This is the Wizards of Money, your money and financial management series, but with a twist. My name is Smithy and I’m a wizard watcher in the Land of Oz. This is part 13 of the Wizards of Money series and it is entitled “Bankruptcy Bill’s Shoot-Out at the Social Safety Net”.
Introduction
In this, the thirteenth chapter of Wizards, we are going to take a look at another Chapter 13 … and a Chapter 7 and a Chapter 11 – these chapters are some of the main ways under federal law to file for Bankruptcy. Importantly we will look at the strong relationship between the non-stop credit offers we find stuffing our mailbox, e-mail and voicemail everyday, the innovative financial Wizardry behind such offers and the rapid rise in personal bankruptcies. We’ll examine who does file for bankruptcy and what causes them to go bankrupt. Then we’ll look at the new Dream Bill of the Credit Card and Banking Industries – called “Bankruptcy Bill” – that looks set to pass into law soon. Bankruptcy Bill is aimed at thwarting people’s attempts to be caught in that final, last-resort, safety net, known as the bankruptcy court. To help us understand both the credit offer onslaught and the salient features of Bankruptcy Bill we’ll talk to Margaret Howard, a Law Professor at Washington and Lee University, and visiting scholar at the American Bankruptcy Institute.
After a look at how people get robbed by credit cards and Bankruptcy Bill, we’ll look at how a small businesses can get robbed by a big bank. In the last section of this Wizards Chapter 13 filing, we’ll talk to Greg Bates at Common Courage Press about how their money from book sales was robbed by Bank One, a credit deletion service provided to them by the bank even though they’re not a customer!
But first lets talk about Bankruptcy Basics and the invasion of the Credit Card Monsters.
What Triggers Personal Financial Ruin?
One book that is an excellent source of information for understanding bankruptcy in America is a book called “The Fragile Middle Class, American’s in Debt” by Sullivan, Warren and Westbrook. The authors have conducted extensive studies of bankrupt Americans in one of the few comprehensive studies not funded by the credit card industry. Here is some of what they found:
- Up until the last year of their study period, which was 1998, Americans that filed for bankruptcy were overwhelmingly middle class – above the bottom 20% but below the top 20% income earners.
- About 80% were forced into bankruptcy due to an unforeseen event such as job loss, sudden illness or injury, or divorce.
- Excessive credit card debt is increasingly a primary force propelling people into bankruptcy. In the years to come this is likely to continue as a major driving force along with a new partner, the wildly popular Home Equity loan.
Bankruptcy law is federal law. When someone files for bankruptcy they would file under either Chapter 7, whereby many debts are forgiven, but many assets are also forgone. This provides relief from aggressive creditors and enables the debtor to wipe the slate clean and start all over again. Under a Chapter 13 filing, an “automatic stay” is granted whereby creditors can’t go grabbing at your last bits of income and assets, and the court process will assist in coming up with an agreed upon repayment plan. Chapter 13 enables a debtor to stop creditors in their tracks while they come up with a more feasible repayment plan so that desired assets (like a home) can remain with the debtor. Filing for personal bankruptcy under both Chapter 7 and 13 is intended to provide some relief for debtors, and a chance for a fresh start, while it comes at some cost to creditors such as banks and credit card issuers.
Over the years personal bankruptcies have been increasing faster than the population. On May 16, 2002 the American Bankruptcy Institute issued a press release stating that record levels of bankruptcies had been achieved for the year ended March 31, 2002. Over that year a record 1.5 million American households filed for bankruptcy.
Several trends are driving this increase. One is the increasing number and size of gaps in the social safety net, which one might otherwise be caught by on the way to this last resort option. With a high number of people without adequate health insurance coverage, a sudden medical emergency can push an individual or family over the edge and into bankruptcy court. More often, it is unexpected job loss or disability that pushes people over the financial edge. Divorce, especially for women who then care for children by themselves, accompanied by difficulty collecting child support, is another common trigger. In fact there is evidence now that suggests that single women head of households make up the largest group using the bankruptcy option. In the absence of comprehensive publicly funded safety nets or public insurance to buffer individuals against these shocks, with creditors pounding constantly on the door, and as drastic as it seems, sometimes bankruptcy provides the only avenue of some relief.
Middle class debt loads have increased over the years. The “Fragile Middle Class” book points out that the amount of debt relative to income that usually triggers a bankruptcy has remained fairly constant over the years. But the number of bankruptcies is rising faster than the population. This is because, on the whole, the middle class debt load relative to income is increasing, meaning that more people are crossing that threshold that can trigger bankruptcy.
Several decades ago, on average, people didn’t accumulate as much debt as they do today and so they had more of a safety net of their own to weather the storm of any of these common financial ruin triggers – which are job loss, sickness and injury, and divorce. But with the increasing debt load, personal safety nets are disappearing right along with the vanishing public safety nets. The increasing debt load has been driven both by increasing credit card debt and by home equity loans in the midst of a strong property market. In addition, the financial ruin triggers themselves are becoming more frequent, with globalization increasing job insecurity, higher divorce rates, ever higher medical costs and higher education costs.
“Beware the Stranger Bearing Gifts” … Invasion of the Credit Card Industry
The sin of usury is well documented in the guidebooks of the popular religions. In the 1980s these chapters of the Good Books may as well have been whited out. During the monetary madness of the eighties and simultaneous high interest rates, religious warnings faced the ungodly power known as “market-discipline”. Usury laws of many states that capped interest rates charged to consumers disappeared like magic and a new religion was born – a full blown, non-stop, nirvana of credit accessibility everywhere you looked. The fact that creditors could now charge huge interest rates meant that credit suddenly became widely available to people who were once considered poor credit risks. A billboard here saying “Credit Problems, No Worries!”, a man with splendid manners on the phone greeting you with “Maam, you’re pre-approved for $5,000!” and a mailbox chock full of tens of thousands of ready made checks and friendly letters saying “Congratulations, You’re Pre-Approved! Sign Here”.
And so the man with the nice manners and the friendly letters came to take the place of the holes that appeared in the publicly funded safety net. If you couldn’t afford your medical bills, put them on a credit card! Lost your job? Never mind – pay your rent and buy your food on credit. Of course, this is one extreme of how credit is used, particularly by people in desperate circumstances and with no other access to adequate money for the necessities of life.
In addition to this is the much more obvious and well-documented role of the credit frenzy in fueling a consumer economy that grew like crazy throughout the eighties and nineties, and hasn’t stopped yet. This widespread credit feeding frenzy feeds the consumerism that props up the financial markets and, in turn, leads to greater capital accumulation ready to fund even more access to credit for the poor and middle class, and so the cycle continues. It is a highly leveraged “House of Cards”.
Recall that we spoke about the role and dangers of excessive leverage in Wizards Part 11. Recall that we also spoke about the “House Edge” – the amount that the House makes, on average, in any betting game. The “House Edge” for the credit industry comes from the huge interest rates it charges, and can get away with, thanks to the market’s discipline of the bothersome religious rules in the era of financial deregulation.
It is instructive to look at trends in the expansion of consumer credit over the past several decades. Some good data is available on the Federal Reserve’s web site at http://www.federalreserve.gov/releases/g19/hist/cc_hist_mh.html
[Go to www.federalreserve.gov, Click “Research and Data”, “Statistics”, G19 – Consumer Credit]. In this data you will see that total consumer credit has now grown to $1.7 Trillion dollars, which doesn’t even include home mortgages and home equity loans.
Provision of consumer credit dates back to the early 1900’s when catalogue stores like Sears, Roebuck and Company enabled consumers to buy goods on credit. “The Fragile Middle Class” points to credit application forms in 1910 that ask sensible credit risk assessment questions such as “How many cows do you milk?”. During the Great Depression, General Electric or GE’s now monstrous unit, GE Capital – the largest of the non-bank financial institutions – was started as a little consumer credit company to help Depression Era folks get access to the necessary appliances for a modern life. In fact, if you look at the Federal Reserve’s consumer credit data you will see that right after the second world war non-financial business, primarily department stores, were the largest providers of consumer credit by far.
Throughout the 1950’s through the 1980’s commercial banks took over as the primary suppliers of consumer credit. But by 1989 a new “Wiz-Kid” emerged on the block and, as of today, the Federal Reserve data shows that it has taken over the banks to become the major vehicle through which consumer credit
is now supplied. This vehicle is the handiwork of the bankers and investment bankers themselves. It is also the one that snuck into the big hole left in the crumbling social safety net while nobody was looking. For, in conjunction with the high interest rates permissible today, the new Wiz-Kid invention is quite likely the very thing that has enabled the provision of credit to people who really can’t afford it – those in poverty or very near to it. These are generally people least able to resist an offer of credit. They are also people who, in a more balanced society, may have basic needs met by publicly funded social safety nets, rather than through high interest loans.
Key to the profitability of lending to the poor is the fact that they desperately need access to credit, often don’t understand the impact of high interest, and therefore do not act at all like the much touted “rational market player”. The creditor can always win the arbitrage game played against the irrational market player. For example, many credit card targets don’t realize that under the attractive minimum monthly repayment plan, a balance of just $2,500 might take more than 30 years to pay off! Just like Keno and Slot Machines in our visit to the Casino in Wizards Part 11, nowhere is the House Edge larger in the financial markets than in lending to the poor without a usury cap.
If it’s got an Income Stream … Catch it, Tame it and Securitize It!
This new Wiz Kid on the credit creation block is called the Securitized Asset. Included in this same family are the mortgage-backed siblings known as Fannie Mae, Ginnie Mae, and Freddie Mac, who you also may be acquainted with, and who will likely be guests on an upcoming episode of Wizards.
To securitize a pool of consumer loans, lets say credit card debt, here’s what happens:
- First, a bank, a group of banks and/or other credit card issuers decide they’d like to sell the credit card debts owed to them by their customers. In return they will get some cash that they can use for some new Wizard adventures.
- An investment banker packages all this debt together in a nice pool of credit card receivables, using what is known as a Special Purpose Vehicle, and does some risk analysis to price the bundled up debt. Then they sell the neat new packages of credit card backed securities for cash in the markets, with the cash proceeds going back to the banks and issuers, less a handsome cut for the crafty investment banker.
The new securities are then traded around the markets according to the whims of Wall Street. This is pretty much what happens with mortgages as well. So whether you’re paying of your credit card or your house you actually never know who you are paying to from one day to the next. You are just a little slice of income in a much bigger security.
The implications of pooling such risks across many issuers and many different bases of borrowers are quite profound and provide many appealing features for investors in these securities that are basically bundles of credit card receivables. By putting a vast number of credit card receivables behind a security, risks of default are spread across the pool as a whole and the cost of default is much easier to estimate. There are bound to be a handful of credit card holders who will end up not paying their bills, but in such a large pool there will be enough of the ones who keep paying their bills to make up for it. The high interest rates charged and paid by the larger paying group more than makes up for the defaulters, leaving a handsome profit for the investor in the bundled up security.
Thanks to these handsome profits, capital keeps flooding into these securities to fund ever more daily credit card solicitations. Due to this ability to pool risks via securitization, combined with saturation of credit in the middle class and the profits that come from uncapped interest rates, credit solicitations are now flooding into the poorest of homes, the bottom 20% of income earners. People in poverty are less able to resist such access to credit, and due to limited experience with it, often don’t understand that the huge interest is a killer. Over the coming years, it is likely that those wishing to file for bankruptcy will increasingly be the poor, in addition to the ever increasing stream of middle class already filing in.
An important study done by the Federal Depository Insurance Corporation (FDIC, who we spoke about in Wizards Part 10) is available at http://www.fdic.gov/bank/analytical/bank/bt_9805.html.
This study documents the relationship between the removal of interest rate caps or usury laws in the 1980s, the subsequent widespread availability of credit to all groups, and the resulting rapid growth in personal bankruptcy filings since the 1980s.
It also gives us an interesting history of the role of usury laws. The FDIC study reports “Usury laws perhaps have a more ancient lineage than any other form of economic regulation. … The Greek philosopher Plato also condemned charging interest because he felt that it produced an inequality of wealth and destroyed the harmony between citizens of the state. … As commerce expanded and money lending became increasingly important, opinions about usury changed. The Romans were more tolerant of usury and were one of the first societies to recognize interest and set maximum legal rates for various types of loans. Throughout much of recorded history, societies around the world have felt it was important to limit the interest rate that a lender can charge in order to restrain lenders from taking advantage of borrowers.”
Today, the modern American society has taken a step even beyond what the Romans would tolerate, by deregulating interest rates and removing usury caps.
As a result, the credit monster extends it tentacles ever further into society and into that sector that just might need bankruptcy protection the most. Just as it does so, the Credit Card industry has almost nurtured into existence its Dream Bill – called Bankruptcy Bill. The Creditors’ Dream Bill makes access to that one final safety net, known as declaring bankruptcy, all that tougher to get to. Meanwhile, Congressional and public debate over Bankruptcy Bill has barely focused on the profound implications of all this.
The end result of making it harder for individuals to declare bankruptcy … Profit margins of credit issuers, banks and investors in asset-backed securities go up, even as their base of credit is still growing. Just when you thought it couldn’t possibly get any bigger, the House Edge Increases!
So that we could get to know Bankruptcy Bill a lot better I spoke to Margaret Howard, a Law Professor at Washington and Lee University in Washington DC who is an expert in bankruptcy and commercial law. She is also visiting scholar at the American Bankruptcy Institute. I started by asking her about the news of the record level of bankruptcies achieved over the past year.
Interview with Margaret Howard, Law Professor at Washington and Lee University
(25 minutes)
That was the interview I did with Margaret Howard, a Law Professor at Washington and Lee University. Later on in our discussion Professor Howard also told me about the controversial provision known as the “Homestead Exemption” whereby even after declaring bankruptcy, under current law, in some states you can keep your home no matter what and creditors can’t touch it. This exemption seems to have come in rather handy for the Enron executives who recently seem to have been doing a lot of home improvement, even as angry investors file law suits against them. It might not surprise you to know that one of the States the Homestead exemption is available is Texas, and another is Florida. Under a compromise reached in Congress, people in these stated can still have their Homestead Exemption unless they are felons or convicted of financial fraud.
We’ve seen how individuals and families can get robbed by banks and other creditors. Now lets see how a small business can get robbed by a bank.
Bank-Robbing Banks
On April 2nd, a book distributor for small independent publishers, known as the LPC Group, sent a letter out to its book publisher clients informing them that they were filing for Chapter 11 Bankruptcy because they had just been robbed … by a bank! The letter also told the publishers that the money that was robbed had been due to the publishers for books sold to a wholesaler.
The bank that robbed them is a subsidiary of Bank One, a very large, quite profitable and well-off bank, one of the largest in the country. LPC group, legally known as Publishers Consortium Inc, is a customer of American National Bank and Trust Company of Chicago, a subsidiary of Bank One acquired during its merger with First Chicago NBD during the late 1990’s. They had a business loan from American National and also a deposit account. This deposit account was used to hold and then distribute funds from book sales of the small publisher clients. On April 1, some monies came into this account from a wholesaler and were getting ready to be distributed back to LPC Group’s small publisher clients. But, all of a sudden, through the wizardry possessed only by banks, the money vanished. The Bank took it! The money from the small publishers’ book sales was taken by the bank with apparently no notice to LPC or to the small publishers.
One of those small publishers who had their money stolen is Common Courage Press. Following is an interview I did with Greg Bates at Common Courage Press about this strange Bank Robbery …
Interview with Greg Bates at Common Courage Press about the Bank Robbery
(10 minutes)
After this interview I spoke with Doug Skalka, a lawyer in Connecticut representing the Bank. He didn’t want to be recorded but told me the following.
- The LPC Group Loan from the bank was secured by the assets of LPC Group.
- The bank had a lien on all assets including inventory.
The heart of this bizarre case can be summed up as a disagreement over two disputed issues:
1) What caused LPC Group to be in violation of its loan agreement so that the bank could call it in? I do not know the answer to this.
But the more important point for the publishers is:
2) What does the bank have a lien on? What are the assets of LPC group? Do they include the proceeds of book sales? The publishers claim that such monies belong to them. After all, they have already incurred all the expenses of publishing and putting the books together for distribution in the first place.
Common sense would say that the money belongs to the publishers.
Nevertheless, as we already saw with Bankruptcy Bill, common sense is quite often set aside in favor of vested interest when it comes to setting the Law of the Land under which the markets operate.
That’s all for the Wizards Chapter 13 Filing. Note that the Wizards of Money has a web site at www.wizardsofmoney.org
