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 indebtedness—the amount due each month—and 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 rise.

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 way—through 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 direction—the easy availability of bankruptcy will cause consumers to take on more debt than they would absent the bankruptcy option.

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 shop—or 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 as Sears.

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.