The Unintended Consequences of the 2005 Bankruptcy Law

By Dawn Handschuh, Personal Finance Writer Archive

Five years is a long time to live on macaroni and cheese. That's how long debt repayment could last for someone filing under Chapter 13 bankruptcy (reorganization).

Used to be, a judge decided how much you'd pay toward debt based on your circumstances. But the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act applies stricter IRS standards to define rent, food and other allowances as part of a formula to determine how much you'll pay toward debts.

So if you're paying a higher-than-average rent, better start shopping at thrift stores.

The "means test" (or "mean test," according to detractors) determines whether you're eligible for Chapter 7 bankruptcy (asset liquidation), basically limiting Chapter 7 filings to low-income households.

Bankruptcy filing rates plummet

Bankruptcy filings dropped dramatically since the new law took effect. As of June 30, 2007, Chapter 7 filings were down 61% from a year earlier. Chapter 13 filings dropped 6%.¹

Because the bankruptcy law made it harder to file under Chapter 7, pushing more people toward Chapter 13, critics said it was really a gift to credit card companies, who stood to gain.

Credit card issuers and banks argued that a new bankruptcy law was needed to prevent abuse of Chapter 7 by debtors looking to use bankruptcy for a free ride.

Of course, when less debt is forgiven in bankruptcy, lenders profit.

Some draw a connection between the rapid increase in bankruptcies before 2005 and the growth of credit card debt, which quadrupled between 1980 and 2004.²

Some consumers may never learn good money management habits. Still, changes in lending practices, which would prevent creditors from extending credit to those who can't afford it, might serve consumers better.

Foreclosure rates rise
While bankruptcies have dropped, the sub-prime tsunami continues. More Chapter 13 filings mean more households face repayment plans on all debt. That means more consumers trying to pay off car loans, credit cards, and medical bills — along with ballooning variable-rate mortgages that once were excluded or discharged under Chapter 7.

While the 2005 bankruptcy law didn't directly cause foreclosures, it certainly didn't do financially-strapped homeowners any favors.

Footnotes

¹ www.uscourts.gov
² The National Bureau of Economic Research