Consumer Over-Indebtedness: A U.S. Perspective

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1 Consumer Over-Indebtedness: A U.S. Perspective A. MECHELE DICKERSON SUMMARY I. INTRODUCTION II. U.S. CONSUMERS AND OVER-INDEBTEDNESS A. Going into Debt: In General B. Credit Card Debt C. Housing Debt Benefits and Perils of the Democratization of Homeownership Current Crisis III. U.S. RESPONSE TO OVER-INDEBTEDNESS A. The Consumer s Right to a Fresh Start B. The Consumer s Duty to Behave Responsibly: BAPCPA C. BAPCPA s Success? IV. COMPARATIVE PATTERNS OF INDEBTEDNESS A. Going into Debt B. Getting out of Debt V. POTENTIAL SOLUTIONS FOR CONSUMER OVER-INDEBTEDNESS A. Need for Response B. Crafting a Response: Recognizing Creditor Motivation C. U.S. Response to Consumer Over-Indebtedness Disclosure and Consumer Education Regulation Changing Issuer and Lender Practices VI. CONCLUSION Fulbright and Jaworski Professor of Law, University of Texas School of Law. I delivered earlier drafts of this Article in lectures I presented on October 2, 2007, at the Federal University of Rio Grande do Sul in Porto Alegre, Brasil and on October 3, 2007, at the annual meeting of Consumer Protection Division of the Federal Office of the Attorney General. I am grateful to the Hon. Antonio Benjamin and to Professor Claudia Lima Marques for inviting me to present these lectures and to Brasilcon for providing support for the lectures. I also am grateful to the editors of the Texas International Law Journal for their assistance with this Article. 135

2 136 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 I. INTRODUCTION Contrary to conventional wisdom, consumer over-indebtedness is not, by itself, a bad thing. Indeed, credit can be a good thing since it lets people pay for current expenses using future income. High current debt levels are acceptable for people who have good reason to believe their income will increase in the future. Over-indebtedness may also enhance the present quality of life of consumers who can afford to repay their debts with future income because it lets them splurge and occasionally buy luxury items. In addition to the benefits to the consumer, consumer spending (and high debt levels) also help develop a nation s wealth and, in the case of the United States, has kept the nation s economy from stalling. 1 Of course, the reason for the current global consumer over-indebtedness problem is not because consumers are in debt. Or that their debts exceed their income. Rather, consumers are waaaaaaaaay in debt. They are drowning in debt and are not likely to receive relief under the present consumer insolvency statutes. This Article will discuss overall consumer over-indebtedness in the United States and two specific types of credit that have increased consumer debt in the United States: credit cards and mortgages. It describes how the U.S. Bankruptcy Code allows consumers to rid themselves of some of their debts and then contrasts consumer over-indebtedness and the U.S. response to this problem to that in other countries. It concludes by suggesting ways that the U.S. Government could respond to consumer over-indebtedness and issues Brazil should consider in deciding how or whether to adopt a comprehensive consumer insolvency regime. II. U.S. CONSUMERS AND OVER-INDEBTEDNESS A. Going into Debt: In General A recent article in the Harvard University alumni magazine observed that [c]onsumerism is as American as cherry pie. Plasma TVs, ipods, granite countertops: you name it, we ll buy it. 2 Americans are voracious consumers, but meager producers and savers. By way of contrast, the difference between what Americans produced and what we consumed in 2006 is about equal to the entire annual output of Brazil, which is striking since Brazil ranks tenth in the world in total GDP. 3 Because the United States consumes much more than it produces, the U.S. economy relies heavily on imported goods. 4 In fact, the U.S. economy is now based on providing financial services, not the production of goods. This shift from a manufacturing to a financial-services economy, often referred to as the financialization of the American economy, 5 means that, instead of making money by 1. Consumer spending has kept the U.S. economy afloat and if Americans were to stop consuming, our economy would collapse. Spending, Incomes Disappoint; Public Projects Help Offset Housing Slump, CHI. TRIB., June 30, 2007, at C3; Nell Henderson & Howard Schneider, Commerce Report Raises Eyebrows: Slower Growth and Higher Inflation Suggest a Hint of Stagflation-Lite, WASH. POST, Apr. 28, 2007, at D1; Gretchen Morgenson, Economy Is Surging but Wall St. Is Down in the Dumps, N.Y. TIMES, Apr. 27, 2002, at A1. 2. Jonathan Shaw, Debtor Nation: The Risking of the American Dream, on a Borrowed Dime, HARV. MAG., July Aug. 2007, at WORLD DEVELOPMENT INDICATORS DATABASE, WORLD BANK 1 (2007), resources.worldbank.org/datastatistics/resources/gdp.pdf. 4. The increase in U.S. imports has been good for our trade partners but detrimental to the U.S. labor market. See Martin Feldstein, The Return of Saving, 85 FOREIGN AFF. 87, May/June See Greta R. Krippner, The Financialization of the American Economy, 3 SOCIO-ECON. REV. 173, 174

3 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 137 making things, Americans increasingly make money by moving money around. Much of this financialized economy involves moving money from the financial services industry to consumers in the form of consumer debt. In 2006, total U.S. household debt was $12.8 trillion, an increase of more than a trillion from total household debt in Debt has risen much faster than income for middle-income families in the United States and the ratio of debt to disposable income is now approximately 125 percent. 7 Some of this debt level is no doubt attributable to the seemingly insatiable desire of U.S. consumers to have the latest gadgets, trinkets, and toys. But many Americans, especially lower- and middle-income Americans, borrow money and use credit to compensate for stagnant or declining wages and to pay for health care, spiraling college tuition 8 and, increasingly, for housing. 9 Rather than buying now knowing that they likely will be able to pay for those items later, consumers are using credit to finance present consumption even though they have no idea how they will repay those debts in the future. The U.S. savings rate or, more accurately, the lack of consumer savings, is closely related to the problem of American consumerism and carries similarly broad implications for overall U.S. financial health. Since 2006, the United States has had a negative savings rate that is, Americans save less than they spend on goods or services. 10 One reason the U.S. savings rate is so low is because of the large number of baby boomers who are spending down their retirement income, i.e., dissaving. 11 The negative U.S. savings rate has now made the U.S. increasingly dependent on non-u.s. funds. In fact, just as the financialization of the U.S. economy forces the United States to rely on imported goods, the United States must also import savings from other countries just to finance domestic business investments. 12 (2005). 6. GLOBAL POLICY FORUM, U.S. HOUSEHOLD DEBT: (2006), [hereinafter U.S. HOUSEHOLD DEBT]. 7. Improving Credit Card Consumer Protection: Recent Industry and Regulatory Initiatives: Hearing Before the Subcomm. on Financial Institutions and Consumer Credit of the H. Comm. on Financial Services, 110th Cong. 2 (2007) (statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation), available at [hereinafter Bair Statement]. 8. CHRISTIAN E. WELLER, DROWNING IN DEBT: AMERICA S MIDDLE CLASS FALLS DEEPER IN DEBT AS INCOME GROWTH SLOWS AND COSTS CLIMB 6 7 (Ctr. For Am. Progress, May 2006), available at Student loan debt doubled from 1997 to COLLEGE BOARD, TRENDS IN STUDENT AID 2 (2007), prod_downloads/about/news_info/trends/trends_aid_07.pdf. 9. Kirstin Downey, Basics, Not Luxuries, Blamed for High Debt, WASH. POST, May 12, 2006, at D1; Karen E. Dynan & Donald L. Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences 4 5 (Fin. and Econ. Discussion Series Working Paper No , 2007), available at 10. Press Release, Bureau of Econ. Analysis, U.S. Dep t of Commerce, National Economic Accounts: Personal Income and Outlays (Nov. 1, 2007), available at pi/2007/pi0907.htm; Press Release, Bureau of Econ. Analysis, U.S. Dep t of Commerce, National Economic Accounts: Personal Income and Outlays (Dec. 22, 2006), available at releases/national/pi/2006/pi1106.htm. 11. Feldstein, supra note 4, at 88 89; Martha M. Hamilton, Could the Market Fall Down and Go Boom? WASH. POST, Feb. 4, 2007, at F3. Like in Brazil, the non-hispanic white population in the U.S. is an aging population. See generally Johannes Doll & Marli Sampaio, Elderly Consumer Weakness in Withholding Credit, Paper presented at the annual meeting of the Law and Society Association (Draft July 25, 2007); Jennifer Cheeseman Day, POPULATION PROFILE OF THE UNITED STATES: POPULATION PROJECTIONS, (last visited Mar. 15, 2008). 12. Feldstein, supra note 4, at 89.

4 138 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 B. Credit Card Debt In the United States, just about anyone or anything can get a credit card. Indeed, former Federal Reserve Chair Alan Greenspan once commented that children, dogs, cats, and moose can get credit cards. 13 In 2006, U.S. consumer credit debt (which includes credit card and other non-mortgage debt) totaled $2.4 trillion and U.S. residents had $745 billion in debt on general purpose credit cards. 14 While it is clear that credit card debt is highly correlated with consumer bankruptcy filings, 15 it is unclear why so many U.S. consumers are unable or unwilling to properly manage their credit card debt. Several factors are typically cited as the leading causes of increased credit card debt. As a general matter, many people do not view credit cards as a form of borrowing, since these loans theoretically can be repaid in full without paying interest. Many of those who understand that a credit card transaction is a loan do not understand credit card billing terms because (a) pertinent information is not effectively disclosed (i.e., a lack of transparency); (b) the complexity of the terms makes it virtually impossible for the average consumer to understand the true cost of the credit; or (c) because the terms change frequently. 16 Other consumers use their credit cards to balance their budget each month and make ends meet and appear to give little regard to the ultimate cost of that credit. 17 Moreover, because of how issuers market credit cards and because certain people have a tendency to overestimate their ability to exercise self-control and borrow more than they can repay in the future, some consumers may find it hard to resist the temptation to charge, charge, charge. 18 Credit card issuers, not surprisingly, target the customers they feel will be the most profitable. For example, issuers covet and aggressively pursue higher risk consumers such as college students, even though they have no income and have high rates of default. 19 Despite their present risk of default, college students are ideal long-term credit card customers because they are comfortable with indebtedness (due to their student loans) and 13. Credit Cards at 50: The Problems of Ubiquity, N.Y. TIMES, Mar. 12, 2000, at C See FED. RESERVE BD., STATISTICAL RELEASE, G-19 CONSUMER CREDIT (2007), U.S. HOUSEHOLD DEBT, supra note 6; Lewis W. Diuguid, Despite Credit Woes, We Just Keep on Digging, KANSAS CITY STAR, Oct. 17, 2007, at B TERESA A. SULLIVAN, ELIZABETH WARREN & JAY L. WESTBROOK, THE FRAGILE MIDDLE CLASS: AMERICANS IN DEBT (2001). 16. GEN. ACCOUNTING OFFICE, CREDIT CARDS: INCREASED COMPLEXITY IN RATES AND FEES HEIGHTENS NEED FOR MORE EFFECTIVE DISCLOSURES TO CONSUMERS (2006), available at Bair Statement, supra note 7; Examining the Billing, Marketing, and Disclosure Practices of the Credit Card Industry, and Their Impact on Consumers: Hearing before the S. Comm. on Banking, Housing and Urban Affairs, 110th Cong. 4 (2007) (statement of Elizabeth Warren, Professor of Law, Harvard Law School) [hereinafter Warren Statement] (citing statement by international business consulting group vice-president that banking products are too complex for the average consumer). 17. JOSÉ A. GARCÍA, BORROWING TO MAKE ENDS MEET; THE RAPID GROWTH OF CREDIT CARD DEBT IN AMERICA 1 (2007), available at WELLER, supra note 8, at 5. The need to obtain additional funds, even if on unfavorable terms, to make ends meet also appears to explain the willingness of elderly Brazilians to take out loans against their meager pensions. Doll & Sampaio, supra note 11. Declining pensions and increasing prices for drugs and health care might also explain why credit card debt has become a serious problem for older Americans. Credit Cards and Older Americans: Hearing before the Subcomm. on Financial Institutions and Consumer Credit of the H. Comm. on Financial Services, 110th Cong. 1 (2007) (written statement of Bob O Connell, Executive Council Member, AARP) [hereinafter O Connell Statement]. 18. Oren Bar-Gill, Seduction by Plastic, 98 NW. U. L. REV. 1373, (2004). 19. Jessica Silver-Greenberg, Countering Credit-Card Pushers, BUSINESSWEEK ONLINE, Oct. 11, 2007; Bair Statement, supra note 7, at 4 (discussing higher rate of late payments for young adults).

5 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 139 also because they theoretically will have higher incomes once they graduate and get jobs. 20 Because most of the revenue credit card issuers receive comes from customers who do not pay their balances in full each month, issuers rationally prefer these customers because they make higher profits if the customer treats the transaction as a loan that will be repaid over time. 21 Thus, even if college students or other high risk customers have shockingly high default rates, they are quite profitable to issuers as long as they continue to at least pay something most months. Similarly, credit card companies have now increased their direct mail credit card offers to subprime customers who have lost or likely will lose their homes in a foreclosure because these customers can no longer tap into the home s equity for cash. 22 Customers who have recently lost their homes are, ironically, good long-term credit risks because they can no longer access the equity in their homes, which gives them a strong incentive to take out cash advances on their credit cards. C. Housing Debt 1. Benefits and Perils of the Democratization of Homeownership Homeownership constitutes the largest component of household net worth for all populations in the United States, except perhaps the highest income groups. 23 Housing prices more than doubled in some U.S. housing markets this decade and have tripled in some markets over the last thirty years. 24 Americans have become over-indebted in the last few years almost exclusively because of the astronomical increase in housing prices and consumers increase in housing debt for the last twenty years. 25 The acceleration in houseprice appreciation, in turn, caused homeowners to increase their consumption based on their belief that they were wealthier and could spend more. 26 Total U.S. home mortgage debt is staggering: in 2006, it was $9.7 trillion, an almost trillion dollar increase from Consumers over the last ten years eagerly took out large loans to buy homes because even with large jumbo mortgages 28 homeowners 20. See Michelle Singletary, The Extra Credit Students Don t Need, WASH. POST, Oct. 18, 2007, at D2; ROBERT D. MANNING, LIVING WITH DEBT: A LIFE STAGE ANALYSIS OF CHANGING ATTITUDES AND BEHAVIORS 25, 42 (2005), available at report.pdf. 21. See Warren Statement, supra note 16, at Robert Gavin, Credit Card Companies Woo Struggling Mortgage-Holders, BOSTON GLOBE, Sept. 4, 2007, at A U.S. CENSUS BUREAU, U.S. DEPARTMENT OF COMMERCE, NET WORTH AND ASSET OWNERSHIP OF HOUSEHOLDS: 1998 AND (2003), available at 2003pubs/p70-88.pdf. Contra Zhu Xiao Di, Role of Housing as a Component of Household Wealth 6 (Joint Center for Housing Studies of Harvard University, Working Paper No. W01-6, 2000), available at (stating that, by 1998, stock values had surpassed home equity as a major component of household wealth). 24. Dynan & Kohn, supra note 9, at 15. See generally Wenli Li & Rui Yao, Your House Just Doubled in Value? Don t Uncork the Champagne Just Yet!, BUS. REV., Q1 2006, at 25, available at 25. Dynan & Kohn, supra note 9, at (noting that a significant percentage of the increase in household debt relative to income is attributable to home mortgage debt). See also Bair Statement, supra note 7, at Li & Yao, supra note 24, at 25; Dynan & Kohn, supra note 9, at U.S. HOUSEHOLD DEBT, supra note In general, a jumbo mortgage is a loan that exceeds the amount ($417,000) that can be sold to government sponsored enterprises (i.e., Fannie Mac and Freddie Mac). Floyd Norris & Eric Dash, In a Credit Crisis, Large Mortgages Grow Costly, N.Y. TIMES, Aug. 12, 2007, at A1.

6 140 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 monthly mortgage payments remained reasonable due to escalating housing prices and decreasing interest rates. Homeowners also used home equity loans to remove the equity they had accumulated in their homes, essentially treating their homes like an automated teller machine. When interest rates were low and housing prices were escalating, consumers removed equity to buy durables, to renovate their homes, to pay off higher interest credit card debt or other consumer loans, or to borrow money to pay for college tuition and expenses. 29 Escalating housing prices also caused homeowners to stop saving, to stop contributing to retirement accounts, and to even withdraw funds held in their retirement accounts. 30 Due to the encouragement of the U.S. Government, lenders developed innovative loan products to make mortgage credit more readily available to lower income, but often higher risk, consumers. 31 This push for a greater democratization of credit 32 generally resulted in lenders giving higher risk borrowers, a group generally characterized as subprime borrowers, greater access to credit in the form of non-traditional mortgage products. Financial institutions were eager to loan to homeowners, even subprime borrowers, because they viewed the loans themselves as low-risk. That is, as long as housing prices continued to rise and the loan originators could continue to quickly sell the subprime mortgage loans in the secondary market, the entities that originated the loans bore little risk that they would not be repaid if the borrower defaulted on the loan payments. In fact, the ability to originate but then quickly sell mortgages had the effect of decreasing the originating lender s incentive to make careful lending decisions since the risk of default would pass from the loan originator to the investors that purchased the loan in the secondary market. 33 The affordability products that lenders created to make homeownership more accessible to subprime customers changed traditional notions of home ownership. These products had several non-traditional features which, when layered together, made it easier for consumers to buy homes, but also made it more likely that the consumer would default and, ultimately, lose the home in a foreclosure sale. These include scenarios where borrowers were offered stated-income loans that were approved even though the borrowers provided no written proof of their income. 34 These loans generally are referred to as lowdocumentation, no-documentation or liar loans because they gave borrowers an incentive to inflate their income in order to qualify for a larger loan. 35 Borrowers could also get a 29. See Bair Statement, supra note 7, at 3 (discussing use of cash-out refinancing proceeds to pay off credit card debt); WELLER, supra note 8, at 1, Dynan & Kohn, supra note 9, at 6 (discussing why consumers may not behave rationally when increasing their mortgage debt); WELLER, supra note 8, at Dynan & Kohn, supra note 9, at (suggesting that financial innovation did not help increase the number of households that could borrow but instead increased the amount of debt held by households who already had access to mortgage loans); see also Vikas Bajaj & Ron Nixon, Subprime Loans Going from Boon to Housing Bans; Minority Buyers Especially Hurt as Interest Rates Adjust Higher, N.Y. TIMES, Dec. 6, 2006, at C Dynan & Kohn, supra note 9, at Kathleen C. Engel & Patricia A. McCoy, Turning a Blind Eye: Wall Street Finance of Predatory Lending, 75 FORDHAM L. REV. 2039, (2007) (discussing the lemons problem and how securitization lets lenders shift the risk of default onto the investor); see also Vikas Bajaj & Christine Haughney, Tremors at the Door, N.Y. TIMES, Jan. 26, 2007, at C1; Lawmakers Debate Necessity of Lending Reforms: Congress Wading into Housing Market s Complexity, May 8, 2007, available at 34. Gretchen Morgenson, Crisis Looms in Market for Mortgages, N.Y. TIMES, Mar. 11, 2007, available at market+for+mortgages&st=nyt&oref=slogin; Peter Henderson, Tim McLaughlin, Andy Sullivan & Al Yoon, Frenzy of Risky Mortgages Leaves Path of Destruction, May 8, 2007, available at 35. Morgenson, supra note 34; Preserving the American Dream: Predatory Lending Practices and Home Foreclosure: Hearing before the S. Comm. on Banking, Housing and Urban Affairs, 110th Cong. 4 5 (2007) (written statement of Jean Constantine-Davis, Senior Attorney, AARP Foundation) (describing perils to consumer

7 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 141 mortgage to purchase a home without making any down payment. 36 Because of the high transaction costs associated with purchasing a home (realtor and attorney fees), a borrower who makes no down-payment will have no equity in her home when the loan term begins, may not have built up any equity in the home even after making her monthly payments for the first few years, and may find that her loan balance is increasing (i.e., negatively amortizing), especially if the loan permits the borrower to defer interest payments. 37 Finally, though mortgages traditionally have been for fifteen- or thirty-year terms, lenders offered forty- and fifty-year mortgage terms to provide a product with lower monthly payments, even though the length of the mortgage term effectively treated the owner as a long-term renter. 38 Potential homeowners, especially subprime borrowers, were often offered adjustablerate mortgages (ARMs) that had very low introductory interest rates and initial payments. Low payments (especially if combined with no down payment) made it possible for cashstrapped renters to buy a home. Once the introductory period passed and interest rates increased, however, borrowers monthly payments would increase often quite dramatically. Borrowers then found that they needed to refinance the ARM sometimes more than once to get a more affordable product. 39 Because of the risks associated with subprime ARMs, bankers and consumer advocates alike have referred to them as neutron loans: they kill all the people, but leave all the houses Current Crisis Making homeownership more accessible to more potential buyers is not a bad thing, if done responsibly. Unfortunately, the current turmoil in the U.S. housing markets has revealed that many consumers were approved for loans they could not afford based on their actual income. 41 Lenders appeared willing to approve these loans largely because housing prices were escalating and the escalating values protected their interest in the home. Even if the borrower failed to repay the loan, the lender could foreclose on the home and sell it or could convince the borrower to refinance the mortgage to get lower monthly payments. Likewise, borrowers seemed willing to buy houses they could not afford because of their of stated income loans). A different variation of stated income loans are no income, no asset ( NINA ) loans. With these loans, the borrower is not required to disclose income or assets. See, e.g., Best No Doc Loans, No Doc Loans, (last visited Mar. 16, 2008). These loans would be approved based on the borrower s employment, credit history, the property value, and the down payment (if any). Another variation, a NINANE (no income, no asset, no employment) loan, does not require the borrower to disclose income, assets, or employment. See, e.g., No Doc Loan and No Doc Mortgages, (last visited Mar. 16, 2008). 36. ALLEN J. FISHBEIN & PATRICK WOODALL, CONSUMER FED N OF AM., EXOTIC OR TOXIC? AN EXAMINATION OF THE NON-TRADITIONAL MORTGAGE MARKET FOR CONSUMERS AND LENDERS 12 (2006), available at 37. See Calculated Risk: Assessing Non-Traditional Mortgage Products: Hearing Before the Subcomm. on Housing and Transp. and Subcomm. on Econ. Policy of the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 11 (2006) (statement of Michael D. Calhoun, President, Center for Responsible Lending), available at 38. Gretchen Morgenson, Home Loans: A Nightmare Grows Darker, N.Y. TIMES, Apr. 8, 2007, at C See FISHBEIN & WOODALL, supra note 36, at 10, Mara Der Hovanesian, Nightmare Mortgages, BUSINESSWEEK, Sept. 11, 2006, at 70, available at 41. See Justin Lahart, After Subprime: Lax Lending Lurks Elsewhere, WALL ST. J., Feb. 20, 2007, at C1; FISHBEIN & WOODALL, supra note 36, at 14.

8 142 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 overly optimistic assumption that housing prices would continue to escalate. 42 In addition to misjudging the unaffordability of their loans, consumers also did not appear to fully understand the terms of the loan. 43 Because many of the subprime ARM borrowers were first-time buyers, many of them did not appear to be aware of the additional responsibilities of home ownership, such as the need to put aside money in escrow for taxes and insurance if the lender did not automatically escrow. 44 Because lenders approved non-traditional mortgages for borrowers with weak credit histories, many of those high-risk borrowers are now defaulting on their loans. In fact, much of the increase in foreclosure rates is attributable to non-traditional and subprime mortgages that originated in late 2005 and early 2006, 45 and many loans were in default after borrowers made only one or two (or no) payments. 46 For example, in the first half of 2007, 320,000 foreclosures were initiated in the United States. 47 Since the average number of annual foreclosures for the last six years has been 225,000, the United States is on track to have almost twice as many foreclosures in 2007 as it has had on average for the last six years. 48 Moreover, most economists and realtors are projecting that the decrease in home values and declining home sales will not recover until at least Recent changes to U.S. consumer bankruptcy laws, as discussed in more detail in Part III, make it harder for consumers to rid themselves of consumer debt. The inability to restructure debts in general and the virtual impossibility of restructuring mortgage debts in bankruptcy make the soaring foreclosure rate particularly problematic for consumers. To be sure, some state exemption laws do allow homeowners to prevent general unsecured creditors from seizing their homes even large, expensive ones after they file for bankruptcy. 50 Moreover, U.S. consumers, unlike consumers in other countries, 51 generally 42. See Allan Sloan, Junk Mortgages Under the Microscope; A Close-up of One Deal Shows How Subprime Mortgages Went Bad, Says Fortune s Allan Sloan (Oct. 16, 2007), CNNMONEY.COM, (last visited Apr. 5, 2008). 43. Calculated Risk: Assessing Non-Traditional Mortgage Products: Hearing Before the Subcomm. on Housing and Transp. and Subcomm. on Econ. Policy of the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 2 3 (2006) (statement of Allen J. Fishbein, Director of Housing and Credit Policy, Consumer Federation of America); Brian Bucks and Karen Pence, Do Homeowners Know Their House Values and Mortgage Terms? (Fed. Reserve Bd. of Governors, FEDS Working Paper No , 2006), available at (noting that households with low income and less education are less likely to know the terms of their mortgage). 44. See The Role of the Secondary Market in Subprime Lending: Hearing before the Subcomm. on Fin. Institutions and Consumer Credit of the H. Comm. on Fin. Servs. 110th Cong. 5 (2007) (statement of Larry B. Litton, Jr., President and CEO, Litton Loan Servicing LP) (recommending that subprime borrowers establish an escrow account to pay taxes and insurance); Susan Schmidt Bies, Member of the Board of Governors of the U.S. Fed. Reserve System, Remarks at the National Credit Union Administration 2007 Risk Mitigation Summit: Enterprise Risk Management and Mortgage Lending 4 (Jan. 11, 2007), available at (suggesting the prudence of escrowing tax and insurance payments or informing borrowers how much they should set aside for those payments). 45. Subprime Mortgage Lending and Mitigating Foreclosures: Hearing before the House Comm. on Fin. Servs., 110th Cong. 2 (2007) (statement of Ben Bernanke, Federal Reserve Chairman) [hereinafter Bernanke Statement I]. Estimates are that two million ARMS will reset to a higher rate in 2007 and See Major Lenders Move to Offer Subprime Help: Freddie Mac, Washington Mutual Will Help Refinance Billions in Mortgages, MSNBC, Apr. 18, 2007, (last visited Apr. 5, 2008). 46. Norris & Dash, supra note Bernanke Statement I, supra note Id. 49. Chris Isidore, Realtors: Home Prices Slump Through 08, CNNMONEY.COM, Sept. 11, 2007, (last visited Apr. 5, 2008). 50. See A. Mechele Dickerson, Race Matters in Bankruptcy Reform, 71 MO. L. REV. 919, (2006) (discussing bankruptcy policy allowing debtors to protect real property). 51. Donna McKenzie Skene & Adrian Walters, Consumer Bankruptcy Law Reform in Great Britain, 80 AM.

9 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 143 are not forced to use the equity in their homes to repay their debts. 52 However, U.S. consumer insolvency laws have staunchly protected mortgage loans and make it virtually impossible to remove a lender s interest in the collateral (i.e., the home) that secures the mortgage loan. 53 Thus, consumers who are over-indebted because of mortgage loans may be able to discharge their personal obligation to repay the loan but, at least for now, it is almost impossible to use bankruptcy laws to modify or discharge the lender s security interest in the borrower s home. 54 III. U.S. RESPONSE TO OVER-INDEBTEDNESS A. The Consumer s Right to a Fresh Start Over-indebted U.S. consumers can seek formal financial relief by attempting to discharge some or all of their debts using the U.S. consumer bankruptcy laws. 55 Unlike a number of countries (including Brazil), the United States has had a formal consumer insolvency regime since 1898 largely because of the recognition that it is virtually impossible for an individual consumer to reach a global debt renegotiation with all her creditors unless a federal law forces the creditors to accept a particular payment plan. Historically, U.S. consumer bankruptcy law have given over-indebted consumers a fresh start that allowed them to discharge their debts and become productive members of the market economy. 56 Many have suggested that the best way to evaluate and respond to consumer over-indebtedness is to examine why consumers find themselves unable to repay their bills. 57 Others argue that the causes of consumer over-indebtedness should be addressed outside of bankruptcy, that consumer bankruptcy laws generally should not be viewed as being part of the protections provided by the welfare state, and that bankruptcy laws should largely be unconcerned about why people found themselves unable to repay their debts. 58 As we shall see in the following sections, a consumer insolvency scheme that ignores the causes of insolvency is unlikely to provide appropriate relief. BANKR. L.J. 477, 485 (2006). Similarly, over-indebted Brazilians appear to be able to keep their homes only if those homes are small and reasonably modest in value. 52. See Dickerson, supra note 50, at See 11 U.S.C. 725 (2008) (requiring trustee to protect interest of entity that has a lien on property of the estate); 11 U.S.C. 1322(b)(2) (allowing modification of lender s security interest in debtor s principal residence). 54. Emergency Home Ownership and Mortgage Equity Protection Act of 2007, H.R. 3609, 110th Cong. 3 (2007) U.S.C. 727; 11 U.S.C The fresh start policy gives the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt. Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). 57. See Elizabeth Warren, Bankruptcy Policymaking in an Imperfect World, 92 MICH. L. REV. 336 (1993) (arguing that bankruptcy laws are created to deal with the problems of market imperfections). 58. See Eric Posner, Should Debtors be Forced Into Chapter 13?, 32 LOY. L.A. L. REV. 965, 969 (1999).

10 144 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 B. The Consumer s Duty to Behave Responsibly: BAPCPA The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), enacted by the U.S. Congress in 2005, 59 significantly changed the U.S. Bankruptcy Code and moved U.S. consumer law policies closer philosophically to the European concept of an earned rather than fresh start. 60 European consumer debt adjustment systems appear to be designed to give consumers an incentive to modify their spending habits and to make wiser spending choices, but also to force them to live with the economic consequences of unwise choices. 61 Many in Congress seemed to believe that earlier versions of the U.S. consumer insolvency laws were too lax and allowed too many people to discharge debts they could afford to repay. 62 BAPCPA was designed to make it harder for people to file for bankruptcy and to give consumers an incentive to avoid over-indebtedness. Rather than use bankruptcy laws to provide comprehensive relief to over-indebted consumers, the U.S. Congress wanted consumers to understand that they have a moral duty to make responsible spending decisions and to at least attempt to repay their debts. 63 Before BAPCPA was enacted, consumers had almost complete control to decide whether they wanted to attempt to repay some of the debts over a three to five year period in a Chapter 13 debt repayment plan, or whether they wanted a quick discharge of their debts in a Chapter 7 proceeding and not even attempt to repay those debt. 64 To reduce the overall number of bankruptcy filings and to force more consumers into Chapter 13 debt repayment plans, Congress made a number of changes to restrict virtually all consumers access to bankruptcy. Perhaps the biggest change in the new law is a means test, a complicated quantitative test consumers must pass before they are deemed to have earned the right to a quick discharge of their debts in a Chapter 7 liquidation proceeding. 65 Until 2005, the U.S. approach had been to allow debtors a quick discharge if they had few assets they wanted to keep, or only had assets that they were allowed to keep statutorily (i.e., exempt) based on either applicable state or federal bankruptcy laws. 66 Consumers who fail this new means test either must attempt to repay some of their debts through a Chapter 13 debt repayment plan or must attempt to renegotiate their debts outside of bankruptcy. 67 Forcing consumers to prove that they are entitled to a particular type of debt relief moves the U.S. 59. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No , 119 Stat. 23 (codified as amended in scattered sections of 11 U.S.C.) [hereinafter BAPCPA]. 60. UDO REIFNER ET AL., CONSUMER OVER-INDEBTEDNESS AND CONSUMER LAW IN THE EUROPEAN UNION 166 (2003). 61. Id. at See Bankruptcy Reform Act of 1998: Hearing on H.R Before the Subcomm. on Commercial and Admin. Law of the H. Comm. on the Judiciary, 105th Cong. 11 (1998) (statement of Rep. James P. Moran) [hereinafter Hearing on H.R. 3150] (characterizing pre-bapcpa bankruptcy as a convenient financial management tool and highlighting its convenience and ease ); id. at (prepared statement of Rep. James P. Moran); 151 CONG. REC. S1834, S1843 (daily ed. Mar. 1, 2005) (statement of Sen. Orrin Hatch) (stating that debtors abusive misconduct is all too often encouraged by a bankruptcy bar that ushers people into Chapter 7 without ever fully considering the client s ability to repay. ); see H.R. REP. NO , at 5 (2005) [hereinafter House Report] ( [T]he present bankruptcy system has loopholes and incentives that allow and sometimes even encourage opportunistic personal filings and abuse. ). 63. See 151 CONG. REC. S1856 (daily ed. Mar. 1, 2005) (statement of Sen. Charles Grassley) ( I think the system needs to be reformed because it is fundamentally unfair. This bill will promote personal responsibility among borrowers and create a deterrence for those hoping to cheat the system. ). See also Hearing on H.R. 3150, supra note 62, at 11 (statement of Rep. James P. Moran) (suggesting that moral principal has been eviscerated because bankruptcy is now the option of first resort for some debtors who are capable of repaying their debts). 64. Dickerson, supra note 50, at U.S.C. 707(b)(2)(A). 66. Id. 522(b)(1). 67. Id. 707(b)(1).

11 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 145 system a bit closer philosophically to the structure and substantive policies of debt adjustment systems in other countries. The Code also requires all consumers to participate in mandatory credit counseling before they file their bankruptcy petition 68 and mandates that Chapter 13 debtors receive financial management training from an approved financial education provider before they can receive a discharge. 69 The number of documents consumers and their attorneys must provide to creditors before and during the bankruptcy case also increased under the new law. 70 Finally, because of the additional time lawyers must now spend on each case and because of higher filing fees, it costs more for consumers to get relief from their overindebtedness. 71 Making it harder for over-indebted consumers to avoid repaying their debts is easily justifiable if purchases of ipods, plasma TVs, Hummers, or sable fur coats cause most consumer over-indebtedness. But empirical data collected by prominent U.S. academics show this is not the case; medical debts, a divorce, or a job interruption cause most consumer bankruptcies in the United States. 72 Although these life circumstances, rather than profligate spending, appear to trigger most bankruptcy filings, the U.S. Congress nonetheless found that only two groups of over-indebted consumers should be viewed charitably and favorably and should be spared from BAPCPA s harsh consequences. 68. Debtors are ineligible for bankruptcy relief unless they receive a briefing from a credit counseling agency approved by the Office of the United States Trustee within 180 days before they file for bankruptcy. This counseling can occur either over the phone or the Internet. 11 U.S.C. 109(h)(1) (2007). See U.S. Trustee Program: List of Credit Counseling Agencies Approved Pursuant to 11 U.S.C. 111, (last visited Mar. 16, 2008) (providing a list of approved counseling agencies by jurisdiction). Debtors pass online briefings typically by answering a series of questions that are posed after each section. See, e.g., American Bureau of Credit Services, Inc., (last visited Mar. 16, 2008) (providing an example of an online debtor education course) U.S.C. 1328(g)(1) (2005). 70. Before the new changes, debtors or their lawyers were required only to file the bankruptcy petition, schedules that list creditors, assets, income, etc., and a statement of financial affairs. Now, they must provide that information plus a host of other documents, including copies of all payment advices (i.e., pay stubs), a statement of monthly net income explaining how the amount was calculated, a means test calculation, an annual income statement, and tax returns. 11 U.S.C. 521(a) (2005); 11 U.S.C. 1308(a) (2005). 71. Section 325 of BAPCPA originally increased Chapter 7 filing fees to $200, but decreased Chapter 13 filing fees from $155 to $150 (ostensibly to encourage more debtors to file under Chapter 13). Congress amended BAPCPA to increase the Chapter 7 fee by an additional $20 as part of the 2005 Emergency Supplemental Appropriations Act for Defense, the Global War on Terror, and Tsunami Relief, Pub. L. No , 119 Stat. 231, 297 (codified as amended at 28 U.S.C. 1930(1)(A)). That the increase was included as a technical amendment in this bill is somewhat ironic, since it forced all debtors even those below-median debtors who presumptively deserve Chapter 7 relief to pay higher filing fees to help finance foreign aid and the Iraq war. In addition to the $220 filing fee, other fees due on filing are $54, making the total fees due $274. In February 2006, Congress increased Chapter 7 filing fees again (from $220 to $245) and increased Chapter 13 filing fees from $150 to $235) as part of the Deficit Reduction Act of 2005, Pub. L. No , 120 Stat. 4, 184 (codified as amended at 28 U.S.C. 1930(a)). Total Chapter 7 fees due on filing are $299. Stated differently, between the time BAPCPA was signed into law (April 2005) and the first anniversary of the signing, Congress increased the cost of filing under both Chapter 7 and 13 by 63%. Moreover, by using bankruptcy filing fees to help offset the federal deficit, Congress substantially diminished the economic incentive for debtors to file for relief under Chapter 13 ($235) rather than Chapter 7 ($245). In addition, because of the increased administrative burdens, attorney fees have skyrocketed since the changes went into effect as well. See Jeanne Sahadi, Bankruptcy Fees could Skyrocket, CNNMONEY.COM, Apr. 14, 2005, index.htm (last visited Apr. 5, 2008). 72. SULLIVAN, WARREN &WESTBROOK, supra note 15, at 75, ,

12 146 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 First, consumers who can document that they are in debt because of medical bills relating to serious medical conditions are largely unaffected by BAPCPA s additional requirements. 73 However, consumers who chose to use their credit cards to make ends meet while they were injured and unable to work were not viewed as favorably. That is, if a consumer used credit cards to compensate for income a debtor lost while injured, such a person cannot easily avoid BAPCPA s additional requirements (i.e., means-testing, mandatory credit counseling, additional reporting) since the credit card debt would not technically be medical debt. To a lesser extent, BAPCPA also favors certain members of the armed forces (current and retired) who can avoid having to comply with some of BAPCPA s additional requirements. 74 The decision to favor members of the armed forces was, of course, an unabashedly political decision: no member of the U.S. Congress wanted to be viewed as penalizing consumers who are in debt solely because they had been deployed to fight in one of the many U.S.-led wars. 75 C. BAPCPA s Success? While BAPCPA has changed how and when people file for bankruptcy, it has also had unintended consequences and imposed additional administrative burdens and costs on consumers. The number of consumers who filed for bankruptcy relief plummeted after BAPCPA became fully effective: there were over 1.5 million filings in 2004, 76 over two million in 2005, 77 but fewer than 600,000 in Given this dramatic drop, BAPCPA arguably succeeded in both making it harder for people to file for bankruptcy and also making people understand that they have a moral duty to repay their debts. However, many recognize that filing levels after October 18, 2005 remained low through mid-2006 because so many people rushed to file their bankruptcy petition before the effective date. 79 Indeed, of the over two million people that filed for bankruptcy in 2005, approximately 600,000 (or, stated differently, an amount equal to the total number of filings in 2006) filed in the weeks before BAPCPA s October 17 effective date. 80 While consumer filings remained low for much of 2006, the numbers already have started to increase as there was a forty percent 73. See 151 CONG. REC. E704 (daily ed. Apr. 19, 2005) (statement of Rep. Dennis Moore) (noting that S.256 properly allows bankruptcy filers to challenge the means test by demonstrating special circumstances, such as a serious medical condition, that justify additional expenses or adjustments to their income ). See also 11 U.S.C. 707(b)(2)(B)(i) (2007) (codifying protections for deserving debtors) U.S.C. 727(a)(11) (2005); 11 U.S.C. 707(b)(2)(B)(i); 11 U.S.C. 109(h)(4). 75. H.R. REP. NO , pt. 1, at (1999); see also 151 CONG. REC. S2424, S2427 (daily ed. Mar. 10, 2005) (statement of Sen. Richard Durbin) ( Mr. President, this amendment will exempt from the bankruptcy bill s means test those disabled veterans whose indebtedness occurred primarily during a period of military service. They have given us their arms, their legs, very important parts of their lives.... We need to honor these veterans who have given so much to America. ). 76. Statistics from the Admin. Office of U.S. Courts, Table F-2: Business and Nonbusiness Bankruptcy Cases Commenced, by Chapter of the Bankruptcy Code During the Twelve Month Period Ended Dec. 31, 2004, available at 77. Statistics from the Admin. Office of U.S. Courts, Table F-2: Business and Nonbusiness Bankruptcy Cases Commenced, by Chapter of the Bankruptcy Code During the Twelve Month Period Ended Dec. 31, 2005, available at 78. Statistics from the Admin. Office of U.S. Courts, Table F-2: Business and Nonbusiness Bankruptcy Cases Commenced, by Chapter of the Bankruptcy Code During the Twelve Month Period Ended Dec. 31, 2006, available at 79. Press Release, American Bankruptcy Institute, Bankruptcy Filings Set Record on Eve of New Law (Dec. 15, 2005), available at TEMPLATE=/CM/ContentDisplay.cfm&CONTENTID= Id.; Statistics from the Admin. Office of U.S. Courts 2005, supra note 77.

13 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 147 increase in consumer filings in While no one expects filings to return to the pre- BAPCPA apogee, filings appear to be headed toward the one million mark and total consumer filings likely will continue to increase for the next few years in large part because of the massive amount of consumer debt. 82 Perhaps more importantly, while the number of consumers who filed Chapter 13 petitions increased after the new changes went into effect, fewer consumers are now filing Chapter 13 petitions relative to Chapter 7 petitions. 83 So, despite Congressional attempts to decrease bankruptcy filings, over-indebted consumers are still filing for bankruptcy and more of them are now seeking to discharge their debts rather than attempt to repay them. One other post-bapcpa development suggests that the revised consumer insolvency laws and the additional requirements BAPCPA imposes on consumers have not had their intended results. The evidence has shown that the credit counseling requirement to be an administrative obstacle to debtors, rather than a financially beneficial exercise. 84 The requirement that all consumers receive credit counseling before seeking formal debt relief is not, by itself, particularly objectionable or unusual. Indeed, debt counseling is common outside the United States and professional debt counselors in Europe historically have been very active in helping consumers restructure their debts and navigate formal debt adjustment procedures. 85 In imposing the new credit counseling requirement, however, members of the U.S. Congress assumed consumers would consult with an impartial counselor before they filed a bankruptcy petition and would then realize that they actually had the ability to repay their debts outside of bankruptcy in a private debt management plan. 86 Thus, the basic normative goal of the new credit counseling requirement is to make consumers understand that they have the responsibility to control and manage their financial affairs in a responsible manner. The specific goal of the counseling was to help potential debtors make an informed choice about bankruptcy, its alternatives, and [the] consequences of filing for bankruptcy. 87 Despite these admirable goals, commentators uniformly have concluded that pre-filing credit counseling is of little value to most consumers because, by the time most people are contemplating a bankruptcy filing, their financial situation is so dire that they have no realistic alternative but to file for bankruptcy. 88 For example, empirical studies conducted 81. Press Release, American Bankruptcy Institute, Consumer Bankruptcy Filings Up Nearly 40 Percent in 2007 (Jan. 3, 2008), available at TEMPLATE=/CM/ContentDisplay.cfm&CONTENTID= Id.; Charles J. Tabb, Consumer Filings: Trends and Indicators, Part II, AM. BANKR. INST. J., Dec Jan. 2007, at Press Release, American Bankruptcy Institute, Bankruptcy Filings in First Half of 2007 Up 48 Percent From a Year Ago (Aug. 16, 2007), available at Template.cfm?Section=Home&TEMPLATE=/CM/ContentDisplay.cfm&CONTENTID= Bankruptcy Reform: Value of Credit Counseling Requirement Is Not Clear: Hearing Before the Subcomm. on Commercial and Admin. Law of the H. Comm. on the Judiciary, 110th Cong (2007) (statement of Yvonne D. Jones, Director, Financial Markets and Community Investment) [hereinafter Jones Statement]. 85. Iain Ramsay, Comparative Consumer Bankruptcy, 2007 U. ILL. L. REV. 241, 252 (2007); Jason J. Kilborn, Out with the New, In with the Old: As Sweden Aggressively Streamlines Its Consumer Bankruptcy System, Have U.S. Reformers Fallen Off the Learning Curve?, 80 AM. BANKR. L.J. 435, 441 (2006) CONG. REC. 3737, 3737 (Mar. 15, 2001) (statement of Sen. Jeff Sessions) ( [T]his is fundamentally what the lawyer tells them. He says: Now, when you get your paycheck, you save that money, and you bring it straight to me all that money and maybe your second check. As soon as I have $1,500 or $1,000, I will file your bankruptcy. Don t pay any of your other debts.... Use your credit card. Run up everything you want to on your credit card.... They are told this is the right thing to do. ). 87. H.R. REP. NO , pt. 1, at 2 (2005). 88. See H.R. REP. NO , pt. 1, at (2005) (dissenting views) (discussing findings that the

14 148 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 during the last two years have found that the overwhelming majority (approximately ninetyseven percent) of debtors who participated in pre-bankruptcy counseling simply did not have enough money to pay their bills, or do anything else except attempt to get relief for their over-indebtedness by filing for bankruptcy. 89 The futility of credit counseling is especially pronounced for Chapter 13 debtors since many of them are facing imminent foreclosures on their homes and can stall the foreclosure only by filing a bankruptcy petition. 90 Thus, the mandatory pre-filing counseling requirement has failed everyone involved: it has not helped consumers and it is not financially beneficial for credit counseling agencies either. Credit counseling agencies are not benefiting because Congress mandated that the counseling services be provided at a reasonable cost and that fees be waived for the poorest consumers (typically based on an amount that is well below the U.S. poverty line). 91 Because of this, most agencies provide counseling on the Internet (the cheapest way) and many have eliminated face-to-face counseling (the most expensive way) even though counseling experts argue that the most effective way to counsel consumers is face-to-face. 92 Because most credit counseling agencies charge consumers only fifty dollars, most are finding that even using the cheapest way to provide these services is not profitable. 93 The credit counseling requirement would have been profitable for these agencies if more consumers could afford to repay their debts in a debt management plan (DMP). Consumers who participate in DMPs are required to repay some of their unsecured debts over an extended period of time outside of a bankruptcy proceeding. DMPs are profitable because credit card companies typically give credit counseling agencies a percentage of the amount consumers pay to their creditors. However, there is virtually uncontroverted evidence that in just two years the pre-filing counseling requirement has diverted few potential debtors into private DMPs. 94 Thus, in addition to placing additional administrative burdens and unnecessary costs on consumers, the credit counseling requirement has failed to be a financially profitable venture for the credit counseling agencies who provide these services for the simple reason that most consumers are too over-indebted to benefit from anything other than discharging their debts in a bankruptcy proceeding. 95 increase in the filing rate is a symptom, rather than a cause, of financial difficulties); see also Jones Statement, supra note 84, at ( clients perceived the counseling session as an administrative obstacle rather than a useful exercise. ). 89. NAT L FOUND. FOR CREDIT COUNSELING, MEETING THE MANDATE: CONSUMER COUNSELING AND EDUCATION UNDER THE BANKRUPTCY ABUSE PREVENTION AND CONSUMER PROTECTION ACT 12 (2006) [hereinafter MEETING THE MANDATE], available at 206%20month%20report%20FINAL.pdf; see also INST. FOR FIN. LITERACY, FIRST DEMOGRAPHIC ANALYSIS OF POST-BAPCPA DEBTORS 4 (2006), available at pdf/ _wp_first_demographics.pdf. 90. See In re Sosa, 336 B.R. 113, (Bankr. W.D. Tex. 2005); In re Cleaver, 333 B.R. 430, 435 (Bankr. S.D. Ohio 2005); In re Talib, 335 B.R. 417, 419 (Bankr. W.D. Mo. 2005) U.S.C. 111(c)(2)(B) (2006). 92. See Leslie E. Linfield, Credit Counseling: BAPCPA s Grendel, AM. BANKR. INST. J., Oct. 2005, at 28, 72; Kathleen Day, Credit Counseling Agencies Dealt Setback; Banks Reduce Funding as Bankruptcies Rise; Consumer Groups Hit Move, WASH. POST, July 16, 1999, at El. Consumers also tend to prefer telephone or Internet counseling, largely because it is the most efficient way to satisfy the counseling requirement. Jones Statement, supra note 84, at Jones Statement, supra note 84, at 13; MEETING THE MANDATE, supra note 89, at NOREEN CLANCY & STEPHEN J. CARROLL, PREBANKRUPTCY CREDIT COUNSELING (2007), available at 95. Jones Statement, supra note 84, at 13; MEETING THE MANDATE, supra note 89, at 9,

15 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 149 IV. COMPARATIVE PATTERNS OF INDEBTEDNESS A. Going into Debt Due in large part to the kindness and generosity of the U.S. financial services industry, consumers throughout the world now can experience the joys provided by the democratization of credit. Starting in the early 1980s, credit cards and other forms of consumer credit were deregulated in most global economies and consumer credit is now more readily available to middle- and lower-class consumers. 96 As is true in the United States, a greater access to credit is not necessarily a bad thing. For example, when the interbank interest rates dropped in Brazil a few years ago and lending laws were relaxed to make it easier for lenders to seize property pledged as collateral for loans that are in default, more of Brazil s working poor gained access to credit and were able to buy their own homes. 97 Consumers in Brazil, Europe, and elsewhere (like their U.S. counterparts) now have staggering amounts of debt. For example, outstanding debt in British households is roughly 150 percent of personal income, which is actually higher than the U.S. figure of 125 percent of personal income. 98 Like U.S. consumers, world-wide consumers routinely spend more than they earn each year. Also, like U.S. consumers, over-indebted consumers in Brazil and other countries appear to be hopelessly in debt because they are attempting to make ends meet. Empirical studies conducted in Brazil appear to indicate that the same factors that cause consumer bankruptcy filings in the United States (medical debt, divorce, loss of job) also are the most common causes of indebtedness and that stagnant or declining wages cause many middle and lower income Brazilians and Americans to borrow money not to over-consume, but just to keep up with the cost of living. 99 Similarly, because of stagnant or declining wages, many consumers find themselves unable to pay their bills each month and they decide to use credit cards to help close the gap between what they earn and what they need to pay their bills. 100 Not surprisingly, these high levels of consumer indebtedness caused many European countries to face the same economic patterns at the end of the 1980s and the beginning of the 1990s that we are now facing in the United States: increased household debt followed by decreased personal savings and rising housing prices, followed by plummeting housing prices. 101 This cycle then triggered a banking crisis in these countries, just as the subprime 96. See, e.g., Diane Ellis, The Effect of Consumer Interest Rate Deregulation on Credit Card Volumes, Charge-offs, and the Personal Bankruptcy Rate, Bank Trends (FDIC, Div. of Ins., Mar. 1998). 97. See Interview with Dean Newman, INVESTMENT ADVISER, Mar. 19, 2007, available at aa/Dean-Newman.jsp. 98. David Smith, Still Climbing the Debt Mountain, TIMES (London), Mar. 12, 2006, at 4; Darren Williams, UK Household Debt: Cause for Concern?, ALLIANCEBERNSTEIN: EUROPEAN ECONOMIC PERSPECTIVES, Mar. 16, 2007, at 2, available at us/storypage.aspx?nid=5342&cid=43892; see also David Smith, Debt s a Burden, but Not for Most, TIMES (London), Jan. 7, 2007, at 4 (indicating that the ratio of annual disposable income to debts in the UK was almost 160%, which was higher than the proportion for the US (135%) or Canada (126%), but well below the percentages in other Commonwealth countries (Australia 173%, New Zealand 181%) and even a few European countries (Denmark 260%, Netherlands 246%)). 99. TAMARA DRAUT & JAVIER SILVA, BORROWING TO MAKE ENDS MEET: THE GROWTH OF CREDIT CARD DEBT IN THE 90S 9 (2003) Id Kilborn, supra note 85, at 437; see also Iain Ramsey, Functionalism and Political Economy in the

16 150 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 housing meltdown has created a financial crisis in the United States. 102 In effect, once European consumers were told to buy now, pay later, they bought, but then found they were unable to repay when unemployment rates rose and there was a general slowdown in the European economies in the 1990s. Thus, as is true in Brazil and the United States now, the credit binging created a credit hangover. B. Getting out of Debt Despite the similarities of world-wide consumer behavior, the U.S. insolvency scheme is fairly unique. Most debt adjustment systems outside the United States are not as comprehensive as the U.S. consumer insolvency system either because they do not restructure all of the consumer s debts or because they lack the ability to dispose of all the consumer s assets. In addition, these systems generally are not designed to help the consumer discharge her debts. Instead, consumer debt adjustment systems outside the United States appeared designed to help creditors collect debts, to prevent overindebtedness, and to enforce the societal norm that people have an obligation to honor their contracts and pay their debts. 103 Traditionally, non-u.s. consumer insolvency laws have not been designed to treat the problem or the causes of over-indebtedness. 104 This was the view that many in Congress held in enacting BAPCPA and making it harder for U.S. consumers to discharge their debts in bankruptcy. V. POTENTIAL SOLUTIONS FOR CONSUMER OVER-INDEBTEDNESS While it is unclear whether the U.S. Government should bail out consumers, investment banks, hedge funds, or any other entity that helped facilitate the massive amount of consumer over-indebtedness in the United States, one thing is clear: the current U.S. approach to handling consumer over-indebtedness is just not working. Consumer debt is at a record level, bankruptcy filings are increasing, foreclosure rates are astronomical and the subprime mortgage meltdown has caused chaos in the financial markets. A. Need for Response When foreclosure rates began to increase in early 2006, some questioned the wisdom of bailing out borrowers who were at risk of losing homes they should have known they could not afford and some politicians continue to argue against homeowner bailouts. 105 Preventing borrowers from fully internalizing the costs associated by their reckless behavior would, it is said, create a moral hazard problem. Because of the negative externalities associated with home foreclosures, however, the subprime mortgage crisis should not be Comparative Study of Consumer Insolvency: An Unfinished Story from England and Wales, 7 THEORETICAL INQUIRIES L. 625, (2006) (discussing over-indebtedness legislation in the UK) See Ramsey, supra note 85, at See Jacob Ziegel, Facts on the Ground and Reconciliation of Divergent Consumer Insolvency Philosophies, 7 THEORETICAL INQUIRIES L. 299, (2006) Ramsey, supra note 85, at 254; see Pablo Lerner, The Chief Enforcement Officer and Insolvency in Israeli Law, 7 THEORETICAL INQURIES L. 565, 569 (2006) Larry Rohter and Edmund L. Andrews, McCain Rejects Broad U.S. Aid of Mortgages, N.Y. TIMES, Mar. 26, 2008, at A18; Kathleen Pender, Why We Shouldn t be Bailing Out Subprime Lenders or Borrowers, S.F. CHRON., Apr. 22, 2007, at D1; Meddling in the Markets, THE ECONOMIST, Dec. 7, 2007, available at

17 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 151 viewed as an isolated problem that affects just the reckless, over-indebted homeowner. Even if individual homeowners should be forced to suffer the most harm (i.e., the loss of their homes and any equity they may have accumulated in those homes) from their own improvident credit decisions, the U.S. and global capital markets have an incentive to care about these borrowers because of the harmful spillover effects of consumer overindebtedness. Consumer over-indebtedness leads to greater credit card defaults and mortgage foreclosures; and increased foreclosure rates harm municipalities and neighboring property owners. Municipalities suffer whenever there is a real estate slump because they lose the revenue that is generated by the building or selling of homes (e.g., the issuance of building permits). In addition, property tax revenues fall because of the foreclosed homes and municipalities suffer a decline in revenue because of potentially lower real property assessments. 106 Lower tax revenues also affect cities ability to borrow cheaply 107 or to adequately fund schools and other public services, or provide other vital governmental services. 108 Additionally, though faced with declining tax revenues, cities are often required to increase police protection in areas with vacant homes to prevent vandalism and to prevent criminal activities from taking place in the homes. 109 Cities often respond to decreased revenue by passing the costs on to its citizens in the form of tax increases. For example, the City of Chicago recently requested a fifteen percent increase in property taxes as well as increases in sales, gasoline, and parking taxes to compensate for the lost revenue caused by flattening property assessments and rising mortgage foreclosures. 110 Of course, just as cities likely will seek to increase property taxes to compensate for lost revenue, homeowners have an economic incentive to seek lower assessments and lower taxes to reflect the decrease in their property values caused by the mortgage foreclosures. Studies consistently show that foreclosures impose costs on neighboring properties by lowering their market value. 111 Even if the owner of a neighboring home has not borrowed recklessly, the close proximity of foreclosed properties to property the owner wants to sell increases the risk that the responsible owner will be financially harmed because the neighboring foreclosed properties will negatively affect the sale price for her property. 112 In addition, depressed home prices make it harder for owners to refinance their existing loans or to obtain new financing, which then creates a negative cycle of disinvestment. 113 The presence of foreclosed properties in a neighborhood also gives people an incentive to 106. Monica Davey, Housing Downturn Takes Big Toll on Cities Revenue, N.Y. TIMES, Oct. 18, 2007, at A See id. (explaining that cities may be prevented from borrowing cheaply because the value of the collateral for municipal loans i.e., the assessed value of their property base will be lower) Id See Dan Immergluck & Geoff Smith, The Impact of Single-Family Mortgage Foreclosures on Neighborhood Crime, 21 HOUSING STUD. 851, (2006); see also Engel & McCoy, supra note 33, at 2076 (describing generally the abuses associated with predatory lending) Peter Slevin & Kari Lydersen, Daley Urges Sweeping Tax Hike, WASH. POST, Oct. 15, 2007, at A Editorial, Losing Homes and Neighborhoods, N.Y. TIMES, Apr. 10, 2007, at A See Calculated Risk: Assessing Non-Traditional Mortgage Products: Hearing before the Subcomm. on Housing and Transp. and the Subcomm. on Econ. Policy of the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. 10 (2006) (statement of William A. Simpson, Vice President, Mortgage Insurance Companies of America) Press Release, Comptroller of the Currency, Comptroller Dugan Expresses Concern over Subprime Mortgage Foreclosures; Receives Making-the-Difference Award from Credit Counseling Foundation (Apr. 24, 2007), available at (last visited Apr. 5, 2008).

18 152 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 vandalize the vacant home, steal copper, or conduct criminal activities in the home. 114 An increased risk of criminal activities in a neighborhood populated with homes that are in foreclosure stigmatizes the neighborhood. Once a neighborhood s overall reputation for quality of life declines, the quality of schools and other neighborhood amenities and activities will likely decline. In addition to the harm to individual homeowners or neighboring communities and municipalities, the subprime meltdown has detrimentally affected the U.S. and global capital markets. The subprime meltdown triggered a liquidity crisis that has harmed prime borrowers who sought to obtain mortgage credit and were not in default. Since 2006, lenders have been reluctant to initiate mortgage loans generally, and jumbo mortgages specifically, even to consumers and businesses with good credit ratings. 115 This liquidity crisis also has harmed entities that invested, or sought to invest, in subprime mortgages because lenders restricted the credit available to hedge funds or private equity firms because of the risks associated with securitized subprime loans. 116 This credit restriction has made investors less willing to buy mortgage-backed securities, which has decreased the issuance of these securities. 117 To spark economic activity and prevent further damage to the economy caused by the tightening of credit and general chaos in the housing and credit markets, since October 2007, the Federal Reserve has repeatedly cut interest rates. 118 The Chairman of the Federal Reserve also conceded that the gravity of the problems with the U.S. housing market has hurt the overall economy. 119 A number of major retailers in the United States, including Home Depot and Wal-Mart, have reported lower corporate earnings because of slower than expected consumer spending; U.S. auto manufacturers lowered their 2007 sales forecasts as well. 120 Finally, the problems with the U.S. mortgage market have affected global financial markets. Despite interest rate cuts, the U.S. and global stock markets have been on an almost non-stop roller-coaster ride due in large part to the liquidity crisis caused by the subprime lending meltdown. 121 Indeed, the liquidity crisis has caused the collapse of a major U.S. investment bank and several major U.S. hedge funds that had invested in securitized subprime loans, caused a run on at least one bank in Great Britain, lead to the 114. Les Christie, The Ugly Face of Foreclosure, CNNMONEY.COM, May 7, 2007, Immergluck & Smith, supra note 109, at The Economic Outlook: Hearing Before the Joint Economic Comm., 110th Cong. (2007) (statement of Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System) [hereinafter Bernanke Statement II], available at bernanke a.htm Id Id Id.; see also Bob Davis, et al., U.S. Mulls Next Steps in Crisis, WALL ST. J., Mar. 18, 2008, at A1; Paul R. LaMonica, Fed Cuts Rates to 4.5%, CNNMONEY.COM, Oct. 31, 2007, (last visited Apr. 5, 2008). There is some concern that other large institutional investors, like pensions and university endowments, will be harmed by the subprime mortgage crisis. See Julie Creswell & Vikas Bajaj, $3.2 Billion Move by Bear Stearns to Rescue Fund, N.Y. TIMES, June 23, 2007, at A Bernanke Statement II, supra note Terry Kosdrosky & John Flowers, Credit Turmoil is Likely to Crimp U.S. Auto Sales, WALL ST. J., Mar. 19, 2008, at A11; Mike Spector, Jeffrey C. McCracken & Neal E. Boudette, How Housing Slump Is Risk To Big Three Rebound, WALL ST. J., Nov. 27, 2006, at A See Bob Davis, et al, U.S. Mulls Next Steps in Crisis, WALL ST. J., Mar. 18, 2008, at A1; Adam Shell, Subprime Troubles Send Stocks into Swoon, USA TODAY, Mar. 14, 2007, at 1B.

19 2008] CONSUMER OVER-INDEBTEDNESS: A U.S. PERSPECTIVE 153 termination of the CEOs of Citigroup and Merrill Lynch, and is wreaking general havoc with the global financial markets. 122 B. Crafting a Response: Recognizing Creditor Motivation Neither creditors, who loaned recklessly nor debtors who borrowed recklessly should bear the sole blame for the current problems. However, as Brazil considers possible solutions to its increasing problem of consumer over-indebtedness generally, or the specific problems involving credit card or other forms of consumer debt, policymakers should carefully consider why creditors engage in certain behavior and why that behavior is not only understandable, but is actually quite rational. As market actors, businesses that provide credit to consumers have an incentive to act solely in the interest of maximizing their profits. Thus, it is not surprising that credit card issuers target U.S. college students since they are in the habit of being in debt and their potential future income makes them a lucrative customer base. 123 Likewise, while unsettling, it should not be surprising that credit card issuers have targeted undocumented workers 124 as well as homeowners who are facing a foreclosure and, thus, losing access to the equity in their homes, 125 since it is perfectly rational for companies to aggressively market to customers who have limited access to other types of credit. Before the United States imposes additional regulations on the subprime lending market, or before Brazil or other countries decide what type of consumer insolvency system to adopt, policymakers must realize that, quite simply, it is extraordinarily profitable to do business with consumers with weak credit histories or who are perceived to be financially naïve or desperate. These customers can be charged higher interest and fees and, if they are given a credit card, are more likely to carry large credit card balances and to make only the monthly minimum payments. 126 In fashioning relief to over-indebted consumers, policymakers must understand that creditors generally will engage in acts that are not profitmaximizing only if there is a concerted effort to discourage consumers from participating in market activities that increase their over-indebtedness, or if judicial or administrative supervision, such as laws or agency regulation, force them to do so, or if some extra-legal cultural norm shames them into being benevolent. As discussed in the following sections, these factors of profit-maximization, social optimality, and regulatory pressure all appear to be at work as the United States considers how to respond to the current consumer overindebtedness crisis Bob Davis, et al, U.S. Mulls Next Steps in Crisis, WALL ST. J., Mar. 18, 2008, at A1; Eric Dash & Landon Thomas Jr., Citigroup Chief Is Set to Exit Amid Losses, N.Y. TIMES, Nov. 3, 2007, at A1; Landon Thomas Jr. & Jenny Anderson, A Risk-Taker s Reign at Merrill Ends With a Swift, Messy Fall, N.Y. TIMES, Oct. 29, 2007, at A1; Julia Werdigier, Official Assurances Fail to Stem Rush of Withdrawals at British Bank, N.Y. TIMES, Sept. 18, 2007, at C3. The U.S. housing crisis is somewhat similar to the housing problems that affected some European nations (including France, Great Britain, Finland, and especially Norway) during the 1990s. There was an escalation in real estate values followed by somewhat steep declines, which then triggered a private consumer debt crisis. Johanna Niemi-Kiesiläinen, Consumer Bankruptcy in Comparison: Do We Cure a Market Failure or a Social Problem?, 37 OSGOODE HALL L.J. 473, (1999) See Singletary, supra note Ieva M. Augstums, BofA Steps Into Immigration Minefield, OAKLAND TRIB., Mar. 4, Another example is that Brazilian lenders are targeting the elderly to offer them high interest loans secured by their meager pension. Cf. Doll & Sampaio, supra note RONALD MANN, CHARGING AHEAD 146, (2006).

20 154 TEXAS INTERNATIONAL LAW JOURNAL [VOL. 43:135 C. U.S. Response to Consumer Over-Indebtedness 1. Disclosure and Consumer Education When the U.S. credit crisis started earlier in 2006, few members of Congress and no one in the current Bush Administration were willing to propose substantive, immediate solutions to the housing crisis. No one wanted to be perceived as arguing for a bailout of either homeowners or hedge funds. Instead, the most common response was to propose either additional homeowner counseling services or to suggest that consumers be given even more disclosures about the terms of their mortgages or credit cards. 127 In crafting a response to the problem of consumer over-indebtedness, policymakers in both the United States and in Brazil should avoid adopting a solution that merely increases the amount of information or disclosures that consumers receive before each credit transaction. 128 While disclosure information appears to be useful for higher income borrowers, consumer counseling organizations in the United States have generally found that consumers who have received counseling still are prone to succumb to the aggressive marketing and advertising of lending organizations. 129 Thus, additional counseling or enhanced disclosures by themselves are not likely to help resolve the problem of consumer over-indebtedness. 130 Counseling and additional disclosures are especially unlikely by themselves to help decrease consumer over-indebtedness because of certain cognitive biases people have. That is, people are prone to be overly optimistic about their financial futures and to systematically underestimate the risk that bad things will happen to them, such as an inability to repay their debts. People also tend to discount the harm that may occur to them in the future, such as default, because they tend to place a high value on positive current events: the ability to own their own home or to buy something with a credit card. 131 Given this, it is unrealistic to assume that most consumers will consistently control the impulse to over-consume. Since some consumers (like college students) may have reason to believe that their incomes will increase significantly in a few years, providing additional disclosures will likely be meaningless in convincing them to temper their spending. 132 Finally, shifting the burden to the consumer to understand the terms of complex credit transactions creates perverse 127. See, e.g., Calculated Risk: Assessing Non-Traditional Mortgage Products: Hearing before the Subcomm. on Housing and Transp. and the Subcomm. On Econ. Policy of the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 8 (2006) (statement of George Hanzimanolis, President-Elect, National Association of Mortgage Brokers), available at ( Once the... borrower possess[es] the financial literacy tools necessary to understand the information imparted throughout the loan origination process, the disclosure becomes an invaluable communication tool. ). The mortgage industry continues to argue that the best way to help consumers is to provide additional counseling to consumers and to encourage homeowners to contact their lenders to participate in the lender s loss mitigation programs. Straightening Out the Mortgage Mess: How Can We Protect Home Ownership and Provide Relief to Consumers in Financial Distress?: Hearing before the Subcomm. on Admin. and Commercial Law of the H. Comm. on the Judiciary, 110th Cong. (2007) (statement of Steve Bartlett, President & CEO, The Financial Services Roundtable), available at oversighttestimony.aspx?id=1107 [hereinafter Bartlett Statement] Cf. Bair Statement, supra note 7, at (expressing skepticism about improving credit card disclosures without imposing additional regulations) Bucks & Pence, supra note 43, at 20 21; WILLIAM C. APGAR, CREDIT, CAPITAL AND COMMUNITIES: THE IMPLICATIONS OF THE CHANGING MORTGAGE BANKING INDUSTRY FOR COMMUNITY BASED ORGANIZATIONS 75 (2004), available at communitydevelopment/ccc04-1.pdf APGAR, supra note 129, at Bar-Gill, supra note 18, at See Singletary, supra note 20.

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