How bankruptcy was broken

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published 11 January 2020

Sen. Elizabeth Warren (D-Mass.) wants to fix American bankruptcy law. Indeed, as she's told people many times, studying bankruptcy is what convinced Warren to quit her career as a Harvard professor and enter politics — it's largely why she jumped ship from the Republicans to the Democrats, and why she became a populist progressive firebrand. As part of her campaign for the Democrats' presidential nomination, Warren just released a meaty plan to reform U.S. bankruptcy law.

The proposals are designed to once again make bankruptcy what it's intended to be: a balanced process that allows creditors to recoup some losses and gives debtors a genuine fresh start, while making sure both parties share responsibility for the failure. But how did American bankruptcy break in the first place? The key turning point was a 2005 law, backed by the banking and credit card industries, that made personal bankruptcy a lot harder to obtain.

Personal bankruptcy comes in two forms. Chapter 7 bankruptcy more or less wipes out people's debt, in exchange for their handing over assets and cash not protected by law from bankruptcy proceedings. The basic idea there is to allow the debtor to start over with a clean slate and make sure the creditor is reimbursed to some degree, but also that the debtor retains enough resources that they can actually start over. Chapter 13 bankruptcy allows the debtor to keep much more of their property, but also puts them on a long-term payment plan.

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The Bankruptcy Abuse Prevention and Consumer Protection Act (or BAPCPA) of 2005 made a number of changes: It significantly increased the paperwork and fees required to file Chapter 7 for people making over 150 percent of the poverty line. It also made it a lot harder for people to take Chapter 7 over Chapter 13 if they made more than their state's median income. The law forbade Americans from getting rid of student loan debt through bankruptcy, and it instituted a number of other changes that generally made the process less forgiving.

In the years before the 2005 law, personal bankruptcies were on the rise, and champions of BAPCPA claimed people were abusing an overly lax system — hence all the additional hurdles that BAPCPA brought. The law's proponents also argued that making bankruptcy harder to obtain would lower the cost of credit for all the other Americans who didn't file for bankruptcy. (Interestingly, BAPCPA's fans included one Senator Joseph Biden — a Democrat from Delaware, where a huge proportion of America's credit card companies are based, and one of Warren's current challengers for the party’s presidential nomination.)

Taking the opposite side of the fight were people like Warren, who argued that rising bankruptcies were caused not by personal shiftlessness, but by a decades-long trend of Americans getting squeezed by stagnating wages and ever-rising costs of living. That left working people in ever more precarious financial straits, in which one run of bad luck could pitch a family over the precipice. "The data showed that nearly 90 percent of these families were declaring bankruptcy for one of three reasons: a job loss, a medical problem, or a family breakup," Warren wrote.

Since BAPCPA's passage, it does look like credit became cheaper for Americans: "Typical credit card interest rates for people with fair credit might be in the mid- rather than low 20s had the reforms not been adopted," according to a summation of the research by Vox's Matt Yglesias. But the price of that reduction was that a lot of low-income families who aren't quite poor enough to fall below 150 percent of the poverty line got slammed by the increased paperwork and fees and the shift to more Chapter 13 filings. Filings for bankruptcy due to medical debt fell, and of course a lot of Americans were condemned to labor under student debt they couldn't get rid of. The period of time where people and families struggle with the decision whether to file bankruptcy — nicknamed "the sweatbox" — also grew considerably. That's more time in which people are bleeding down their finances, while banks and creditors continue to profit from their debt payments.

Warren's new plan proposes a number of reforms to BAPCPA. The centerpiece is she would combine Chapter 7 and Chapter 13 into one singular bankruptcy process, while doing away with the income tests and the higher fees and paperwork. Debtors would be able to choose the wipe-the-slate-clean approach or the payment-plan approach, depending on their needs. Warren would include student debt in the mix of debts that bankruptcy can do away with. Warren would also raise the amount of home equity that filers can hold onto during the bankruptcy process, and she would empower bankruptcy judges to adjust the payment terms of mortgages — something the Obama administration promised to do in response to the 2008 housing crisis, and then reneged on.

Other noteworthy changes include allowing parents to protect more money for spending on their children during bankruptcy; allowing union members to keep paying their union dues; and allowing people to keep paying rent, so that the bankruptcy process doesn't result in their eviction. In fact, a lot of these alterations started life as amendments that lawmakers tried to attach to BAPCPA itself, but that were ultimately shot down.

Zooming out to the big picture, capitalism only functions when people are free to take risks without fearing that failure will be the end of them. Every loan is a risk; an effort to do something in the economy better than was done before. And a crucial thing to realize is that the decision to create the loan is a risk taken by the creditor as much as by the debtor — both are equally responsible if the risk happens to not pan out. It's worth noting that corporations and wealthy individuals file for bankruptcy all the time — often with far more advantages and options for protections than everyday consumers have — and yet failure to pay debts in full only gets treated as a distinctly moral failing when everyday Americans are the debtors.