We recently reported that total debt in the U.S. economy has reached an all-time high as a share of GDP, driven by growth in borrowing by both financial businesses and by households. The American Bankruptcy Institute reports that before the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the number of personal bankruptcy filings in the U.S. exceeded two million – up from less than 300,000 two decades earlier.

Pre-passage, U.S. bankruptcy law was among the most “debtor friendly” in the world as debtor obligations to repay creditors in bankruptcy proceedings were loosely related to their actual ability-to-pay.

This law has made it more difficult for individuals to file for bankruptcy, both under Chapter 7 and Chapter 13, but particularly under the former. Chapter 7 was (and remains) the most “popular” procedure used to file bankruptcy. Under Chapter 7, debtors must pledge all of their non-exempt assets to pay off creditors, whle their future income remains protected from garnishment. Assets exempt from creditor seizure included clothing, furniture, occupational tools, some or all of one’s home equity and various other items. By 2005, nearly 80 percent of all filings were conducted under Chapter 7 meaning that most bankruptcy filers were under no obligation to pay off their debts from future income, regardless of how high that income was.

Chapter 13 procedures, in contrast, do not require debtors to part with any of their assets, but do require repayment of debts from income in the post-filing period. Major features of pre-reform Chapter 13 filings were that debtors were able to pose their own repayment plans, and most were allowed to discharge certain debts under a Chapter 7 proceeding before moving on to a Chapter 13 filing.

BAPCPA altered U.S. bankruptcy law in three major ways. It eliminated the ability of debtors to choose between Chapter 7 and Chapter 13 proceedings by introducing a means test by which debtors must demonstrate that their monthly income averaged over the prior six months is less than the median monthly income in their state. Second, it eliminated the ability of debtors to propose their own prepayment plans under Chapter 13 by introducing a formula for repayment based on procedures used by the IRS when it calculates how much it can collect from delinquent taxpayers, allowing exemptions for various living expenses. The third change was that BAPCPA raised the costs of filing for bankruptcy. It did so by requiring filers to take credit counseling courses and financial management courses; to file four years of tax returns with the bankruptcy court; to pay more in filing fees; and to subject their lawyers to increased responsibility.

Together, these reforms have made it more difficult and costly for an individual to file for bankruptcy. In fact, since the number of individual filings peaked at 2 million in 2005, they fell to 600,000 in 2006, and were on a pace to exceed 800,000 through September 2007, the lowest number of filings since 1994 (though still increasing rapidly).

Why the number of bankruptcy filings increased for two decades before BAPCPA remains an open-question, as does the ultimate impact of the new law on consumer credit markets. In regard to the former, from 1984-2004, “revolving debt” (i.e. credit-card debt) per household increased five-fold, rising from 3.2 percent of U.S. median family income to 12.5 percent, according to a recently published paper by Michelle White, economist at the University of California-San Diego. As of 2004, she reports, the average debt among households that had positive credit card balances exceeded $15,000. This increase in the amount of consumer debt is the likely explanation for the increase in bankruptcy filings, and not more popular stories of “adverse events” such as job loss, high medical costs, divorce, etc. The major reason for this explanation is that adverse events have not become more frequent over time, while revolving debt accumulation has. For example, she shows that out-of-pocket medical expenditures borne by households increased only slightly as a share of median U.S. income – rising from 3.5 percent in 1980 to 3.9 percent in 2004.

In terms of the latter, clearly the new bankruptcy law has made it more difficult for those in debt to declare bankruptcy. This, in turn, has made it less risky for credit card companies to offer credit to a wide swath of individuals. Indeed, Professor White shows that incentives to offer more credit to families increased post-BAPCPA, and the amount of credit card debt has escalated since.

Despite the new law appearing more "creditor-friendly" a Federal Reserve Bank of Philadelphia report finds that creditors continue to receive very little on their debts post-reform - less than 40% of their outstanding balances. This rate has not seemed to escalated much over time, even though secured creditors are supposed to receive full payments in a successful Chapter 13 case, according to bankruptcy law.

Whether these reforms ultimately improve the well-being of debtors is unclear. Anecdotal evidence suggests that the number of wage garnishments has escalated since the passage of BAPCPA - making it more difficult to file for bankruptcy does not mean that consumers are in a better financial position. Professor White offers some helpful suggestions about how bankruptcy policy can be better coordinated with other policy tools to improve outcomes. These include requiring more of lenders beyond the current loose patchwork of “guidelines” that requre little of lenders in excess of accurate disclosure of loan terms. Such reforms might include raising the minimum montly payment required on credit cards beyond the current one percent (to reduce the amount of interest debtors pay); truth-in-lending laws that require card issuers to include information on how long cards will take to repay if debtors pay only the monthly minimum; and other measures.

Whatever reforms are pursued going forward, we hope that policy is driven by two objectives. The first objective is that responsible consumers remain able to access credit in a cost-effective and formal manner when they need it. The unintended consequence of poorly designed credit regulations, such as usury laws, is that debtors rely on “payday” lenders, pawn shops, and other informal means that are far more costly, and potentially dangerous, to consumers. The second objective, important to remember in lieu of the current financial crisis, is that when reforms are imposed to benefit creditors in the event of adverse economic outcomes, the creditors should also be subject to financial losses from their own bad behavior, without recourse to taxpayer pocketbooks.