A bankruptcy wake-up call.

New tools are needed to combat a surge of consumer bankruptcies. Financial education and counseling are two potential solutions that could address a growing problem.

Personal bankruptcy filings (chapter 7 and 13) have vaulted well over the psychological 1 million mark for the first time in American history, costing the bank-card industry about $7.5 billion, or roughly half that industry's total credit losses for 1996 [ILLUSTRATION FOR FIGURES 1 AND 2 OMITTED]. The significance of this represents more than simply crossing a numerical threshold. A small increase in bankruptcy filings that incidentally pushed filings passed the 1 million-case mark might be interesting, but unimportant, from a policy or economic perspective. This record, however, comes as the result of an astounding 20 percent increase in personal bankruptcy filings during the previous 1996.

It is apparent that this increase is something more than a mere cyclical, statistical uptick. It may, in fact, reflect certain fundamental changes in consumer behavior and in the credit industry. For instance, unlike previous peaks in bankruptcy filings, the current explosion occurs amid an expanding economy and declining unemployment. The average consumer today holds more than four credit cards, with an average balance per card of $2,000, up from an average balance of $1,400 per card in 1991.

Until recently, most lenders' opinions about and management of consumer bankruptcy was neatly informed by whether they were "secured" or "unsecured" creditors. The distinction between the two, however, is becoming less and less clear, as the position of a secured lender suffers from modification in bankruptcy laws, house-price depreciation, overextension of credit, job loss, changing attitudes and financially devastating events. Each of these factors, external to the credit evaluation process, results in increased exposure to bankruptcy for mortgage and other lenders when an overextended consumer encounters financial crisis.

This article describes how the credit-card and mortgage banking industries face common problems when a borrower files bankruptcy. It examines the effects that bankruptcy have on the credit system. It also summarizes current research into the causes and alternatives to bankruptcy and suggests education of debtors as a common element that can and should be pursued as a preventive and rehabilitative solution. Finally, we suggest that a tracking system for individuals once they enter the bankruptcy system be pursued so that education programs can be continuously improved to provide borrowers with a true fresh start - not just debt relief but tools necessary to manage their money and credit to avoid future distress.

Secured and unsecured lenders: The indistinct distinction

Historically, mortgage lenders have generally assumed that their secured positions insulate them from bankruptcy losses. However, the staggering losses stemming from personal bankruptcies that currently affect the bank-card industry affect secured lending as well, with several notable correlations. Gordon Monsen, in his article in the June 1996 issue of Mortgage Banking, accurately observes the correlation between trends in the mortgage lending industry toward lower equity, lower savings levels, lower home-price appreciation and higher consumer-credit levels, to early mortgage default. Monsen correlates charged-off bank cards and high balance-to-credit levels with mortgage default.

In noting job loss as the most common cause of mortgage default (it is also one of the most common life events correlated to bankruptcy), Mortsen hypothesizes that homeowners who encounter sudden unemployment tend first to deplete whatever savings are available to finance living expenses until a new job is found, then whatever bank-card credit is available, before finally exhausting these resources and defaulting on their mortgage loans.

Secondly, the 1996 credit playing field has been leveled by a real estate market that can no longer rely on steady appreciation to compensate for faulty credit evaluation. Monsen also notes that borrowers with high equity positions in their properties tend to sell the home rather than face foreclosure, while those with little equity tend to turn in the keys. It may not be coincidental, then, that borrowers with few or no assets to protect tend to turn to Chapter 7 bankruptcy. In such a case, the mortgage lender may be faced with a loss similar to that of the bank-card lender.

Thirdly, borrower behavior prior to filing bankruptcy and prior to defaulting on a mortgage provides less and less warning to the lender through late payments. Maximum bank-card usage also is correlated to subsequent mortgage default. This may result from a "borrowing from Peter to pay Paul" syndrome, or using credit advances to make minimum required payments on other (mortgage and nonmortgage) debt, before finally exhausting all available resources to suddenly default or declare bankruptcy without warning.

Such a trend threatens the underwriting standards and scoring systems upon which consumer-credit, automobile, small-business and mortgage lenders rely to serve the widest possible market with the fewest possible losses. Given these trends, the mortgage and the consumer-credit industries face a common threat from bankruptcy and can mutually benefit from a collective effort to respond to consumers in financial distress.

Bankruptcy basics

As growing numbers of consumers perceive bankruptcy as a first rather than last resort to dealing with their financial problems, mortgage lenders are beginning to join their consumer-credit colleagues in searching for a solid understanding of the principles, processes and procedures of the U.S. Bankruptcy Code (the Code). The Code itself poses challenges common to both the credit-card and mortgage banking industries by blurring the distinction between secured and unsecured creditors and by emphasizing the nature of the claim rather than the status of the entity holding the claim.

Congress, in Section 506 of the Bankruptcy Code (11 U.S.C. 506) eliminated the terms "secured creditor" and "unsecured creditor." It split the claim instead into a secured portion and an unsecured portion. A creditor who has a lien, security interest or mortgage on property of the debtor may in fact have a partially or totally unsecured claim, depending on the value of the collateral. A borrower who moves out of the mortgaged residence, for example, which has lost value, may leave the first lender with a secured and an unsecured claim. A second lender, as a practical matter, may be in a position no different than that of unsecured creditors.

The effect of Section 506, to some extent, depends on the type of relief the borrower chooses in bankruptcy. Chapter 7, sometimes referred to as "straight bankruptcy," provides an orderly process for liquidating a debtor's assets and distributing the proceeds to his or her creditors. A "fresh start" intent is afforded through the discharge of the borrower from his or her debt including secured debt - leaving only those assets that the law exempts from distribution.

In Chapter 7, a secured creditor may ultimately recapture the value of the collateral. However, any deficiency that remains after liquidating the collateral will likely be discharged and will generate little, if any, recovery, even for the secured creditor. The Bankruptcy Code does permit the debtor to "reaffirm" an obligation to a creditor (11 U.S.C. 524[c]) if he or she chooses to do so, in which case the creditor may receive full payment. However, the' creditor cannot seek to have a court compel reaffirmation.

If the debtor chooses to proceed under Chapter 11 or 13 of the Bankruptcy Code, the secured creditor, other than a creditor whose rights are secured by a "security interest in real property that is the debtor's principal residence," risks having his claim split into secured and unsecured portions. Chapter 13 allows a debtor the breathing room to rehabilitate or reorganize his or her debts through means other than the liquidation of assets. Often referred to as the "wage-earner's bankruptcy," Chapter 13 assumes the repayment of all, or a portion, of the debtor's obligations from future earnings, and thus the borrower is placed on a repayment plan.

However, Chapter 13 also permits the debtor to "modify the rights of secured claims" in the Chapter 13 plan (11 U.S.C. 1322[b] [2]), subject to certain limitations. To cure a default of a mortgage on the debtor's principal residence, the debtor must repay the amounts due "in accordance with the underlying agreement," rather than the value of the collateral (11 U.S.C. 1322[d]).

Despite the clear language of the Bankruptcy Code, as well as rulings by the Supreme Court, secured creditors face many of the same risks as unsecured creditors, even in Chapter 13. Mortgage lenders suffer continued delays in foreclosure obtained through the automatic stay and successive filings available to consumers through bankruptcy. Furthermore, despite clear language of the Bankruptcy Code and the Supreme Court's decision in Nobelman vs. American Savings Bank et al., 508 U.S. 324, 113 S.Ct.2106 (1993), bankruptcy courts continue to order modification and reduction of mortgages.

Reluctant decisions: What's driving bankruptcy?

Some argue that the current bankruptcy crisis has been exacerbated by changing ethical values. However, 200 hours of interviews with borrowers who had recently declared bankruptcy, conducted by Visa in the third quarter of 1996, reveal that, in fact, bankruptcy is still perceived as a serious issue and one that the debtor has usually straggled to reluctantly accept.

Further research from several sources using both quantitative and qualitative methods indicates that while bankruptcy may hold somewhat less of a stigma than it once did, the growing acceptance - albeit reluctant - of bankruptcy as an alternative may also be the result of several separate but often converging socioeconomic factors. Ongoing research at the Purdue University Credit Research Center indicates that the risk lenders underwrite today do not reflect trends external to the lending environment, such as:

* Corporate downsizing has affected the income base of the population;

* More borrowers are self-employed;

* Borrowers who have lost their jobs find that it takes much longer to find a comparable job;

* When recently unemployed consumers do find jobs, often they are forced to accept employment with reduced benefits, leaving them vulnerable to life events that can often trigger financial crisis;

* Lack of, or inadequate, health care presents financial risk not assumed in the original underwriting of a loan; and

* More borrowers are aware of bankruptcy as an option.

Given the absence of a system to alert a creditor to the existence of any one or more of these events taking place in the life of a borrower, the lender is usually the proverbial last one to know that his original A-quality borrower is now at risk. It is no wonder that scoring models are strained to predict financial disaster that has not been reflected in a borrower's past behavior and are not yet capable of providing warning of an impending trigger event.

WEFA Study

While empirical research dating back to the early 1960s has identified a variety of economic and social factors that have affected trends in bankruptcy filings, by the mid-1980s many of the historical relationships appeared to be weakening. Bankruptcy filings, which normally decline during periods of economic growth, grew 150 percent from 1983 through 1990, even though the U.S. economy experienced the longest peacetime expansion in its history. Furthermore, after a brief reduction in the number of filings in 1993 and 1994, the pace of filings accelerated, even though the underlying economy was still expanding.

In 1996, Visa contracted with the WEFA Group, an economic consulting firm, to provide technical expertise and resource support to identify the primary factors that drive bankruptcy. Econometric modeling and data-pooling techniques were used to measure the effects of macroeconomics and social factors on personal bankruptcy filing rates. Approximately 65 variables were examined to explain trends in personal bankruptcy filings. After extensive econometric analysis over the 16-year interval, an equation was developed that explains more than 99 percent of the variation in personal bankruptcy filing trends:

* Growth in total employment. Employment growth rates proved to have the single most powerful coefficient in explaining bankruptcy behavior. Interruptions in income have clearly been shown to correlate negatively with trends in bankruptcy filings, i.e., when employment growth declines, bankruptcy filings increase. The unemployment rate, on the other hand, proved to have less predictive value. This may be caused primarily by the way unemployment is measured. Unemployed workers who become discouraged and no longer search for jobs are not counted among the ranks of the unemployed. Consequently, as the ranks of the discouraged unemployed grow, the unemployment rate loses explanatory power [ILLUSTRATION FOR FIGURE 3 OMITTED].

* Share of population aged 25 to 44. The second most powerful term in explaining bankruptcy filing trends is the share of the population between the ages of 25 and 44. The analysis indicates that as the proportion of the population in this group increases, so does the number of bankruptcy filings. Adults in this age category are in their peak consumption years and typically consume and borrow more than individuals in other demographic age groups. As a result, they often have fewer reserves to draw on during periods of financial hardship. In addition, this age group may not view bankruptcy as carrying the same stigma as previous generations did and may be more inclined to file for bankruptcy.

* Divorce rate. Divorce ranks third in power to explain bankruptcy filing trends and correlates positively, i.e., as the divorce rate increases, the number of bankruptcy filings increases [ILLUSTRATION FOR FIGURE 4 OMITTED].

* Median existing home prices. The median prices of existing homes serve as a proxy for equity (or accumulated wealth) in the equation. This variable was negatively correlated, reflecting two phenomena. First, a collapse in home prices means that individuals may owe more on their homes than the property is worth, making bankruptcy a less onerous way to deal with debt problems. Secondly, equity can be a source of funds that may be tapped in an emergency. When values decline, this source of funds dries up, making bankruptcy more likely.

* Social factors. Because of the acceleration in bankruptcy rates shown in Figure 5, "Bankruptcy Filings per 1,000 Adults," during a period defined by economic growth, noneconomic factors are likely to have played a more important role in determining changes in personal bankruptcy filings. Many social factors are not easily quantifiable, as consistent, historical data does not exist. Such factors include changes in the bankruptcy laws, the reduced stigma associated with filing for personal bankruptcy and broader advertising of legal assistance with bankruptcy filings.

* Ratio of consumer installment debt to personal disposable income. Intuitively, increases in a cardholder's debt service burden, defined as the contractual minimum principal and interest payment, could be positively correlated with bankruptcy filings. However, the debt service burden alone is less important than debt service burden relative to personal disposable income. This driver was found to be positively correlated with bankruptcy filings and was most significant when it was lagged two, three and four quarters.

The debtor's story

Also in 1996, Visa surveyed 5,000 individuals who had filed for bankruptcy during the previous 12 months. The purpose was to ask them to identify factors that influenced their decision to take this drastic step, to learn what impact the bankruptcy action had taken and to elicit recommendations for changes in the law or the process.

The No. 1 reason for filing bankruptcy, cited by nearly 29 percent of the debtors, was simply that they were overextended. Other major causes (which support the Purdue study and the WEFA economic analysis) included loss of a job, medical and health reasons, and divorce and separation. More than a third of the respondents reported that the last straw led to their filing for bankruptcy: That last straw was one or more of the tactics creditors used to collect what was owed them. These included repossession, wage garnishment and foreclosure. Other findings included:

* The perception of no other solution. More than 58 percent of the respondents said they believed they had no choice but to file for bankruptcy or were not aware of any other alternatives.

* The perception of an easy process. More than 80 percent of the respondents said they found the decision to file a difficult one, but nearly two-thirds said the process itself was surprisingly easy.

* Repeaters. One of the more disturbing findings was that for a significant minority, this was not their first bankruptcy. The majority, 86.7 percent, had never filed before. But two-thirds of the remaining respondents had filed twice before, and the rest even more frequently.

* Unused counseling resources. One of the most surprising findings of the survey was the relatively small number of individuals who sought credit counseling before deciding to file for bankruptcy. Only 49 percent of the respondents sought professional debt counseling prior to filing.

* Attorney influence. Attorneys have substantial influence over many of the critical decisions individuals make in deciding whether to file for personal bankruptcy, including when to file and the type of filing.

* Rude awakening. A substantial majority of filers had not been able to reestablish credit, and nearly a quarter of the respondents still owed income taxes after the bankruptcy was filed.

1991 Gallup Poll 

In 1991, The Gallup Organization, Inc., conducted a national study of 1,010 heads of household as part of a survey of financial literacy. The findings of this study appear to suggest that when any, or a combination, of the above-identified causal factors occur, an alarming number of consumers lack even basic financial management skills necessary to understand their predicament. Even more disturbing is the lack of the most elementary tools or resources needed either to prevent financial distress or to plan and execute a strategy to repay existing debt or avoid repeating mistakes:

* Forty-eight percent of respondents don't usually set a budget for household expenditures. Forty-eight percent don't add up the amount of their household expenditures. Only 30 percent add up the amount that goes for household expenditures at least every month. Of those who do set a monthly budget, only 67 percent have added up the actual amount of their household expenditures. Of those that do set a budget for household expenditures, only 24 percent indicate that they adhere to that budget. Of those who do adhere to their budget, 17 percent say they sometimes adhere and 7 percent say they rarely do.

* Forty percent of the respondents indicate that they balance their checkbooks each time they write a check. Sixteen percent say they balance once a week, 27 percent less often than that, and 14 percent never balance their checkbooks. Only 29 percent of the respondents record their ATM transactions in their checkbook each time they make a withdrawal; 7 percent record less often than once a week, and 12 percent never record their ATM transactions in their checkbook. As for credit card receipts, 11 percent indicate that they never keep credit-card receipts to reconcile with their monthly statements.

As for setting financial goals, 45 percent of respondents indicated that they have not set financial goals or outlined steps to reach any goals. Only 22 percent said that they ever think ahead about their financial goals and the steps needed to reach those goals.

What can be done

For more than 30 years, members of the credit industry have complained that the bankruptcy system can provide debtors with full relief from debt without any demonstration that it's necessary. It may be that, ultimately, statutory change will be necessary to address this issue, and efforts to effect this reform should continue. However, the legislative process is long and cumbersome, and generally outside the control of members of the credit industry.

Statutory reform is one solution. But one of the most obvious conclusions to be drawn from the research so far is that bankruptcy has many causes and is influenced not only by factors outside the control of the lender but often outside the direct control of the borrower. Clearly, lenders can't do much to anticipate or prevent the life events that unexpectedly exhaust a borrower's financial resources. And clearly the issue of fraud and abuse of the system needs to be addressed through statutory reform.

But the research is just as clear that many borrowers:

* Are ill informed as to basic money-management skills;

* Do not understand the basic principles of credit;

* Increasingly overspend their ability to repay debt;

* Do not know or understand their alternatives when they become overextended;

* Do not make informed choices regarding the obligations for repayment;

* Do not understand the implications of poor credit choices; and

* Once having chosen the bankruptcy option, are often unable to execute a plan to restore themselves to financial health and well-being because they lack the skills and understanding and discipline that's needed to manage credit.

Proposal for education

One direct, immediate and targeted response that can be undertaken immediately is for lenders - whether secured or unsecured to educate consumers on the basic principles of sound money-management. That effort should be collective, well defined and guided by the vision that credit is a valuable resource that for long-term success should be supported by education and counseling.

Credit extended to today's consumers needs to be accompanied by instructions for its use, like any other tangible resource. And credit education needs to be included in the core curriculum of secondary and postsecondary educational programs for tomorrow's consumers.

Today's credit-healthy borrower also needs training in how to avoid financial distress and prepare - where possible - for unforeseen stress. Today's borrower-in-crisis needs to be given the same training to assure true financial recovery, rehabilitation and restoration.

Nonprofit credit counseling organizations, such as the National Foundation for Consumer Credit, headquartered in Silver Spring, Maryland, educate more than 3.5 million consumers a year and counsel more than 1.1 million. In 1996, the Mortgage Bankers Association of America (MBA) announced an agreement with the National Council on Economic Education that will bring high school curriculum called "Financial Choices" developed by MBA for CD-ROM to high school students across the country. Visa also introduced a financial education program for high school students to assist them in developing financial management skills. The CD-ROM-based program has been distributed through its member banks since 1991.

Such educational initiatives need to be supported with tracking, testing for effectiveness and measurements of success, in order to ensure that the financial preparedness is informed by and supportive to new developments in credit products and technology. We also suggest a tracking system for individuals once they enter the bankruptcy system so that any education program can be continuously improved to provide borrowers with a true fresh start. Such a new beginning must go beyond mere debt relief and provide the tools necessary to manage money and credit to avoid future distress.

Andrea Stowers, CMB, is director, issuer risk for Visa, U.S.A. Inc.; Mark Cole is executive vice president, National Foundation for Consumer Credit. Special thanks to Mark Guzinski of the U.S. Trustee's Office, Garry Seligson, general counsel for Citicorp Consumer Assets Division, and to E. Michael Rosser, CMB, vice president for United Guaranty Residential Insurance Co. for their contributions to this article.