Todd J. Zywicki *
This year 1.4 million Americans will file bankruptcy. This, despite
the fact that unemployment stands at less than 5%, economic growth
remains robust, interest rates remain low, and the stock market
continues to roar. Our record-setting bankruptcy rate remains the
one cloud on our otherwise sunny economic landscape.
In response to this bankruptcy crisis, Congress acted this summer
to limit abusive practices in the bankruptcy system in an attempt
to slow the bankruptcy boom. Critics of the legislation charge that
focusing on debtor abuse is misguided, as the primary culprit in
the bankruptcy boom are overzealous creditors and
especially reckless and aggressive credit card issuers. At the heart
of this model of bankruptcy is the idea that the primary cause of
bankruptcy filings is excessive consumer debt, and that excessive
debt results from overaggressive lending practices that cause people
to get over their heads in debt. At some point the debt load becomes
so burdensome that they are "forced" to file bankruptcy
and to shed some of this debt.
For "debt causes bankruptcy" theorists, issuers of credit
bear a large portion of the blame for escalating bankruptcy filing
rates. The attitude of Judge Joe Lee, Bankruptcy Judge for the Eastern
District of Kentucky is representative of this mindset, "The
target of bankruptcy reform should be the consumer credit industry
and the laws governing extensions of consumer credit. Instead they're
robbing the poor to enrich the rich." The solution to the bankruptcy
boom, therefore, lies not in tighter bankruptcy laws, but in tighter
regulations on creditors and greater consumer education. Credit
card issuers, in particular, are singled out for criticism.
But there are numerous flaws in this "debt causes bankruptcy"
model. First, the model incorrectly posits a connection between
total indebtedness and bankruptcy. But more relevant would be current
indebtednessthe amount due each monthand bankruptcy.
Individual bankruptcies result from the inability to meet one's
financial obligations as they come due, not from some aggregate
measure of indebtedness. Because of the low interest rates of recent
years, current indebtedness has remained below historic highs, meaning
that it should be easier for individuals to meet their debt obligations
than at other times in the past. In turn, as interest rates fall
bankruptcies should be falling as well. Instead, they continue to
The "debt causes bankruptcy" thesis suffers from several
other flaws as well. It fails to distinguish cases involving excessive
debt from cases involving excessive individual spending. Many people,
especially high-income and financially-sophisticated debtors, incur
debt ibecause they choose to, not because they are "forced"
to. Consumer debt can only accumulate in one waythrough the
conscious decision of consumers to purchase goods and services,
and to do so on credit rather than paying cash. In short, in many
cases, it is reckless and extravagant spending that causes bankruptcy,
not the debt that lies behind these spending habits. In addition,
consumers will borrow more if they know that they can later discharge
in bankruptcy if necessary. Thus, the causal link also runs in the
other directionthe easy availability of bankruptcy will cause
consumers to take on more debt than they would absent the bankruptcy
The "debt causes bankruptcy" thesis is also inconsistent
with the available evidence. In recent years, the bankruptcy filing
rate has risen far faster than have aggregate consumer debt levels.
For instance, from 1995 to 1996 bankruptcies rose by 29%, and then
from 1996-1997 they rose another 20%. Consumer debt levels did not
rise by nearly as much during those years.
The final nail in the coffin of the "debt causes bankruptcy"
thesis is provided by economists David Gross and Nicholas Souleles.
Gross and Souleles examined the portfolios of several credit card
issuers and found that even after adjusting for levels of risk,
such as debt-to-income ratios, the typical credit card holder was
statistically significantly more likely to file bankruptcy in 1997
than in 1995. As they conclude,
"The main finding is that even after controlling for risk-composition
and other economic fundamentals, the propensity to default significantly
increased between 1995 and 1997. A credit card holder in 1997 was
4 percentage points more likely to default and 1 percentage point
more likely to declare bankruptcy than a cardholder with identical
risk characteristics in 1995. These
magnitudes are approximately as large as if the entire population
of credit card holders had become one standard deviation riskier
between 1995 and 1997, as measured by credit risk scores. By contrast,
increases in credit limits and other changes in risk composition
explain only a small part of the change in default rates over time."
Credit cards provide an especially unlikely explanation for the
bankruptcy boom. Credit cards make up only a small fraction of Americans'
total indebtedness, as total housing debt is many times larger in
amount than credit card debt. Bank card debt also comprises only
16% of overall bankruptcy debt. Thus, credit cards do not provide
a plausible explanation for the bankruptcy boom.
Blaming credit card issuers for rising credit card indebtedness
is also questionable because it focuses only on the supply side
of the credit card market and ignores growing consumer demand for
credit cards as both a transactional and borrowing medium. For convenience
users who do not revolve debt, credit cards offer a wide array of
attractive attributes that other purchasing media lack, such as
frequent flyer miles and cash back bonuses. Credit cards also liberate
users from having to maintain interest-free cash balances in wallets
or checking accounts. Perhaps most significantly, the catalogue,
television, and Internet shopping markets essentially would not
exist without consumers' access to credit cards.
For many, credit cards are also an attractive source of low-transaction
cost, short-term credit. Although interest rates on credit cards
seem high when compared to mortgages and home-equity loans, for
many users credit cards are quite attractive when compared to alternative
sources of credit. Poor borrowers, for instance, do not have access
to home equity loans. As a result, ifnhe needs a new transmission
for his car, a poor person has several unattractive options: selling
some of his personal assets, a pawn shopor credit cards. A
short-term, unsecured bank loan for such a contingency is likely
to be either unavailable or available only at a very high interest
rate with high processing charges. In comparison to available alternatives,
it is little wonder that credit cards are so attractive for short-term
borrowers. Moreover, it should be obvious that restricting the operations
of credit card issuers will tend to injure low-income users the
most, as they have the fewest alternative sources of credit. Restricting
credit card operations will not prevent borrowing, it will just
make it more difficult for those who those who need them the most.
Critics argue that interest rates on credit cards have not fallen
as fast as other interest rates in the economy. Even assuming that
this proposition is relevant to the discussion over bankruptcy,
it appears to be fundamentally confused. First, actual interest
rates have in fact fallen. Second, it ignores the fact that the
cost-of-funds comprises a smaller percentage of the cost of credit
card operations than for other forms of credit, such as home mortgages.
Because credit card lending consists of a massive number of high-volume,
low-value loans, the transaction and overhead costs of processing
credit card accounts are high. Moreover, the high-volume and small-value
nature of credit-card lending makes it infeasible to do the substantial
and in-depth credit examinations that are done for other types of
lending. Similarly, the unsecured and low-value nature of these
loans usually means that it is not cost-effective to pursue payment
on credit card defaults, thereby making these loans more risky than
other types of lending. Finally, the vast majority of credit card
users are "convenience" users who pay off their cards
each month, rather than revolving a balance. For these issuers,
of course, interest rates are irrelevant.
But a single-minded focus on interest rates alone also ignores
the fact that there has been a substantial de facto fall in interest
rates following the Supreme Court's decision in Marquette
National Bank v. First Omaha Services Corp., which effectively deregulated
the credit card industry. Prior to Marquette, many states placed
usury limitations on interest rates for credit cards. Of course,
these usury ceilings were as ineffective as usury regulations have
always been, going back to medieval Europe. Thus, during the high
interest rate period of the 1970's, credit issuers circumvented
usury ceilings by charging annual fees that attempted to compensate
for the losses caused by usury ceilings. Of course, these annual
fees applied to all customers, good and bad alike. The effect of
Marquette, therefore, was not so much to allow issuers to raise
their interest rates, but to repeal the "usury tax" of
annual fees and replace it with a more efficient and rational system.
Similarly, large department stores such as Sears were able to tie
their credit operations to their retail operations, and embed their
credit losses in the cost of their products. Thus, the elimination
of annual fees on almost all credit cards during the past decade
has essentially served as an implicit reduction in interest rates
and has made it easier for small retailers who cannot afford to
run their own credit operation to compete with large retailers such
In conclusion, it is untenable to argue that the recent spiral
in bankruptcy filing rates can be explained by either the "debt
causes bankruptcy" thesis or by the growth of credit cards.
In turn, this suggests that the explanation lies elsewhere, whether
in a decline of shame and stigma, the growth of attorney advertising,
or an overgenerous legal system. A proper understanding of bankruptcy
reform must begin with a proper understanding of the causes of bankruptcy.
* Assistant Professor of Law, George Mason School of Law, and Co-Chair,
Bankruptcy Subcommittee, Financial Institutions Practice Group.