September 2003

Cash me out

Record numbers seek debt relief through bankruptcy

Frank Jossi
Contributing Writer

Twin Cities attorney Tim Theisen's phone has been ringing off the hook lately as the rising flood of bankruptcies in Minnesota and the nation continues unabated. On a warm Monday in late June he reported that “at 11:30 a.m. I took two phone calls and by the time I got off the phone I got 10 messages. I have all the work I need.”

He's not alone. Throughout the Ninth District, bankruptcy attorneys have more clients than they need, thanks to another record year of bankruptcies. The Alexandria, Va.-based American Bankruptcy Institute (ABI) reported that more Americans filed for bankruptcy in the first quarter of this year than in any quarter in history, a total of more than 413,000—on pace for another record year.

Just a year ago Theisen was featured in local legal magazine reporting on the current explosion. At the time the focus of the article was on whether the bankruptcy jump had more to do with people trying to file before the federal legislation—bottled up in Congress for at least seven years—passed and imposed stricter guidelines on consumer filings. Theisen didn't see it that way a year ago, and he does not see it that way now, either.

“The cause of a bankruptcy is usually what I call a 'triage factor'—someone loses a job, gets in an accident and suffers injuries, is paying or not receiving child support or a combination all of the above,” he said. “I would say some people are bad at managing money, and they've always been bad at it. For every person $20,000 in debt I see, I'd say they should have been here when they were $10,000 in debt.”

A numbers game

Since 1980, bankruptcy filings have exploded. Last year bankruptcies grew to 1.6 million, about five times the 1980 figure. Increases in district states over this time have differed somewhat from the national trend, but each follows the upward path.

There are several ways to slice bankruptcy data. Both consumers and businesses are allowed to file for bankruptcy, but total filings have been increasingly dominated by consumer filings. In 1980, 87 percent of the nation's 331,264 bankruptcies were filed by consumers. By 2002, that figure had grown to 98 percent.

Consumers and businesses also have different filing options available. Most consumers pursue what's known as Chapter 7 bankruptcy, a measure releasing them from most debt liability after they pay off as much as they can. In most cases Chapter 7 allows consumers to keep their houses, an automobile, insurance, wages and retirement funds and some property. A Chapter 7 shows up on credit reports for a decade, making it more difficult for consumers to get credit again without paying high interest rates.

Chapter 13, in contrast, allows debtors the option of paying back secured creditors—banks, mortgage companies and so forth—as well as unsecured creditors, who usually receive a portion of the total payment over a three- to five-year span. (A rule of thumb is 10 cents on the dollar, but those figures are determined by a bankruptcy trustee and the debtor.) Chapter 12, meanwhile, is designed for family farms, and Chapter 11 handles business bankruptcies, although consumers can also use it in rare cases.

The ABI statistics show nationally around 70 percent of debtors have filed Chapter 7 bankruptcies since 1990. In the Ninth District, Chapter 7 represents more than 80 percent of the filings in every state.

Today's headlines

What's notable about bankruptcy trends is their steady upward climb over the last two decades. There have been brief respites lasting a year or two, but they are often followed by significant
increases. For example, after a lull in filings from 1999 to 2000, bankruptcy rates have recently trended sharply higher in most district states.

Among states wholly located in the district, Minnesota was tops in bankruptcy filings, hitting about 19,500 last year, an increase of almost 27 percent over 2000; first-quarter results show a 10 percent bump in nonbusiness filings over last year. Bankruptcies in Montana, meanwhile, jumped better than 20 percent (to 4,062) from 2000 to 2002, and the first quarter this year also ran 10 percent ahead of last year.

The Western District of Wisconsin, as defined by the U.S. Bankruptcy Court, includes a good amount of the state that lies in the Ninth District. It saw total bankruptcies shoot up 46 percent from 2000 to 2002, to 8,438. Statewide, Wisconsin had 24,439 bankruptcies last year, about 5,000 more than Minnesota.

The Dakotas have bucked the trend of the last few years, at least somewhat. North Dakota saw a 10 percent increase in 2001 over 2000, but totals dropped last year to 2,074 bankruptcies. This year's first quarter shows a 10 percent jump over the same quarter last year. South Dakota actually saw bankruptcies drop slightly during this period to fewer than 2,659, although first-quarter filings this year were up slightly.

Finally, the Upper Peninsula of Michigan saw bankruptcies grow to 899 in 2000, then drop briefly for a year before climbing back to 958 last year, according to the Bureau of Business and Economic Research at Northern Michigan University in Marquette. Tim Panis, senior research analyst with the bureau, said 565 bankruptcies had been filed as of June. “We're on pace to go over 1,000 this year,” he predicted.

In fact, the state of Michigan (only the rural Upper Peninsula lies in the district) had easily the highest per capita rate of consumer bankruptcy in the district as of 2002, at over 5 per 1,000 people. Minnesota is notable for the fact that its consumer per capita rate dropped for four consecutive years—to fewer than two bankruptcies per 1,000 people—before spiking in 2002 (see chart).

Though business bankruptcies are up, they have not contributed significantly to district bankruptcy levels, mostly because of their comparatively small number. In fact, business bankruptcy appears to be a less attractive option than simply shutting the company down for good, at least according to statistics from the Small Business Administration's Office of Advocacy.

Minnesota's business bankruptcies totaled 1,887 in 2001—up 27 percent. But business terminations in the state leapt 40 percent to 6,770. Annual business bankruptcies increased at a higher rate than business terminations in South Dakota in 2001 (23 percent to 19 percent, respectively), but the 2,156 business terminations far surpassed the state's 164 business bankruptcies that year. Montana in 2001 showed 149 bankruptcies and 2,404 terminations.

Source: American Bankruptcy Institute

But business bankruptcies, terminations and work slowdowns all tend to have the same effect on consumer bankruptcy. In Montana, where many residents work multiple jobs to earn a living, several instances of either bankruptcy or dramatic downsizing among large businesses there have led to an increase in consumer filings, said Don Torgenrud, a bankruptcy trustee and an attorney in St. Ignatius. For example, Montana Power Co. shed more than 3,000 employees when it moved from electricity to telephone service just in time to get washed away in the telecommunications bubble. Jore Corp. in Ronan, a maker of power tools, has laid off more than 500 people over the past two years.

But what all the figures and anecdotes mean is hard to ascertain since the government does not collect much information on bankruptcy—indeed, the best information today is collected by the ABI.

Conventional wisdom on the matter says that an increase in bankruptcy portends economic doom, and is the result of spend-happy consumers and aggressive (even immoral) credit card companies preying on the financially illiterate; even culture can play a role. While economic theory can't burn that argument whole cloth, it can poke enough holes to suggest there is still a lot to learn about the nature of credit and related risk taking, and the role of bankruptcy in micro and macro economies.

Culturally bankrupt

Jay Lawrence Westbrook, a law professor at the University of Texas and co-author of two studies on bankruptcy, points out he and two other professors are among the few who have ever studied bankruptcy records to determine income levels, assets and other data on bankruptcy filers.

Over a decade they have published two books reporting on their findings of 25 of the nation's 90 bankruptcy districts. Rates vary within states and regions substantially, he said. Indiana, around Wisconsin's size and population, records twice the number of bankruptcies as its neighbor to the northwest, a fact Westbrook does not find surprising.

“It's as much about the local legal culture as anything else,” he said. The state with the largest number of bankruptcies per capita is Tennessee and a large number of those are Chapter 13s, and much of the reason, Westbrook said, is because Tennesseans find little shame in filing for bankruptcy, though they do try to pay back what they can. “It's all about the local culture, not the state law,” he said.

“[Bankruptcy] is seen as part of doing business on an individual basis and a commercial basis,” said Dave Nadolski, a stockholder in the Sioux Falls-based law firm of Lynn, Jackson, Shultz and Lebrun PC. “Some clients are sophisticated and knowledgeable about it and see airlines doing it, and Spiegel doing it, and seemingly everybody doing it. There's not the stigma it had even 10 years ago.”

What law? I knew that

Some have attributed bankruptcy growth to consumers filing before Congress takes action on new and tougher bankruptcy legislation. That's not exactly how bankruptcy attorneys see it.

Although bankruptcy attorneys use impending congressional legislation in their advertising to attract clients in the Twin Cities, Theisen said only 10 percent of the people he represents even know the bankruptcy laws may change in the future. Roger Minch, an attorney with Serkland Law Firm in Fargo, N.D., points out congressional bankruptcy reforms passed in 1984, 1986, 1994 and 1996, and none has put a damper on consumer filings.

According to Michael Dove, chair of the Minnesota Bar Association's bankruptcy section, the current rash of bankruptcies stems in part from a weak economy. Thousands of layoffs in manufacturing and other industries have some Minnesotans unable to pay their debts, leading them to seek relief in the courts, said Dove, who is also an attorney at New Ulm-based Gislason & Hunter LLP.

But job loss is not the only factor behind rising bankruptcy trends because, in fact, the majority of Dove's clients have not lost their jobs. What they have lost is their ability to repay debt. For this, Dove points to easier access to credit debt and the falling stigma of confessing to the government you're broke and cannot pay your bills. One client had accrued $298,000 in debt on 15 cards, although the average, Dove said, is more like $15,000 spread out over three or four cards.

Many of Theisen's clients are solidly in the middle class. They live paycheck to paycheck, and one bump on the financial road—an accident, job loss or reduction in overtime—can hurtle their families into debt, sometimes accompanied by a time lag. “It's usually not something that happened last month; it happened last year,” he said. “Now there's no other way out except bankruptcy. Where bankruptcy was once one of several options, it clearly has become their only viable option when they get here.”

Previous research indicated people petitioning for bankruptcy were largely working-class people with low incomes, Westbrook said, an economic portrait that no longer appears true. In describing the typical bankruptcy filer, Westbrook says they have an average household income of a little less than $25,000, a slightly higher level of education (usually a few years of college), than the average American and often a white-collar job. The household income may have been higher in the past, but then one parent lost a job or a divorce occurred, leading to bankruptcy.

Charging into debt

Many attorneys cite credit cards as the chief culprit in bankruptcies. Panis, the research analyst in Michigan, points to debtors having as many as 16 to 20 cards on average, and while many, for a time, pay the required monthly minimums they eventually fall behind on several cards and tumble into bankruptcy. “It comes down to people spending too much money for what they have in terms of income,” he said.

“This is about credit card companies not using credit sense in making loans and giving cards to anybody,” added Randall Blake, owner of Blake Law Office in Sioux Falls, S.D. “I think that a huge part of the problem is the extending of credit to people who shouldn't have it. When people are offered credit, it's hard for them to turn it down.”

Credit card companies seem more willing now than ever before to go after the subprime market of consumers who have scarier credit ratings, said Dan Freund, a bankruptcy attorney in Eau Claire, Wis. When Wisconsin eased up on its usury limits several years ago, the subprime lenders moved into offering credit at high interest rates to what Freund calls two categories of individuals: the ignorant and the desperate. “It's a game between a consumer and lenders, and when the music stops the person getting the credit can't pay them back,” he said.

Attorneys say many clients have no clue as to what assets and liabilities they have or even a fundamental understanding of debt and equity, spending and income, household budgets and fiscal restraint. “There's a problem when you see these young, inexperienced people who don't know how to manage their money. They don't know how to survive,” said Minch. “When people are seniors in high school, they never learn anything about mortgages, checking and savings accounts and car loans.”

Even people declaring bankruptcy often start receiving credit card offerings after only a year or two, albeit with very high interest rates. Westbrook said credit card operations view bankruptcy in an actuarial manner, figuring the payoff for high interest rates and late charges more than pay for the 3 percent who default. “It's junk consumer credit,” he said.

But neither is it a foolproof business model. The Ninth District's largest subprime credit card lender, Minnetonka, Minn.-based Metris Cos. Inc., has seen its once considerable fortune falter in the wake of rising bankruptcies and a difficult economy. The nation's 10th largest credit provider closed out 2001 with a stock price of $25.54, but saw the price plummet in June to $5.32 after being hammered by consumers defaulting on credit card debt. Conseco Finance, a mobile home subprime lender with an office in St. Paul, has had a similarly rocky performance over the past five years.

First heads, now tails

Given the data void in bankruptcy—somewhat curious considering its economic prevalence—much of this bankruptcy discussion amounts to argument by anecdote, even among longtime lawyers in the business. Economic theory and current economic conditions, in fact, can at least call into question a number of the perceived causes of higher bankruptcy filings.

For example, the notion of easy credit carries a negative connotation, but economists argue that in fact it's a good thing because it shows that credit markets are open to more people and businesses. Bankruptcies might trend higher—an unfortunate side effect—but more people are able to borrow and leverage new-found capital into economic and social goods, creating a net benefit among those previously denied credit. Indeed, when banks and other credit institutions deny low-income and small businesses access to financing, they are accused of being too credit-stingy.

Some say the problem is that such credit is only available at high interest rates. But offering cheap money to people with meager resources or bad credit would be financial and actuarial suicide. Over the long term, such a strategy would either lessen the credit available on the market (as more credit institutions go out of business for failing to match interest rates with credit risk) or force good credit risks to pay higher interest rates, effectively cross-subsidizing or buying down the rates of higher-risk clients.

Other arguments might seem common-sensical and relevant at a particular time, but fail to explain long-term trends. Westbrook and his co-authors, Teresa Sullivan and Elizabeth Warren, suggest five sources of increased bankruptcy in their 2000 book Fragile Middle Class: a volatile job market and changing incomes, sky-high interest rates, divorce and single-family households, “the astonishing ability to treat medical problems—at astonishing prices,” and the "fierce determination" of Americans to “buy and retain a family home at all costs.”

Volatile job market? Yes, if you look only at unemployment since 2001. But the U.S. economy saw unprecedented, decade-long job growth, yet bankruptcies were still up over this period. What's more, even at 6 percent, U.S. unemployment is considerably lower than its historic average. Job volatility was much higher during the recession in the early 1990s, and bankruptcy rates were lower than they are now.

Interest rates, by the same token, were falling already in 2001 and reached historic lows the following year and into this year. Given the importance of interest rates in home-mortgage costs, credit card rates and other economic factors commonly assumed to affect bankruptcy trends, low interest rates should have kept a lid on 2002 bankruptcy rates, even in a soft economy, and bankruptcy rates should be smoothing out for 2003; neither appears to be the case.

Maybe most important, economic theory counterintuitively suggests that bankruptcy might even have a positive role in the economy. The fact that both bankruptcies and gross domestic product have been on a steady upward path since 1980 suggests some correlation, but this is a phenomenon that existing data or research can't yet explain.

One possibility, economists point out, is that risk taking is the fuel of capitalist markets. Bankruptcies, then, might act as something of a (lagging) indicator of risk—which would also suggest that easy credit, cultural acceptance of bankruptcy and other factors commonly derided, in fact, should be celebrated.

Speaking only from experience

About the only thing a person can say for sure about bankruptcy is that we have much to learn about it.

To Theisen, high bankruptcy numbers may be a bad thing for individuals but a good thing for the economy. He recalls a French philosopher—perhaps Voltaire, who was quite familiar with personal debt—who said bankruptcy is good for the economy because people keep buying things and employing others. “I don't think it's bad for the economy,” said Theisen. “It's just another form of risk sharing.”

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