Partners (Number 2, 2007)

Is Bankruptcy Reform Legislation Working?

bankruptcy reform graphic In 2005 when legislators launched bankruptcy reform measures, annual personal bankruptcy filings were averaging well over 1 million per year.

The number doubled to just over 2 million in 2005 due to the surge of filings in anticipation of the October enactment date. (See Partners Vol. 15, No. 2.)

Not surprisingly, the barrage of filings in 2005 was followed by a dramatic decrease in 2006. Consumer bankruptcies dropped by 71 percent, to a total of 598,000 filings for the year.

Does this mean the legislation has succeeded in putting a damper on bankruptcy filings? Not necessarily. Most analysts believe that passage of the legislation prompted many consumers who were working through credit problems to opt instead for filing—before tougher measures were put in place. According to the American Bankruptcy Institute (ABI), 500,000 consumers raced to file claims the week before the bankruptcy law took effect.1 This rush to file in 2005 very likely contributed to the subsequent steep drop in 2006 filings.

The question remains whether the new legislation will keep bankruptcy filings low. Figures for 2007 already indicate a significant rise in filings. Growth in the numbers of bankruptcy filings can be traced to an increase in mortgage delinquencies and foreclosures nationwide. Some analysts predict that bankruptcy filings could reach pre-reform levels of one million by year-end.

Credit counseling needs improvement
The effectiveness of credit counseling, a critical component of the bankruptcy reform legislation, is under scrutiny in response to opinions stated in a recent Government Accountability Office (GAO) report. It indicates that the pre-filing credit counseling required by the law does not seem to be working as intended.2

According to the GAO, "Anecdotal evidence suggests that by the time most consumers receive counseling, their financial situations are dire, leaving them with no viable alternative to bankruptcy." The GAO recommended that the Justice Department track and analyze the results of credit counseling to gauge its impact on bankruptcy filings.

Justice Department tracking results show that at least 10 percent of the consumers who completed counseling decided not to file bankruptcy. However, the data do not rule out the possibility that filings may have occurred at a later date. The Justice Department plans to improve current tracking procedures with enhanced automation and time series data that will provide more reliable information on the outcome of credit counseling.

Georgia leads as nation's "bankruptcy capital"
Most states logged a significant decrease in personal bankruptcy filings in 2006. Georgia saw a drop as well but continued to lead the nation with the highest number of individual filings. On a per capita basis (based on filings per 1,000 households), however, Georgia ended the year second behind Tennessee.

Table 1: Consumer Bankruptcy Filings by State
*() denotes 2005's ranking
STATE 2006 2005
GEORGIA 39,142 79,273 (8)*
CALIFORNIA 37,107 162,532 (1)
TEXAS 34,550 117,612 (3)
OHIO 34,446 133,541 (2)
MICHIGAN 32,746 88,402 (7)
TENNESSEE 31,406 65,360 (11)
ILLINOIS 29,774 105,964 (6)
NEW YORK 29,059 107,489 (4)
FLORIDA 24,709 106,250 (5)
PENNSYLVANIA 23,190 77,587 (10)
Table 2: Bankruptcy Filings per 1,000 Households
*() denotes 2005's ranking
STATE FILINGS PER 1,000 HOUSEHOLDS
2006 2005
TENNESSEE 13.3 28.0 (3)*
GEORGIA 11.4 23.6 (11)
ALABAMA 10.8 26.7 (7)
INDIANA 9.0 32.5 (1)
MICHIGAN 8.5 23.0 (13)
ARKANSAS 8.5 27.8 (5)
MISSISSIPPI 8.1 21.9 (18)
OHIO 7.7 29.7 (2)
KENTUCKY 7.4 24.3 (9)
LOUISIANA 6.8 21.6 (19)
Source: U.S. Bankruptcy Court, U.S. Census Bureau

Part of the reason for Georgia's dubious distinction may be the state's creditor-friendly laws, which have often left borrowers with few options other than bankruptcy to protect them in the event of financial difficulties, especially when a mortgage is involved. Georgia is a non-judicial state that permits lenders to foreclose on a home without going to court. From initiating foreclosure proceedings to selling a home on the courthouse steps, the process can be completed in as few as 37 days in Georgia, compared with a timeframe of close to a year in states like Florida and New York where foreclosure happens under judicial law. Rather than lose their homes, most consumers opt to file for Chapter 13 protection to slow down or stop foreclosure proceedings.

In addition, Chapter 13 reorganization bankruptcy relief filings are more common in Georgia than Chapter 7 liquidation filings. Because federal bankruptcy reform targeted Chapter 7 filings, the legislation's impact was not as pronounced in Georgia.

Another contributing factor was Georgia's high volume of nontraditional and subprime mortgage loans in recent years. Most of these mortgages were extended to first-time home buyers who qualified based on low introductory rates scheduled to reset within one to two years. Now that rate adjustments have begun to occur, many affected borrowers have not been able to make the higher payment. Often they are not able to refinance because of the negative amortization typically associated with these products. Many of these consumers now face the prospect of foreclosure and possibly bankruptcy.

Also of note, the top 10 highest filing states on a per capita basis included five Sixth District states: Alabama, Georgia, Louisiana, Mississippi and Tennessee. Florida ranked 38 and 35 for 2006 and 2005 respectively (Table 2).

Conclusion
Debate continues about the effectiveness of the bankruptcy reform legislation. Some argue that the new requirements and additional costs only impose more burdens on consumers who legitimately need debt relief. Others assert that the law is necessary to curb abuse and ensure that those consumers who can afford to repay at least a portion of their debts do so.

This article was written by Lisa Easterwood, financial analyst in the Supervision and Regulation division at the Atlanta Fed.

Endnotes

1Erika Lovely, "Bankruptcy Filings Rise Upward—Trend is Expected to Continue Through 2007." Houston Chronicle, April 9, 2007.

2 Gregory Stanford, "Bankruptcy: Repairs to Law Needed." The Milwaukee Journal Sentinel, May 4, 2007.