For the past decade bankers pursued legislation to stamp out perceived abuses of the Bankruptcy Code, and now that they have achieved their goal, the second-guessing has begun.
The industry's call for reform intensified as banks moved out of moribund, low-yield corporate lending in favor of high-growth, high-yield consumer business. Keeping borrowers out of bankruptcy - and recovering more from those who could not avoid it - became a priority.
Courts reported more than 600,000 filings for bankruptcy protection in the two weeks before Oct. 17, when the new law took effect, compared with the 1.6 million cases filed in all of last year. Filings have subsequently dropped to about 10% of normal, pre-frenzy levels, and lenders say a little short-term pain should not obscure the law's long-term benefits.
But a growing chorus asserts that those benefits will prove elusive, especially for credit card lenders, and that the industry miscalculated in tampering with a credit regime that yielded record profits in recent years.
Lenders were "betting the ranch that by getting tougher, the financial payback would be greater," said Duncan MacDonald, the former general counsel for the North American cards unit at Citigroup Inc. But because the old law "encouraged people to borrow out the wazoo … the status quo was probably better than what they will get through a system that tries to manage through punishments."
Lenders expect overall filings to drop in the future. More borrowers who file will be pushed from a Chapter 7 plan, in which debts are generally wiped out, into a Chapter 13 one, in which most debts are repaid over a period of up to five years.
The law requires borrowers to seek credit counseling before filing for protection from creditors. It limits how frequently borrowers can file, and it establishes tighter residency requirements to discourage jurisdiction shopping. Means tests determine how much filers must repay. Recent purchases come under tighter scrutiny, and attorneys must certify the accuracy of borrowers' filings - a step expected to drive up debtors' costs.
Nathalie Martin, a professor at the University of New Mexico School of Law and the resident scholar at the American Bankruptcy Institute, said she also is not convinced that lenders will do better under the new law.
"I don't know how this is going to bring more money to the table," she said. "The industry's message is, 'We just want people to pay their bills,' but there are only two ways to accomplish that. One is with more income, and the other is to make the bills smaller."
Several bankers asked about their support for bankruptcy reform deferred to their trade groups, particularly the Financial Services Roundtable and the American Bankers Association.
Wayne Abernathy, the ABA's executive director of financial institutions policy and regulatory affairs, said that the new law is narrowly focused on high-income borrowers who gamed the old system, but that bankruptcy lawyers wedded to the old system distorted its likely effect.
"Most of the people who borrow in this country will be totally unaffected by the legislation, other than decreasing the costs imposed upon society as a whole by people who were abusing the system," Mr. Abernathy said.
That's the industry's gamble: There has been enough abuse that limiting it will compensate for any losses the changes might cause.
Bankruptcy lawyers and investment bankers say unsecured lenders, especially credit card lenders, will likely be worse off under the new law, because it extends protections for secured lenders - particularly by limiting cramdowns (which treats the difference between what a borrower owes on collateral and what the collateral is worth as unsecured debt).
"Debtors have the same amount of disposable income, regardless of the changes in the law," said Lawrence Friedman, a former director of the Justice Department's U.S. Trustee program and now a managing director at Bear Stearns Cos.' eCast Settlement Corp. "If the mix of dollars shifts towards secured, it has to come from somewhere, and the only logical conclusion is [that it will come] from unsecured."
Administrative fees are expected to increase, and Ira Herman, a bankruptcy lawyer at Bryan Cave LLP who represents creditors, said debtors' attorney fees could double.
"The cost of filing is going to increase. The cost of administering them is going to increase," he said. "If there is a small amount of money in the case, the administrative costs are going to eat the money up."
Because administrative and attorney fees are given priority, recoveries by unsecured lenders have nowhere to go but down, said Henry Hildebrand, a Chapter 13 trustee in Nashville. "You can't make the pie any bigger - you can just change the size of the slices."
Under the old system, he said, over a quarter of the money he distributed every month went to unsecured lenders, but that amount seems certain to fall substantially. Most payouts from Chapter 13 will now be determined by mathematical formulas.
"I'm appalled because for 23 years as a Chapter 13 trustee, I've been struggling to increase distributions to unsecured creditors - it's kind of built into our genetic DNA as trustees to do that," he said. "I cannot challenge the lifestyle choices of the debtor" under the new law. "I can't challenge the toys they get to keep, and I'm stuck with what the math shows. It doesn't take long to see that the math that was constructed by Congress doesn't work."
Mr. Abernathy said the changes only clarify the differences between secured and unsecured lending.
"By secured lenders having better access to the collateral, does that leave less available for the unsecured? Potentially, but that's what the nature of an unsecured lender is, and that's why the unsecured lender charges more in interest rates," he said.
Higher attorney fees may also make borrowers less inclined to file for bankruptcy protection, but that change would not necessarily work in creditors' favor. Opponents of the new law say it will force some borrowers underground; in more common parlance, they will become deadbeats.
Industry lobbyists say they are confident diverse consumer lenders have done the calculations and have a good handle on how the changes to the law will affect their various business lines - and that they will come out ahead. Critics of the law say it is illogical and weakly crafted, particularly for one that has been contemplated for a decade.
"The lobbyists were the ones in charge of the coalition, as opposed to reasoned minds that have to do the work," Mr. Hildebrand said.
Phil Corwin, a lawyer with Butera & Andrews who lobbied for the bill, dismisses that criticism and says that many bankruptcy professionals naturally resisted change. "They liked the world they had."
But he acknowledged the law is not perfect, and he considers its occasional inconsistencies an unavoidable byproduct of the legislative process. "Anytime you have a 500-page bill, it's not going to be entirely cohesive."
The industry's lobbyists said lawmakers will eventually complete technical corrections to iron out problems. Over all, the lobbyists defend the new law as an essential rationalization of consumer borrowing.
As Mr. Abernathy points out, bad borrowing ultimately is as bad for creditors as it is for consumers.
"I don't think it will in any way inhibit borrowing for legitimate purposes," he said. "If we discourage people from borrowing beyond their means, that's a good thing."
Mr. MacDonald said how aggressively the new law is enforced will be an important element of its effect. If lenders back off from harsh enforcement for fear that doing so would stifle demand, it may not have much effect at all, he said.
But "if they get tough, two years from now they are going to wake up and find that they achieved what they set out to achieve: to affect borrowing behavior and to reimpose a sense of shame about going into bankruptcy," he said. "If that happens, it should result in smarter borrowing habits, which means less borrowing."
At this point, there's precious little data to support definitive conclusions. The tremendous increase in third- and early fourth-quarter filings was an aberration, and rock-bottom levels after the law was changed are hardly any more representative of future bankruptcy volume.
Borrowers and creditors will begin testing the system and appealing decisions. Only after that process will creditors have a good sense of whether their push to reform bankruptcy law was the profit-booster they desired or the demand-killer they neglected to consider.
"You won't know probably for five years if lenders have shot themselves in the foot," Mr. Herman said.
