New tools are needed to combat a surge of consumer bankruptcies. Financial education and counseling are two potential solutions that could address a growing problem.
Personal bankruptcy filings (chapter 7 and 13) have vaulted well over the psychological 1 million mark for the first time in American history, costing the bank-card industry about $7.5 billion, or roughly half that industry's total credit losses for 1996 [ILLUSTRATION FOR FIGURES 1 AND 2 OMITTED]. The significance of this represents more than simply crossing a numerical threshold. A small increase in bankruptcy filings that incidentally pushed filings passed the 1 million-case mark might be interesting, but unimportant, from a policy or economic perspective. This record, however, comes as the result of an astounding 20 percent increase in personal bankruptcy filings during the previous 1996.
It is apparent that this increase is something more than a mere cyclical, statistical uptick. It may, in fact, reflect certain fundamental changes in consumer behavior and in the credit industry. For instance, unlike previous peaks in bankruptcy filings, the current explosion occurs amid an expanding economy and declining unemployment. The average consumer today holds more than four credit cards, with an average balance per card of $2,000, up from an average balance of $1,400 per card in 1991.
Until recently, most lenders' opinions about and management of consumer bankruptcy was neatly informed by whether they were "secured" or "unsecured" creditors. The distinction between the two, however, is becoming less and less clear, as the position of a secured lender suffers from modification in bankruptcy laws, house-price depreciation, overextension of credit, job loss, changing attitudes and financially devastating events. Each of these factors, external to the credit evaluation process, results in increased exposure to bankruptcy for mortgage and other lenders when an overextended consumer encounters financial crisis.
This article describes how the credit-card and mortgage banking industries face common problems when a borrower files bankruptcy. It examines the effects that bankruptcy have on the credit system. It also summarizes current research into the causes and alternatives to bankruptcy and suggests education of debtors as a common element that can and should be pursued as a preventive and rehabilitative solution. Finally, we suggest that a tracking system for individuals once they enter the bankruptcy system be pursued so that education programs can be continuously improved to provide borrowers with a true fresh start - not just debt relief but tools necessary to manage their money and credit to avoid future distress.
Secured and unsecured lenders: The indistinct distinction
Historically, mortgage lenders have generally assumed that their secured positions insulate them from bankruptcy losses. However, the staggering losses stemming from personal bankruptcies that currently affect the bank-card industry affect secured lending as well, with several notable correlations. Gordon Monsen, in his article in the June 1996 issue of Mortgage Banking, accurately observes the correlation between trends in the mortgage lending industry toward lower equity, lower savings levels, lower home-price appreciation and higher consumer-credit levels, to early mortgage default. Monsen correlates charged-off bank cards and high balance-to-credit levels with mortgage default.
In noting job loss as the most common cause of mortgage default (it is also one of the most common life events correlated to bankruptcy), Mortsen hypothesizes that homeowners who encounter sudden unemployment tend first to deplete whatever savings are available to finance living expenses until a new job is found, then whatever bank-card credit is available, before finally exhausting these resources and defaulting on their mortgage loans.
Secondly, the 1996 credit playing field has been leveled by a real estate market that can no longer rely on steady appreciation to compensate for faulty credit evaluation. Monsen also notes that borrowers with high equity positions in their properties tend to sell the home rather than face foreclosure, while those with little equity tend to turn in the keys. It may not be coincidental, then, that borrowers with few or no assets to protect tend to turn to Chapter 7 bankruptcy. In such a case, the mortgage lender may be faced with a loss similar to that of the bank-card lender.
Thirdly, borrower behavior prior to filing bankruptcy and prior to defaulting on a mortgage provides less and less warning to the lender through late payments. Maximum bank-card usage also is correlated to subsequent mortgage default. This may result from a "borrowing from Peter to pay Paul" syndrome, or using credit advances to make minimum required payments on other (mortgage and nonmortgage) debt, before finally exhausting all available resources to suddenly default or declare bankruptcy without warning.
Such a trend threatens the underwriting standards and scoring systems upon which consumer-credit, automobile, small-business and mortgage lenders rely to serve the widest possible market with the fewest possible losses. Given these...