Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
The continually rising bankruptcy rates are a perplexing aspect of an economy that has more people employed than ever before, earning more money than ever before, and holding consumer optimism at near-record levels.
Yet every year more than 1.3 million Americans--nearly 1 in every 100 households--declare bankruptcy.
But as a result of proposed changes in federal personal-bankruptcy laws, there are more reasons than ever before to avoid bankruptcy--except as a very last resort. Congress is debating new legislation to deal with the issues of who may “wipe the slate clean” through the bankruptcy law, and who should be forced to repay at least a part of his or her debt.
The issue is politically charged. Democrats tend to believe that lenders have pushed easy credit onto gullible consumers, thus causing the rise in bankruptcy filings. Republicans line up on the side of creditors, saying that current law makes it too easy for consumers to get out from under the obligations of their debt.
But while the larger philosophical issues have political opponents lining up to debate the causes, Congress is being asked to reshape the law in ways that should make consumers think twice about the economic consequences.
The old moral arguments against bankruptcy don’t seem very effective in the “new economy.” The stigma of bankruptcy has largely passed--especially as major corporations and popular movie stars declare bankruptcy without shame. And the everybody’s-doing-it mentality seems to override the argument that when one borrower defaults, all of the rest of us pick up the tab in the form of higher prices.
Even the practical arguments against bankruptcy have less weight. In the past, it was assumed that you could never get credit again after filing for bankruptcy, because the filing would stay on your credit report for 10 years.
But now an entire industry has grown up to extend credit to people who have previously filed for bankruptcy. You can easily get a car loan, even a mortgage loan as the headlines blare: “Bad credit, no credit, no problem!”
So why not file for bankruptcy? Chapter 7 of the bankruptcy code wipes out all debts, while Chapter 13 allows the debtor to keep some assets in return for making regular repayment of at least a portion of his or her debts. While state courts can establish their own rules for minimum assets to be retained in a Chapter 7 filing, most follow the national guidelines, which allow debtors to keep $7,500 in home equity, $1,200 in equity in a car, $4,000 of household items, $4,000 cash value life insurance, and tools of a trade, as well as books.
States such as Florida also have a “homestead exemption” which allows an unlimited amount of value to be sheltered in a personal residence. That has led to millionaires filing business bankruptcies, while maintaining palatial estates for their personal residences in Florida.
Congress is now looking to close that particular escape route. One proposal is to require a two-year residency before a person becomes eligible for a bankruptcy homestead exemption.
But the most potentially painful amendment to the bill being negotiated is a proposal to make retirement plan accounts--currently mostly off-limits to creditors--partly available to settle old debts.
Currently, 40l(k) plan accounts are subject to federal Employee Retirement Income Security Act laws that protect retirement accounts, and thus they cannot be attached by creditors.
Many people assume that IRAs fall under the same legislation, but several states currently consider IRA accounts to be part of a debtor’s estate for debt-repayment purposes. Illinois law holds that if a pension plan meets ERISA standards, the asset is beyond the reach of creditors in a personal-bankruptcy case.
But one proposed change in the federal bankruptcy laws would exempt only $250,000 in retirement plan accounts from a debtor’s assets.
It’s likely that consideration of the entire bankruptcy reform bill may be postponed in this political season, or these proposals may be attached at the last minute to some other pressing legislation. But the debate signals that consumers may have new reasons to get their financial house in order while the economy is humming along.
We don’t have debtor’s prisons in America. In fact, that was one reason many of our founding fathers set sail for the New World. America has always believed in second chances. But if the economy sours, and the market falls, and jobs are lost, and home equity loans are foreclosed, we could see another surge in bankruptcies.
This time the debtors will not get off so easily. And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail at firstname.lastname@example.org. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.