Will the Bankruptcy Reform Bill Protect You When the Delinquency Wave Hits?
By Eric Browndorff
The devastation created by the tsunami that hit Southeast Asia was exceeded only by the worldwide outpouring of assistance, generosity and goodwill. It is both a testament to the precarious reality of our existence and the resiliency and fortitude of mankind. The tsunami resulted from an earthquake which few, if any, experts anticipated. As a consequence, there were no warning signs. There was no time to act, react or prepare.
Fortunately, the “delinquency tsunami” in lending, which many economists characterize as inevitable, is preceded by substantial warning signs. There is time to act. There are concrete steps that can be taken to fortify our positions prior to the onslaught. At the end of the day, those who ignore these warning signs and fail to provide for and manage these tangible risks will suffer, perhaps irreparably.
SOARING CONSUMER DEBT
Consumer debt is at the highest level in 50 years. The year 2004 saw a 4.5 percent increase to over $2.1 trillion. This is solely credit card and car loan debt. If mortgages and other consumer credit are included, the figure rises to $9.3 trillion. Gas prices have skyrocketed and interest rates are creeping upwards. Not surprisingly, consumer confidence and the stock market are down.
Only a gambler or a fool would believe that they could predict precisely when the bubble will burst. My professor at Cornell University always said, “The only thing constant about the economy is nothing is constant.” When assumptions like “real estate always appreciates” are raised to the level of truisms, hard lessons are learned. Turbulence, change and challenge are clearly ahead.
Neither a borrower nor a lender can presume that the days of free money will continue for long. Many contend that cleaning up one’s balance sheet by recasting a defaulted loan at lower rates is no different and no more effective than when a consumer resolves his delinquencies by obtaining a larger credit line. Both merely delay the inevitable day of reckoning.
Many consumers back into the amount they are willing to pay for their home by starting with the monthly payment. As a consequence, artificially low interest rates cause low monthly payments which artificially inflate the value of housing. Higher rates will reverse this process, causing values to plummet. If the economy does in fact travel down this slippery slope, as many predict is inevitable, the ramifications will be far reaching.
THE BANKRUPTCY ABUSE PREVENTION AND CONSUMER PROTECTION ACT
Notwithstanding low interest rates and widely available credit, bankruptcy filings in New Jersey were the highest in 5 years at 42,377. Chapter 13 filings in New Jersey were the highest in history. Nationally, consumer bankruptcies have nearly doubled in the past decade, rising 7.4 percent to more than 1.6 million in the 12 months ending Sept. 30, 2003. With or without bankruptcy reform, if the delinquency tsunami hits, there will be more defaults and more filings.
On Feb. 1, 2005, Sen. Grassley introduced comprehensive legislation to reform the existing bankruptcy code. It is similar to the bill introduced last year. The Senate Judiciary Committee held hearings to consider the bill on Feb. 10, and the pundits believe there is a 60/40 chance of it becoming law in 2005 and a 50/50 chance if carried over until 2006.
Sen. Grassley indicates that the bill is designed to cut down on abusive and frivolous bankruptcy filings which hurt the economy. If the bill becomes law, it will be much more difficult for a debtor to discharge debt through the filing of a Chapter 7 proceeding. Absent being able to overcome some significant and substantial hurdles, debtors will be forced to file Chapter 13 repayment plans or forgo filing bankruptcy entirely.
Perhaps the most difficult obstacle will be the “means test.” This prevents any individual from filing a Chapter 7 proceeding unless they can prove, with pay stubs, that their income is insufficient to fund a repayment plan. Under Sen. Grassley’s bill it will be a “flexible means test” which generally presupposes abuse of the system if the individual earns more than the state median income. While living expenses are considered, the allowances are derived from IRS guidelines that set forth what constitute reasonable expenses given the region or county in which the debtor resides.
The bill would allow any creditor impacted by the debtor’s Chapter 7 filing to file a motion to dismiss or convert the matter to a Chapter 13. If the court grants the creditor’s motion, the bill would require the court to order the debtor’s attorney to pay the creditor’s legal fees. If enacted, this may eliminate all but pro se Chapter 7 filings.
Even if a debtor overcomes these obstacles, the relief they will obtain in Chapter 7 will be substantially different than under the current law. The discharge itself is conditioned upon the debtor taking a personal financial management course; and if they intend to retain their motor vehicle, they will have to pay the full cost of the auto loan irrespective of whether the balance due exceeds the value of the vehicle.
For the first time, there are nationwide restrictions on exemptions for real estate and retirement funds. Irrespective of whether the debtor files in Florida, Texas or anywhere else in the nation, the bill would provide for a national cap of $100,000 on the homestead exemption, provided the house was purchased within two years of filing. Any amounts over $1 million in IRA accounts are available for creditors. These provisions, known in some circles as the anti-Enron provisions, are designed to prevent forum shopping and prevalent asset protection schemes by the “formerly wealthy.”
There are also provisions in the proposed bill which will require lenders to take specific steps to advise customers how long it will take to pay off their balances, prohibit deceptive advertising with respect to low rates, deal with predatory debt collection practices, and penalize credit card companies who refuse to consider out of court repayment plans. Notwithstanding these provisions, it is clearly a pro-creditor bill designed to protect creditors from perceived abuse.
Will the passage of these bankruptcy reforms protect lenders from the turbulent times ahead? Some experts answer unequivocally, “no.” They contend that, “Ninety percent of families declare bankruptcy not because they suddenly decide to avoid their obligations, but because one of three family emergencies occurs: a job problem, illness and/or accident, or divorce.” Surely, if the bubble bursts, real estate values plummet and consumer delinquencies rise, this bill will be inadequate to protect creditors. Some believe it will create a class of individuals unable to own assets, unwilling to work hard enough to generate meaningful income, and individuals permanently dependent upon governmental assistance.
The unscrupulous predators are unfazed by these consequences. Responsible bankers understand that the key to preventing much of this despair and preparing for the inevitable tsunami begins at the underwriting stage. Loans that are based on rational and reasonable underwriting criteria, which are properly documented and have a basis in hardcore value, will survive even the most difficult environmental changes.
We strongly encourage each bank to examine its portfolio to insure that even the most current credits are sturdy enough to withstand whatever may be forthcoming.
Eric Browndorf, Esq., is a partner and chairman of the Creditor’s Rights Department of Cooper Levenson April Niedelman & Wagenheim, P.A. He has restricted his practice exclusively to banking, creditor’s rights, bankruptcy and commercial litigation. He may be contacted at firstname.lastname@example.org. His professional associations include the New Jersey Bankers Association, New Jersey Mortgage Bankers Association, New Jersey Consumer Creditors Association, American Bankruptcy Institute, National Association of Trustees and Creditor Debtor’s Section of the New Jersey Bar Association. He has lectured throughout the United States on creditor’s rights to attorneys, bankers, accountants and national consumer lending institutions. A footnoted version of this article is available from the author.