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03/27/2005

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Craig Jordan

I hope the bankruptcy bill will lower interest rates generally, but I doubt the effect will be very significant. Most credit card issuers use risk-based pricing, so rates for prudent borrowers presumably will not be changed in response to the bill, as those rates don't presently contain any significant bankruptcy premium.

Unfortunately for high-risk, high-rate borrowers, the market mechanisms that would drive rates down in response to the reduction in bankruptcy risk rarely apply. For the most part, these borrowers were originally extended credit at favorable rates, but because they were late in making payments (2 late payments in 6 months is a common standard) or because their credit score has dropped they get hit with penalty rates of 24% or more. These rates are imposed retroactively to their existing balances, not just to new transactions, so these borrowers' ability to reduce the impact of the penalty rate by simply switching to another credit card provider for new charges is substantially reduced. Moreover, these borrowers' capacity to transfer balances to competing cards is often limited compared to that of low-risk borrowers. As a result, the credit card companies that impose these rates may do so with only limited risk of losing revenue to competitors, and therefore with only limited incentive to pass their reduced bankruptcy costs to these borrowers.

Is there a sweet spot in the risk curve where the bankruptcy premium in current rates is significant and where competition will require a reduction of the premium? I doubt it.

Rather than precipitating a transfer to the prudent from the imprudent, the bankruptcy bill will result in a transfer to the politically connected from the politically unconnected.

Josh

I'm curious why the consumer has to unilaterally disarm in the "vicious cycle" discussed above. Why not impose stricter limits on interest rates and follow that with bankruptcy reform? There's an important issue of time lags in the rate at which interest rates will update after this. And since the debt is already there from existing interest rates, this reform seems to put the cart before the horse.

Corey

Here we are again in fantasy-land. We eat mushrooms, and they make us believe that giant
banks which are beholden to nothing but the profit motive of their shareholders will
unilaterally reduce their interest rates from
30% because they are just so... warm and caring.
In fact they would have done this long ago, but those shifty irresponsible citizens to which they have been loaning billions and billions of dollars just forced their hand! bah.

Interest rates will ALWAYS be as high as the market will bear absent positive regulation. A company which does otherwise will be punished by its shareholders. This new law reduces the incentive of companies to lower interest rates because they no longer need worry about people escaping even the most aggressive loan sharking.

What under the new scheme prevents MBNA from charging you 200% interest on the debt you currently have? Even the minimal competitive
pressures of the increasingly monopolistic credit industry don't work for you once they decide you are more valuable as a loan-slave than a future borrower. Want out under Chapter 13? OK, we'll
destroy your credit rating for 10 years and by the way, you still have to pay for at least 5!
Ha ha ha ha! Sucker!

This legislation was written and aggressively
lobbied for by MBNA and other credit companies
for a decade until a suitable pro-business
majority took control of the government. Now Posner and others would have us believe that having escaped billions in responsibility for bankruptcies stemming from bad loans, MBNA will be so overjoyed as to forgo billions in profits by reducing its usury. Yeah, and monkeys might fly out of my butt.

An amendment to the new Bankrupcy prohibition was
proposed that would limit maximum credit card
interest to 30%. The amendment was violently opposed and REJECTED 74-24 in the Senate. Why, if the purpose of this legislation is to enable benevolent mega-corporations to be nicer to consumers, would those corporations care about maintaining their right to gouge consumers with high interest? What purpose do those rates serve if the law passes? Obviously, the amendment failed because MBNA intends to continue to charge 30%+ everywhere it can.

Another consideration that proponents of this law ignore is the fact that 100 million Americans negotiated their current debt arrangements in reliance on the existance of Bankruptcy protection for severe economic reversals. This new "reform" changes the law midstream on people who are in good faith trying to repay their debts.

Even if a particular consumer overspent in comparison to forseeable risks of medical (or other) emergency, there is no justification given for dumping responsibility on him or her as opposed to the bank which must have similarily overextended credit in comparison to forseeable risks of default. The plain pro-corporate bias of this law is so facially apparent that it makes me sick.

BillSaysThis

Behind the Bankruptcy Reform Act, as behind the Presidents proposal for social security reform, is an ideology of giving nonwealthy people greater responsibility for their own economic welfare...

First, I agree with the previous comments on the likelihood of banks reducing interest rates in response to this legislation and that, even if they do, quite some time will pass before it happens as the new rules effect borrower behavior.

Second, your comment on the plight of individuals forced into bankruptcy under current rules by medical emergencies is so condescending I'm reminded of the first days this blog was published and people were questioning its authenticity; I mean your comments are just heartless.

However, I'm most concerned with the opening of your last paragraph as quoted. That statement is such a bunch of marketing spin malarkey that I'm surprised you were comfortable publishing it on Easter Sunday. The reason for this legislation and for social security reform is to benefit the wealthy investors and contributors who supported Bush's re-election.

This analysis is clear from reading the details of both packages instead of the rhetoric coming from the politicians. In the long run, as Santayana said, we are all dead but in the meanwhile both of these absurd political trickbags will cost the mass of our society substantial amounts of money and emotional distress.

The required government borrowing in the first two decades, if Bush's SSR plan passes, will put huge profits into the pockets of bond investors and investment banks while pushing up interest rates paid by middle income consumers. The bankruptcy legislation, to its credit with those same investors, is riddled with loopholes that benefit only the wealthiest percent or two.

One can only hope you'll revisit your thinking on these subjects and lend your voice to those of us who are trying to see this emperor's real clothing.

Daniel Chapman

I don't know... I have no background in economics, but I understand that competition drives low prices. No matter how much opponents of this bill try to show otherwise, most consumer debt is voluntary. Since creditors want to attract borrowers, they will compete to please the customer. This means that interest rates and other benefits will favor the consumer as much as possible in order to let the creditor still turn a profit.

How does it not make sense that lowering the risk of lending will lead to lower interest rates? It seems paranoid to suggest otherwise.

Palooka

"What under the new scheme prevents MBNA from charging you 200% interest on the debt you currently have?"

State usury laws.

Palooka

I agree that the reform will lower rates, ceteris paribus, though I am not certain the consumer will be congnizant of these rate decreases (as they may be relatively small and may be offset by other economic variables).

I have a lot of thoughts, which I plan to share later, but I wanted to throw out this one idea and see what others think. The reform requires lower income, higher debts, etc to qualify for chapter 7 bankruptcy. The catch here is that the reform--like so many government actions--creates some unintended consequences which are counterproductive. If someone is in moderate financial trouble with a decent paying job, they have a considerable incentive to lose their job and accrue more debt. Whereas someone may have just filed for bankruptcy pre-reform, but kept their well-paying job and not accrued more debt. Now it seems there would be incentive to intentionally worsen their financial condition as to qualify for the better bankruptcy protection. The reform may produce some considerable moral hazard issues, if I understand it correctly. Am I crazy here? Somebody tell me I am wrong!

Craig Jordan

State usury laws don't apply to credit cards issued by federally regulated financial institutions, as they are preempted. The institutions can choose to adhere to a federal usury rate or to the rate applicable under their home state's law. That's why the major companies have all located themselves in Delaware, South Dakota and Nevada, states that have no usury ceilings.

Corey

"How does it not make sense that lowering the risk of lending will lead to lower interest rates? It seems paranoid to suggest otherwise."

Well, see, that's the basic assumption that
proponents of the bill make. They say, "Interest rates are high because of high default rates."

In fact, interest rates are high because of a number of factors, including softening or total repeal of usury laws, unprecedented amount of debt being extended, and collusion in the marketplace. (for example, rates on one card tied to payment performance on other cards via the magic of FICO scores)

Credit card companies are at least partially responsible for the "risk of lending" that they claim is hurting them and requiring this law. But anyone with 15 minutes and access to the internet can see that major credit card companies have been making record profits. If high default rates were a problem serious enough to warrant wholesale changes in settled bankruptcy laws, it would be reasonable to ask credit card companies to show how their alternative solutions were not working. Of course, this isn't a reasonable law, it is corporate welfare to one of the largest political contributors, MBNA.

So now a bunch of free-contract ideologues want to change the law in a way that reforms the circumstances under which every American with a credit card originally contracted. (Almost as ironic as the States Rights ideologues trying to use the Federal Courts to overturn a FL state decision.) Well, I guess I will go out and bargain with a multi-national bank. I'm certain they will give me a fair deal in the absense of any legislative reason to do so. After all, I am handsome and I have red hair!

Corey

One other thing... saying that spending is voluntary is not the same thing as saying that debt is voluntary. Characterizing consumer debt as a choice does not resolve the issue. (And not just because it overlooks the choice made by the creditor to risk loaning the money.)

Unforeseeable reversals (medical emergency, loss of a job) can transform a perfectly reasonable consumer debt into an involuntary servitude. We want to encourage investment in the future, so we look favorably on a young person who might buy an expensive suit to assist in a job interview, or purchase a car upon graduation from college in order to commute to a job. When that job is lost without cause because of a stock market reversal, the question becomes "who bears the risk relative to repayment of the loan."

The consumer is the obvious choice, until we realise that the debt company has evaluated and priced the risk of default into the terms of the loan. This is obvious from the record profits derived even in a period of record defaults.

The bankruptcy "reform" law drastically reduces the risk of default to near zero. The authors of the law resisted inclusion of ANY limit on creditor's ability to charge the highest rate the market will bear.

David Nieporent

Corey: they make us believe that giant banks which are beholden to nothing but the profit motive of their shareholders will unilaterally reduce their interest rates

This is true of all businesses and all products. And yet, we do not see million dollar Chevrolets or 20% mortgages or milk that costs $30/gallon. It is not because they are prevented by law from having high prices. It's because the "profit motive" requires them to keep prices at levels where they can actually gain customers.

So now a bunch of free-contract ideologues want to change the law in a way that reforms the circumstances under which every American with a credit card originally contracted. (Almost as ironic as...

A complete non-sequitur. People contracted for certain benefits and costs. People may have considered the state of the bankruptcy code (doubtful, but possible) when they entered into these contracts, true. Of course, that's true of every single contract ever entered into, not just credit card contracts. That doesn't mean the code itself was part of any of these contracts.

If it did -- that is, if your reasoning were valid -- the bankruptcy code could never be changed at all because there would always be millions of existing contracts which one could point to and say, "We shouldn't change the circumstances under which these contracts were entered into." But your logic isn't valid. There's nothing special about the 1978 bankruptcy code.

The bankruptcy "reform" law drastically reduces the risk of default to near zero.

No, of course it doesn't. Nothing in the law "reduces the risk... to near zero." Indeed, for lower income people, the law doesn't change bankruptcy much at all. There is no basis for this hyperbole. Your comments seem predicated on the strange notion that Congress is abolishing bankruptcy.

-----------

Bill: The reason for this legislation and for social security reform is to benefit the wealthy investors and contributors who supported Bush's re-election.

If that were the case, we wouldn't expect it to see bipartisan support.

In the long run, as Santayana said, we are all dead

That was Keynes.

hyh

At what point, if ever, will corporations formally be expected to possess and demonstrate responsibility beyond maximizing profit and/or return to shareholders? I won't accept the corporate social responsibility malarky because anyone who has spent time inside a large for-profit corporation knows who wears the pants in that family. And I don't buy the argument that individuals have the ability to seek redress in courts because that playing field is not fair given the discrepencies in legal resources between individuals and corporations, nevermind the tort reform that will flow like manna from the current Congressional high priests of business.

Are we individual human citizens really expected to attribute to corporations some degree of ethical behavior and responsibility to society? One can only hope that the corrective mechanism of pupular democracy will kick in sooner rather than later in response to these latest corporate wealth creation proposals. Problem is, such corrective measures will be painful and disruptive. There must be a better way.

Corey

There are CURRENTLY no restraints on credit card
interest rates beyond "ability to gain customers".
This is why all credit cards come with "low introductory rates" and an often unread contract term that allows rates to be raised arbitrarily.
The top "penalty" rate on most if not all cards now is 30%, 40% on some. Many free-thinking individuals find these practices unfair, immoral, and counterproductive to repayment.

So we go from no restraints to no restraints,
but drastically reduce the risk exposure of one side at the expense of the other. Then when confronted, we rely on market theory to reduce fears that Widow Smith will be charged 50% interest on the loan she takes to buy her cancer meds. Maybe your fears are reduced, all I can say is, if this law passes you are in the jungle with the rest of us. I hope you are rich and tenured.

"Indeed, for lower income people, the law doesn't change bankruptcy much at all."

And for Norwegians, it doesn't matter. Means testing to "qualify" for Chapter 7 is the same thing as abolishing Chapter 7 if the means minimums are so low that you have to be homeless to qualify. The whole point in bankruptcy is to provide relief BEFORE people are reduced to the nonproductive status of impoverished property-less beggars.

"If that were the case, we wouldn't expect it to see bipartisan support."

hahahahahahaha... oh wait, you were serious...
I have news, the Democratic Party only looks to be on the side of consumers because they are standing next to the Republicans. MBNA contributes to practically everyone but Nader.

If we remember our civics classes, Congress is not supposed to make retrospective laws. I believe that would be Article I, Section 10, Clause 1 of the good old Constitution... yep, no ex post facto laws. OK, so given that there is over a trillion dollars in debt that was extended with both parties relying on the current regulatory scheme (yes they do), how can we argue in good faith that the imbalanced nature of this current law does not upset settled expectations in an unequal way? Even if we allow the law, why do the debtors have to bear the sole risk of changes to the regulatory scheme...

Because debtors don't have the ability to influence the regulatory scheme! Collective action problem. How fortunate for the creditors that there are increasingly few of them! Collusion by uniform business practice is the number one undiagnosed cause of market failure.

Corey

Oh, sorry, technically the Federal prohibition on ex post facto laws would be Article 1, Section 9, clause 3. The clause I cited is the State prohibition.

I guess I might get a bad grade in Con Law.

John David Galt

Posner asks why debtors are ever allowed to discharge their debts. There are two, related, answers: one, nondischargeable debts in excess of one's assets would constitute involuntary servitude and violate the 13th Amendment (this is how I was taught it in school, correct me if I'm wrong); and two, even in the early days of our republic, the usual alternative -- debtor's prison -- was considered unacceptable and abolished (though in recent decades it seems to have been reestablished, at least for child support debts, by the workaround of finding the debtor in contempt of court and fining him the amount of the debt for not paying).

I believe that payback plans such as Chapter 13 and Chapter 11 (both now allowed for individuals, as I understand it) are an acceptable alternative to discharge and would have no problem with seeing Chapter 7 bankruptcy abolished. However, I would first like to see a reform of those aspects of bankruptcy law that unduly discriminate in favor of the rich. There is no way that a homeowner should be allowed to exempt a six-figure house from forfeiture during (any type of) bankruptcy, while someone who has never owned a home is not allowed to exempt a similar amount of assets he does have.

I would also like to see reform in the case of the child support situation. Often courts will impute these people an ability to earn income that vastly exceeds reality, and then jail them for not paying support that exceeds their real income. Ideally the debtor's prison should be re-abolished; but if there must be involuntary servitude, at least make the court responsible for finding the defendant that good job before claiming that it's available to him.

Robert Schwartz

I am a lawyer with 30 years of experience. In the course of my career I have provided advice and representation to Credit Card Companies (CCC) in connection with the operation of their businesses and major transactions.

Judge Posner said: "Under the present system, the prudent and the imprudent consumer pay the same high interest rates, assuming creditors cant readily determine which consumers are prudent and which are imprudent."

However, the life of the law is experience, not reason as Holmes said.

First, the Credit Card Companies (CCC) can, and do, make very fine determinations on who they will lend to, how much they will lend, and what rates and fees they will charge the debtor. As is explained in the text and transcripts of the Frontline program cited by BillySaysThis above, the CCCs use the stagering data gathering abilities of the Credit Bureaus and the analytic tools provided by Fair Issac and others to make these determinations on a real time basis. (Have you gotten your free credit report yet, if not why not, go to http://www.annualcreditreport.com/ you will be amazed by the amount of information they have).

Second a little history is instructive. Before the early 1980s CCCs could not exploit the national bank loophole to state usury laws, and many, if not most state usury laws were quite restricitive. IIRC, New York limited rates to 12%. In 1980 interest rates shot up as the Federal Reserve tried to get the inflation of the 1970s under control. When the prime rate peaked above 20%, the CCCs went to the legislatures and asked them to raise the usury ceilings, which they did. In the 1980s Banks also gained the right to set up in States other than their traditional homes.

The convergence of these phenomena allowed the banks to set up CCCs in states that would let them charge unlimited rates. It was only then that credit cards with rates well in the 20s appeared.

Since that time, there has been no general decline in credit card rates, despite the fact that money rates have declined fairly steadily from their 1980 highs down to the low single digits. To be sure the CCCs offer low rates, sometimes as a teaser and sometimes to a very limited subset of their customers. But the bulk of the CCC's debtors pay high rates, which are jacked up at the slightest hint of financial trouble.

If the CCCs have been so stingy with rate reductions that could be made because of the much lower cost of funds, why should we expect them to more generous with the much smaller gains attributable to changes in the Bankruptcy Code. Isn't it just as likely that they will apply the profit to increasing market share by lending to riskier customers rather than reducing costs for existing customers?

Two more points:

First on the debtors prison point raise above. Now that many people will not be able to elect between Chapters 7 and 13, they will be the slaves of the bankruptcy court. If you are worried about this prospect, you are justified.

Read "U.S. Gets Tough on Failure to Repay Student Loans", Wall Street Journal 1/6/05 (No URL, $). There was a story about methods used to collect from bankrupt student loan debtors. One aids patient was having his disability payments garnished. Another case was a student, Jonathan Gearhardt who had studied cello in music school. He even found a job playing for an orchestra in New Orleans. His student debt was almost $100,000. He was working and making $20,000/yr and was the envy of his classmates because he was working. Now an orchestra job may only be 15 hours a week of playing and rehearsing, but he also has to put in 4 to 6 hours a day of practice to keep his chops up. The trial job heard his story and discharged his debt. The creditor appealed! and the circuit overruled the trial judge and told the debtor to take a second job!!!!!!!!!!!!!!!!!!!!!!!!!!!

Want another glimpse of the future read 255 B.R. 555. Basically, the reform will encourage this type of judicial micromanagement of debtors lives and discourage the use of Bankruptcy Court. I know that this case was a judicial mugging, because I know the debtor personally and well. The money went entirely into his kid's educations and charity. He had sold the house, which was not a palace. He was driving an old car and taking the bus to work. at the age of 50+ the debtor who is a lawyer,was busting his butt -- 2500 hours, after heart surgery.

This is a very grim view of the future.

Another point. One of the engines of economic growth has been the willingness of Entrepenures to take risks. By depriving them of the ability to use Chapter 7 as a life raft will be interfering with that engine of economic growth?

Finnaly, I want to note that I am not a liberal. I have not voted for a Democrat since 1976. I believe in free markets and freedom of contract. But this is one time that I think a lot of folks on the right have got it wrong.

John Smith

Posner seems to posit that if the total/overall amount of credit offered were lower, then interest rates would be lower. This is probably true, as if no credit were offered, then the interest rate one received would be perfectly proportionate to one's foreseeable ability to repay over the term of the loan. But this is not a defense of prohibiting bankrupts from squirming out of repayment, it is an argument in favor of limiting the total amount of credit offered and encouraging personal savings. The same gains could be realized by taxing credit card companies that exceed a certain level of credit-lending, much like we "tax by regulation" energy companies that exceed a certain level of pollutant emissions. In fact, we could make entry into the credit-card company more difficult, by drastically increasing the licensing costs. This would jack-up the price of using a credit-card, which would discourage use of a credit-card. Posner could argue that without plugging up the back-end, people would just escape paying their debts, but we could make it easier to escape paying credit-card debt, thus increasing the tax the credit-card companies so much that their continual losses in bankruptcy court would encourage them to stop over-lending credit to those who cannot foreseeably repay. There is no reason why we must plug up the back-end and side with the credit-card companies, other than pro-business libertarian ideology, if the problem is that credit-card companies are lending too much credit.

John Smith

By "perfectly proportionate to one's foreseeable ability to repay over the term of the loan" I meant the assets one has and one's foreseeable cash flow.

John Smith

Sorry, by "the credit-card company" I meant "the credit card industry"!

RWS

In response to Robert Schwartz's posting of the case from the Bankruptcy Record, I think the ruling in that matter was correct. The lawyer was making well over $100,000 per year at a large law firm but had spread himself too thin. Even at the time of bankruptcy, he still had kids in very nice private schools, and his wife had a $350 per month cleaning lady because she apparently wanted to preserve her clean lifestyle, despite the fact that the wife did not work.

Giving to charity is a luxury that credit card companies should have zero obligation to subsidize at his discretion. The fact that his wife does not even work is also significant. Lastly, private high school for kids is a major luxury. The man had 15 credit cards listed in his bankruptcy liabilities with 6-figure debts to them. Apparently, credit card spending should have been replaced by saving for his kids' education. Credit card companies and their customers should not have to finance that.

His was a straightforward case for Chapter 13; looks like the ruling was correct.

--

A very good lawyer friend in town killed himself about two months ago because he could not keep up his very luxurious lifestyle after his client base dried up and he had to declare personal bankruptcy. It was truly one of the saddest funerals I have ever been to, but he was the one that refused to see reality and cut back to reflect that financial reality. Refusal to cut back and live more modestly, as personally humiliating as that might feel, is a private matter and not one for public subsidy through Chapter 7.

Anonymous

Why not bring back debtor's prison?

lincoln

First,I'd like to thank Judge Posner for making this act understandable to me.Then a few comments to Corey.Interests rates of companies will fall if they can increase their volume of lower risk customers.All it takes is one company to lower rates (if it is profitable to do so) and the others must follow suit or lose customers.Secondly,you never replied to my query(some time ago) on the name of your insurance plan that only allows generics.Would you please do so?Finally, since the bankruptcy plan is only applicable to the population with incomes above the median it has no chance of lowering rates to near zero.

John Smith

"If bankruptcy is more costly, there will be less of it."

If lending credit is more costly, there will be less of it.

David Nieporent

And for Norwegians, it doesn't matter. Means testing to "qualify" for Chapter 7 is the same thing as abolishing Chapter 7 if the means minimums are so low that you have to be homeless to qualify.

And if buses had wings, they'd be 747s. But they don't and they aren't. The means minimums are not "so low that you have to be homeless to qualify." They're based on median household income. If you're in the bottom half, incomewise, it doesn't affect you. This isn't exactly poverty line.

If we remember our civics classes, Congress is not supposed to make retrospective laws. I believe that would be Article I, Section 10, Clause 1 of the good old Constitution... yep, no ex post facto laws.

Ex post facto is a criminal concept. If bankruptcy laws fell into the ex post facto category, then there could never be any changes to the bankruptcy code, ever.

how can we argue in good faith that the imbalanced nature of this current law does not upset settled expectations in an unequal way? Even if we allow the law, why do the debtors have to bear the sole risk of changes to the regulatory scheme...

Any change will affect debtors and creditors "in an unequal way," so again, we're back to the issue of you trying to lock in the bankruptcy code permanently. You act as if the current bankruptcy code is sacred, as if, miraculously, they got the balance between debtor and creditor perfectly right the last time and therefore any change in favor of creditors is somehow unfair.

--------------

In addition to Mr. Schwartz's anecdote about the wealthy lawyer who wanted to lead a lavish lifestyle while not paying his debts, Mr. Schwartz also provides an anecdote about a musician who he feels was treated unfairly. But if we're to accept that anecdote at face value, this person borrowed $100,000 and decided to spend it in such a way that he would have no realistic shot of ever paying it back. Why should we feel sorry for such a person?

I have always operated under the assumption that advocates will trot out the most heartwrenching stories they possibly can in order to sway us. If the best sob stories that an advocate can come up with are ones involving unsympathetic figures, that suggests to me that their case is really weak.

Palooka

"But if we're to accept that anecdote at face value, this person borrowed $100,000 and decided to spend it in such a way that he would have no realistic shot of ever paying it back. Why should we feel sorry for such a person?"

I do not support the bankruptcy reform, though I would support more minor reforms. But I thought the exact same thing about that scenario.

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