The right to default: when did bankruptcy become an accepted fixture of everyday life?

My friend "Tom" is your typical yuppie. He has the pretty wife, the cute kid, the well-paying job in high-tech, the two cars (one a Mercedes 300), the sailboat (a 35-footer rigged for racing)--and the obligatory Chapter 7 bankruptcy on his credit report.

Yes, this December Tom joined actress Kim Basinger and former baseball commissioner Bowie Kuhn among the swelling ranks of Americans taking advantage of Uncle Sam's debt forgiveness program.

By now you've all heard the disturbing news: Despite a thriving economy, and the decline in corporate bankruptcies, Americans are declaring personal bankruptcy in record numbers. When the American Bankruptcy Institute reported last summer that 1996 petitions were on track to hit a record 1.1 million, every newspaper in the country ran an article on our nation's consumer bankruptcy crisis. Leading off each piece was a disheartening tale about how some naive young couple (or single mom or grandmother) had either: a) been struck a devastating financial blow such as an unexpected illness or layoff or b) allowed themselves to sink slowly into a morass of unrecoverable credit card debt. The ultimate result: bankruptcy.

On the heels of these personal narratives came laundry lists of the common causes of consumer bankruptcy--job loss, divorce, high medical bills, car accidents, credit card debts--along with the requisite finger pointing: The lawyers blame the banks for making excess credit too obtainable; the banks blame the government for making filing too easy and the lawyers for being too quick to recommend bankruptcy; and everyone blames society for being morally bankrupt, thus removing the stigma from financial bankruptcy. But regardless of the experts quoted and the individuals profiled, at some point in every article, someone would note that Americans are operating so close to the financial edge that one unexpected expense pushes them over. In other words, the rise in bankruptcies is an unfortunate--but unavoidable--fact of modern life.

Maybe. But financial hardship has always been a part of life. Neither illness nor job loss is a recent invention. Yet the number of personal bankruptcy filings has tripled since 1981. Now, with the filing rate eight times that of the Depression era, most people agree that something needs to change.

Specifically, a measure of justice needs to be injected into the system. There is nothing inherently immoral about financial problems--or about a system that helps people deal with such problems. The injustice comes when debtors receive more relief than they need. Although a small percentage of people find themselves with debts that are more than they could ever repay, more often than not the problem is that people are unable to meet creditors' demands for payment right now. In an ideal world, bankruptcy would protect a debtor from creditor harassment while he worked out a repayment plan. Each creditor, in turn, would receive his fair share of the debtor's budgeted payments. Only individuals for whom repayment was an unreasonable burden would receive a total discharge of debt.

The current system, however, is far from that ideal. Hundreds of thousands of Americans are treating debt discharge as an entitlement, wiping their financial slates clean regardless of their income or assets. But reversing this trend will involve more than tweaking the existing bankruptcy code, because the rise in filings--estimated to have begun around 1981--cannot be traced to any single change in law or economic policy. Rather, four key developments began taking shape around that time whose combined influence created a debt-default juggernaut that shows no signs of slowing.

Nice n'Easy

To my friend Tom, the impetus behind the rise in filings is clear. "The system makes it too easy just to walk away from debt," he says. "It's a pathetic law"

He isn't far off base. Under the Bankruptcy Act of 1898, debt forgiveness was an ill-defined, cumbersome process. The Bankruptcy Reform Act of 1978 changed all that. Today's filing process is relatively quick, easy, and cheap, with court filing fees running well under $200. A debtor's first step is to determine which of the two main consumer filing options he needs, Chapter 7 or Chapter 13. Chapter 13 is known as a wage-earner plan. It allows debtors to shelter their assets from repossession while working with a court-appointed trustee to draw up a repayment schedule. Repayment plans typically last three to five years, at the end of which the remainder of the debt is discharged. Far more popular is Chapter 7 liquidation, which accounted for 70 percent of 1996 consumer filings. Under Chapter 7, debtors are allowed a certain number of property exemptions, broken down by category: $15,000 in home equity, $1,000 in jewelry, $8,000 in furnishings, and so on. Remaining assets are collected and sold off by a trustee, who distributes the proceeds to the various creditors. (The trustee receives a commission based on the amount recovered.) Most Chapter 7s, however, are ruled no-asset cases, which means unsecured creditors (those to whom significant collateral, such as a car or home, has not been pledged in case of default) rarely see any of their money. Certain types of debt are considered nondischargeable, including child support, recent IRS debt, and student loans. But for the most part, Chapter 7 gives people a fresh start.

Anyone is eligible for Chapter 7; petitions are almost never denied, except in cases where there's proof of "substantial abuse" (the definition of which remains vague). There is no minimum amount of debt or specific income-to-debt ratio required, and no distinction is made between the portions of a person's debt that they can and cannot repay. Tom, for example, makes over $75,000 a year. His decision to file bankruptcy stemmed from a five-car pile-up his vehicle was involved in three years ago. Even though Tom was not at fault, he was facing a $250,000 lawsuit. Bankruptcy, he determined, was his best option. But in addition to rendering pending legal claims pointless, Tom's Chapter 7 wiped away everything from his credit card bills to penalties he owed on back taxes. "The lawsuit was a debt that I could never have paid back," he says. "But since I was about to trash my credit history, I discharged some legitimate debts as well. There are guidelines about what you can and can't discharge, but there's no structure in place to check that. So I threw in a few little things just to see what the system will do with me. I doubt they'll even notice"

Tom admits he's abusing the system, but rationalizes: "I'm not an idiot. I'm paying a big price for being bankrupt, so I might as well take advantage of it"

To this end, Tom began planning for his filing months in advance. "I went and saw an attorney back in March. Right after that, I quit paying on my condo. I used that money to pay off debts that I wouldn't be able to discharge, like new taxes"

Although it may sound criminal, such asset juggling is perfectly legal, and is recommended by some attorneys and accountants as smart financial planning. Take the case of former corporate raider Paul Bilzerian. Several years ago, when, due to legal troubles, he was preparing to file bankruptcy, Bilzerian sunk $6 million into a mansion in Florida, where state law allows filers to exempt an unlimited dollar amount in home equity. Similarly, a Virginia millionaire preparing to file took advantage of his state's exemption allowance for one horse and invested close to $650,000 in a racing thoroughbred.

Of course, Tom also did some "asset readjustment" that wasn't kosher. One of the little things he failed to mention on his Chapter 7 petition was that, up until the day before filing, he owned a sailboat. Having read that the sale of assets up to six months prior to filing must be reported, Tom took care not to leave a paper trail: "I signed the boat over to a friend who wanted to buy it, then filed a pre-dated transfer-of-liability notice" It gets better. Rather than squirrel away the money (which would have been illegal), Tom had it diverted directly into the account of another friend whose larger boat he had been planning to purchase (a move both illegal and frivolous). "The guy I'm buying from has agreed to keep the boat in his name for a few months and just add me to his insurance. The money from the sale of my boat will never cross my hands"

Tom knows that his shell-ye could mean big trouble if for some reason his bankruptcy trustee decides to launch a post-filing investigation. "But the trustee has 500 cases sitting on his desk," notes Tom. "He probably spent an hour total on mine. At the creditors meeting in January, he asked me exactly one question about my finances: Which Mercedes did I intend to keep? That's it! The only assets I turned over were one of our cars and a camera"

Now seems like a good time to point out that Tom is not a bad guy. He loves his new baby. He's good to his parents. He would do anything in the world for his friends. But he did not hesitate to stick his creditors with several thousand dollars worth of uncollectable debt, while simultaneously flirting with bankruptcy fraud. An upstanding citizen in other respects, Tom's willingness to walk away from his financial obligations reflects another key to the rise in filings: this culture's growing acceptance of bankruptcy.

No longer is filing bankruptcy tantamount to sewing a scarlet "B" on all your clothing. While this is in part the result of millionaires, celebrities, and major corporations joining in the debt-discharge orgy, it is also an outgrowth of our society's increasing reliance on debt spending. The Federal Reserve reports that consumer debt, having more than doubled in the past decade, has reached $1.19 trillion. And with consumer spending making up 68 percent of the nation's GDP, we have become a society in which living beyond your means is considered, not only acceptable, but downright patriotic.

Volumes have been written about what turned us from a nation of savers into one of feckless spenders. The favorite culprit is mass advertising and television, which drive consumerism with their message of instant gratification. But Hollywood and Madison Avenue can't take all the blame for this one. The government has done its share of spreading the message that debt is good for you, particularly in recent years. While regular deficit spending has been part of the U.S. fiscal agenda since the late 1940s, Ronald Reagan elevated the practice to high art. With his massive tax cuts and foreign borrowing, the Gipper showed the entire nation what kind of party could be financed with debt. As former Secretary of Commerce Peter Peterson writes in his book Will America Grow Up Before it Grows Old?: "Reagan gave us a spectacular consumption boom...a borrow-and-spend administration, a feel-good decade in which we could have it all--without the bother of actually producing it" As a result, Americans have developed a sense of entitlement to a certain lifestyle, a belief that a downturn in one's financial situation doesn't have to mean tough spending choices. We want it all, we want it now, and we don't want to worry about paying for it until next month.

Let's be clear. I'm not saying that everyone who files for bankruptcy is a cheat, a deadbeat, or a self-indulgent yuppie. Flipping through the filings at the District of Columbia bankruptcy clerk's office, you find numerous cases of people who fell on hard times. One December filing was by a single mother of two, who less than a year earlier had gotten off state assistance and taken a clerk's job paying just under $10,000 a year. Included among her reported debts were medical bills totaling more than $5,000. Clearly, this is a person for whom the bankruptcy system was intended.

My friend Tom, however, clearly is not--a fact he is unabashedly honest about. "People like me shouldn't get away with this," he admits.

While we're on the subject of exploiting the system, now seems the time to introduce the third major contributor to the bankruptcy crisis: the lawyers. Nineteen seventy-eight was a red-letter year for bankruptcy law. In addition to ushering in the Reform Act, which made the filing process infinitely quicker and easier--and thereby more lucrative--for attorneys, this was the year the Supreme Court overturned a ban on attorney advertising. As a result, it has become increasingly difficult to tell the lawyers from the used-car salesmen. Radio and television ads, billboards, and flyers tout bankruptcy as the quick, simple way to solve your financial problems. One Miami legal firm actually markets itself as The Bankruptcy Clinic. Even attorney Harvey Miller, a senior partner with New York's Weil Gotshal and Manges and a 25-year practitioner of bankruptcy law, admits the legal community has gone overboard: "Flipping through the TV channels at night, you see all these ads with lawyers saying, `Don't be burdened with debt. There are legal means available."' As a result, he notes, people are much more aware of the bankruptcy option.

Unfortunately, many lawyers are all too happy to file a no-fuss Chapter 7 for a client who might benefit just as well from some other option, such as debt consolidation or a repayment plan with an individual creditor. In areas where filing rates are high, "bankruptcy mills" have sprung up, legal firms comprising only one or two lawyers, and a team of paralegals to handle the actual filings. Overhead is low, and the firm can churn out dozens of Chapter 7 cases per month.

The Debt Peddlers

The most vocal critics of bankruptcy being treated as a quick-fix are the creditors associations, including Visa U.S.A. and the American Bankers Association. Their concerns are clear: The bankcard industry estimates it lost $4.7 billion to bankruptcies in 1995 alone, up 45 percent from 1994. With profit margins at risk, creditors are looking to overhaul a system they believe makes default too attractive for consumers.

But while the creditors blame the lawyers, the law, and society for the crisis, practically everyone else blames the banks for dispensing credit unwisely. George Salem, a securities analyst with New York's Gerard Klauer Mattison & Co., issued an investment report on the banking industry last June and later presented his findings at the House Banking Committee hearings on consumer debt: "[Personal] bankruptcies are up sharply because of the proliferation and looseness of credit card debt. No one at the lender level seems to care about overextension of debt, and human nature being what it is, most people believe they can afford more debt, when many simply cannot"

Without question, Americans are drowning in credit card offers. According to Behavioral Analysis Inc., more than 2.7 billion solicitations were mailed in 1995 alone. The reason: profit. The FDIC reports that, since 1990, the average return on assets of"credit card banks" (those with more than 50 percent of their assets in card loans) has ranged from two to four times that of other insured institutions. This kind of profit potential leads to fierce competition: There are currently an estimated 7,000 institutions issuing Visas and MasterCards.

In this rush to grab new business, banks have replaced careful debt underwriting with hard-sell marketing--loosening lending criteria, extending excessive credit to lower-income households, and tempting existing card holders with higher limits and low introductory interest rates. As Salem notes:"[C]ard issuance has taken on the character of mass-mailed advertising or promotion rather than a loan"

Banks insist that this "democratization" of credit helps feed the economy and enables low-income families to participate in the marketplace. But, as is often the case, what is positive in moderation can be lethal in the extreme. More to the point: While extending a $1,000 credit line to a family with a $10,000 annual income may be good democratic capitalism, extending the family multiple cards or $25,000 in credit borders on the criminal. Yet credit counselors and attorneys report that clients frequently come to them with debts on 8 or 10 or 20 cards. In reference to a former client who was the proud holder of 63 major cards, one Florida bankruptcy attorney asks: "Now if you're a bank and you pull this woman's credit report and see that she's got 58 cards, is it responsible to send her another one?"

"No one is sent a credit card against their wishes," says Philip Corwin, a Washington lobbyist for the American Bankers Association. "And no one is sent a card without applying for it" OK. Let's ignore for a moment that debt isn't so much the problem as is excessive debt, and that people's credit limits are frequently upped without their consent. The reality is that Americans aren't as financially sophisticated as we like to think; most people don't know what their credit card interest rates mean in terms of real dollars--or even what rates they're paying. (Be honest, how many of you know the exact rate you're paying on your cards?) To compound the problem, creditors encourage borrowers to carry large balances--and rack up interest payments--by liberally expanding the credit lines of customers who carry a heavy debt load, and by setting minimum monthly payments as low as 2 percent of the principal. Last year, General Electric went so far as to impose a $25 annual fee on "convenience users," customers who selfishly pay off their balance every month without allowing interest to accrue.

The result can be seen in the phenomenon of "creeping debt," says Alan Dubow, president of the Debt Relief Center, a national non-profit chain of financial counseling centers. "Say you have a $5,000 credit limit. If you charge $200 every month and pay off only $50 dollars of that, your debt will increase monthly by $150 plus interest. Now, because you are such a good customer and are making regular payments, by the time you reach your credit limit, the bank will most likely have upped it to $7,500 or $10,000." As a result of a creeping balance, often accompanied by multiple cards, Dubow says, "It's not unusual for people to come in with $20,000 worth of card debt"

Many people also assume that banks--which, after all, are in the business to make money--wouldn't extend a line of credit to a person who wasn't financially qualified for it. But, Dubow notes, just because someone eventually defaults on a card balance doesn't mean that the bank didn't make a profit. When a bank extends you a line of credit, he explains, they are working with a formula. They know that the average customer will charge a certain percentage of his income every month, then pay off a certain percentage of that balance at month's end. The bank can then figure out what its break-even point is, that point at which the bank has collected payments from you totaling more than your credit limit. After that point, even if you charge up to your limit and default, the bank has turned a profit.

Fair Play

Whatever their sins, however, creditors are dead-on in their criticisms of the current one-size-fits-all Chapter 7 bankruptcy. The entire concept of debt-forgiveness is based on overwhelming need, and the process should reflect as much. Yet, a 1996 study by Purdue University's Credit Research Center found that 45 percent of people in Chapter 7 had the ability to repay a third or more of their unsecured debt over a three-year period.

As undemocratic as it may seem, a form of means testing should be implemented. All debtors should initially be required to file a Chapter 13, after which, each case would be reviewed to determine what percentage of an individual's debts he was equipped to repay over time, or if the case merited a Chapter 7. This would protect those who need a full discharge, but prevent people with significant assets or earning potential from using bankruptcy as an easy out. A provision should also exist to allow someone like Tom, faced with one overwhelming expense, to discharge a specific debt without tossing out all his others. Currently, the court does allow debtors to "reaffirm" individual debts (i.e., reach a repayment agreement with specific creditors), but there is little incentive to do so.

Creditors say they'd be happy with this arrangement, and in fact, are proposing such a measure to the National Bankruptcy Review Commission, the panel set up in 1994 as part of a package of minor reforms to analyze the system. (The commission is scheduled to present its findings in October.) "If someone has the ability to repay a portion of their debts, they should file a Chapter 13," says Philip Corwin, adding, "Of course, if someone is either unemployed or income insufficient, our position is that's a mistake we made as lenders, and we'll have to eat it"

Certainly, no fair reform is possible until the issue of lending practices is addressed. Taking Corwin at his word--that is, holding banks accountable for their actions--might put a measure of prudence back into credit issuance. As a first step, banks need to provide customers with the basic information necessary to help them manage their debt. To this end, credit card statements would include information such as, "If your income is x amount, you should not be carrying a balance of over x amount" Or, "If you pay x amount each month on a balance of x dollars, it will take you x years to pay off your debt" Such data would help consumers understand the price involved with carrying a debt and enable them to make better-informed financial decisions. Of course, the actual dollar amounts might shock customers, but if lenders are genuinely interested in helping people use credit wisely, they need to be upfront about what those little interest payments can add up to.

To encourage banks to provide such data, court judgments about whether a particular credit issuer should be included in a debtor's repayment plan could be contingent upon whether that creditor had acted responsibly in its dealings with a debtor. Banks expecting to collect on a debt would need to show that they'd been reasonable in issuing credit to the filer, and upfront in keeping him informed of his debt load.

To make the system function more fairly and efficiently, a uniform national exemption policy needs to be set up. Currently, 35 states preempt federal exemption allowances with state ones, some dating back to the 1800s. These varying standards are what allow for abuses like the Florida mansions and Virginia racehorses.

Regardless of how smoothly the system runs, however, the additional steps involved with filing and evaluating each Chapter 13 would lengthen the process. But the debtor would still be protected from creditors from the moment he filed, and the additional work involved might slow attorneys' filing frenzy just enough to make them consider what other options might better benefit a client. (Considering the overall litigation-fest of recent years, it may also be time to retighten legal-advertising standards so that attorneys don't stray from the marketing of services into the promotion of specific ways for clients to milk the system.)

Extending the six-year wait now required before a Chapter 7 filer can declare bankruptcy again could also give repeat offenders pause for thought. (A 1996 survey by Visa found that 14 percent of filers had declared bankruptcy at least once before.) But this measure would need to be combined with tougher standards for reacquiring credit after bankruptcy. Currently, while quick to condemn debt default, lenders are even quicker to help filers re-establish credit--at the highest interest rate allowed. Some banks even target Chapter 7 filers because the customer can be charged steep interest rates and cannot declare bankruptcy again for six years. Such practices have removed a once major deterrent to filing.

Of course, the ideal solution would be to help people avoid falling into a position where they feel they need to file bankruptcy. And although economic disasters cannot be controlled, consumers can be educated as to the dangers of excess debt.

The concept of bankruptcy providing a fresh start is understandably appealing, but it shouldn't wipe away the concept of personal responsibility (which the country seems so eager to throw in the faces of welfare recipients). Why should the majority of Americans struggle to meet their daily expenses when their neighbors have decided simply to tear up the bills and start from scratch? After all, consumers who don't default on their debts wind up paying the price of bankruptcy in the form of higher bank fees and interest rates. And continuing to accept misuse of the system perpetuates the notion that the government should clean up our messes for us, because we are either too dumb or too self-indulgent to help ourselves.