the bonsues it was handing out to the executives as part of the reorganization plan.  The reason?  Such disclosure ""may create low morale and an unhealthy work environment." Just to drive home the point, the hearing itself was closed to the public.

What can this mean except that the employees are asked to take a hit while the executives are taking home sacks of money?  And if keeping it a secret is supposed to help morale, then is it fair to assume that the amount of money the executives are keeping is more even than the rank-and-file employees could possibly imagine?

So the new rule is "discose, disclose, and keep it a secret if the big boys want it that way"?  I just want to be sure that I have it right before I try to teach it to a new generation of students.

Phony Numbers

In today's New York Times, Vikas Bajaj and David Leonhardt offered a creative explanation for how home sales could be slowing and inventories building while home prices continued to nudge upwards:  incentives.  They report that in a weakening market sellers are giving rebates on prices, either in goods, services or outright cash.  In other words, the records may show that the house sold for $350,000, but the effective price was $343,000. 

The reasons for this ruse are partly psychological (individual sellers who think: "I don't want to lower the price!") and partly economic (builders who think:  "I don't want the people who already signed contracts for homes in this subdivision to know that the new guys can get in for lower prices.") 

Back in the day (say, 1972) when the median first-time home buyer coughed up an 18% downpayment, a few bucks of incentives probably wouldn't have mattered.  But with the median first time homebuyer today making a ZERO down payment, a little rebate means the mortgage starts out in the red.  Bajaj and Leonhardt note at the end of the article that the mortgage companies try to police the rebates, but c'mon, does anyone think that really happens?  Besides, by keeping the prices high, the comparables stay high as well, giving everyone an inflated appraisal on which to base that 100% financing. 

Here's one more little piece of evidence why everyone on this list should be selling their mortgage-backed securities (if anyone on this list ever had any mortgage-backed securities):  The valuation numbers are phony.  Maybe just a little phony in this case, but at 100% financing, a even a little bit phony is going to come out of the investor's hide. 

As housing values continue to deflate, those of us who teach mortgage foreclosure law will have many attentive students. 

Iraq Payday

President Bush announced this morning that he is recalling 2,500 Marines to active duty, and more recalls may be on the way in the next few months.  "Recall" in this context means that men and women who have completed the agreed term of their active service and who are now civilians with jobs, families, mortgages, credit card bills, car loans and, as Zorba said, the "whole catastrophe" will pick up stakes and head back to Iraq. 

So what do their families do?  What if they made financial commitments based on new jobs that pay better?  What if their families need to move to wait out the deployment?  What if they can't make it on a marine's pay? 

Katie Porter just posted about the recently released report from the Department of Defense that tells what the market solution has been:  some of these families will turn to the payday lenders that surround the military bases.  And some of these families will seal their financial doom when they do so.  The DoD has weighed in, asking Congress to rein in the payday lenders, explaining that the practices of payday lenders hurt our troops. 

I note the deployment here to make a point:  it's all connected.  There are no credit issues in a vacuum.  Lenders ring military bases because military families are vulnerable.  As we push our troops harder to fight a war in Iraq, their families become more vulnerable.  And as their vulnerability increases, the payday lenders and other predators close in tighter.

I cannot think of an issue that affects American families that does not also connect to a credit issue.  And I cannot think of a credit issue that does not affect an American family.  Iraq and payday lending are just one more reminder.

One Voice or Two?

Newsweek ran a story this week about the scandals rocketing through the medical research field: a huge dispute over how much corporate sponsorship of research influences outcomes. The debate centers on the conflicts of interest that result from who paid for the research and whether that influences outcomes.  But there is an interesting side note that some scientists say is potentially more important: With sponsored research, the sponsor can simply fail to report the bad results. When the drug works—publish! When the drug doesn’t seem to have much effect—don’t publish! In effect, only the good outcomes (from the sponsor’s point of view) ever see daylight.

This relates directly to Katie Porter’s post about the need for empirical research that produces original data in a field such as credit research. There are tons of data collected about customers, defaults, debt-income ratios, the role of job loss, etc. But those data are proprietary, which means the owners (the creditors) don’t have to tell anything. If they have something to say that advances their interests, e.g., during the debates over the bankruptcy law, then they can produce those data. But everything else is secret.

Original data are very expensive to develop. Without them, however, Katie has it right: our understanding of credit will be completely one-sided. We will hear only one voice—and that will be the voice of those who make money from promoting a particular point of view.

Doctors and patients are starting to worry about the effects of bias in medical research. I hope the number of people who worry about biases in what we know about credit will expand as well.

Fed Says We're All Doing Great with Credit Cards

The Federal Reserve has issued a new report on whether credit card practices might have something to do with people getting into financial trouble (short version: no problems, market is working fine). 

Ronald Mann has written terrific response.  Check it out.   

Deregulation Drags Down Economy

The NYT ran a story that connects two dots—the housing bust and a slowing economy. Because housing has been a big employer, as new home construction comes a standstill, the effects will reverberate through the economy. Thus comes the answer to a question I’ve heard many times:  So long as I’m not strung out on some crazy mortgage, why should I care if the housing market implodes? Because it affects the whole economy.

Now let’s add a third dot to the picture—the impact of an effectively unregulated home mortgage market. Over the past five years, lenders have sold billions of dollars of mortgages that are designed to go into eventual default because the borrowers cannot possibly afford to pay them. These so-called “creative mortgage products” have two powerful effects: They fueled the boom, pouring more money into an overheated housing market. Now they will accelerate the bust, pushing more people out of their homes through distressed sales, thereby accelerating price collapses on the way down. In other words, a housing bust doesn’t just happen. Regulators who won’t regulate have an effect as well.

Note the irony: Much of the middle class takes the hit either way. When the housing market exploded, houses became unaffordable in many cities. Last week we talked about firefighters and teachers who cannot afford to live in many cities. (“Great news—get a second job,” said a federal reserve economist.) Families took on terrible risks to try to get a home before they were completely closed out. 

Now Vikas Babjas and David Leonhardt describe who will be hurt most by the housing implosion: people who work in the real estate industry. “On average, real-estate jobs pay somewhat less — about 7 percent less a year on average — than those in other parts of the economy. But real estate has also been one of the only industries creating good jobs for workers without college degrees in recent years, especially in construction and contracting work.” A big chunk of the middle class crumbles away.

Housing prices rise and fall for many reasons. The effects of interest rates are widely appreciated, but mortgage rules—or lack of rules—play an important part too. A boom and bust in housing may be hard to avert, but better regulation of home mortgage would have moderated the rise in housing prices as well as the subsequent contraction in the economy when housing cools off.

Regulation has become a dirty word, but many middle class people will pay a steep price for poor oversight of mortgage lending.

The 2/28 Game

The New York Times ran a front page story yesterday about re-refinancing. Families now facing the end of the teaser rates on their adjustable-rate mortgages can’t make the payments when the rates re-adjust, so they are taking out another adjustable rate mortgage—with another teaser rate. They stay alive for another two years. And what happens when that one comes due? Evidently they are following the Scarlet O’Hara plan to worry about that tomorrow.

The obvious problem is that if housing prices level out, these families will have no options at all. No more teaser rates because the value of the home won't back up the mortgage.  They will have rented homes for two years or four years that they could not afford, and they will lose everything they invested and more. If the amount owed on the home is more than the outstanding loan balance when the music stops, the homeowner will face bad credit ratings and bankruptcy.

The Times article does not emphasize how expensive this re-refinancing is. Closing costs and fees all get lumped back in to increase the outstanding balance. Keep in mind that these buyers couldn’t make market-based payments on the old, lower balance. The odds of making those payments on the new, higher balance are worse than those in any Las Vegas gambling parlor.

In the industry, these mortgages are called 2/28s. The numbers refer to the teaser period (the 2) and the real payout period with the higher-than-market interest rates (the 28). How can the “2” be profitable for the lender, if the debtor re-fi’s the loan without paying the high 28 period? Many of these loans carry a pre-payment penalty, along with up-front fees and closing costs that make them instantly profitable. Even if the debtor refi’s immediately, the amount paid off includes all these costs, making the effective interest rate for the “2” ten or twenty times higher than the stated interest rate.  In the 2/28 game, the lender nearly always wins.

Could re-refinancing be the knife that will cleave what is left of the middle class?  There will be those who have fixed-rate mortgages, who pay off their homes, and who have something for retirement or savings if a catastrophe hits.  And then there will be those who live in houses, paying high rent, always vulnerable to rate hikes, flat real estate markets, job layoffs, etc.  That last group will nominally be called "homeowners" just like the first, but they won't really be.  They will play the 2/28 game until they go bust.