New Bankruptcy Law Backfires by Increasing Foreclosures

Readers probably know that the changes in the bankruptcy law, which went into effect in October 2005, were a victory for the credit card industry, which had lobbied for tougher rules for years. I had very little sympathy for the banks, since credit cards were an extremely profitable business even under the old law, and if banks thought they were nevertheless taking too many bad debt losses, the solution was to tighten credit standards (of course, that ignores the fact that the most profitable customers are the ones that are overextended, carrying large balances at high interest rates, but haven’t gone under, in other words, the near bankrupt).

One bankruptcy lawyer told me that MBNA (now part of Bank of America) had pushed hardest for the changes, and estimated that the new law would enable it to extract an extra $100 a month from consumers who declared bankruptcy, which would increase their profits by $85 million.

In a bit of schaudenfreude, it looks like the new rules may have increased the profits of their credit card business at the expense of their mortgage business, and in the case of big mortgage lenders, their balance sheet.

From Bloomberg:

Washington Mutual Inc. got what it wanted in 2005: A revised bankruptcy code that no longer lets people walk away from credit card bills.

The largest U.S. savings and loan didn’t count on a housing recession. The new bankruptcy laws are helping drive foreclosures to a record as homeowners default on mortgages and struggle to pay credit card debts that might have been wiped out under the old code, said Jay Westbrook, a professor of business law at the University of Texas Law School in Austin and a former adviser to the International Monetary Fund and the World Bank.

“Be careful what you wish for,” Westbrook said. “They wanted to make sure that people kept paying their credit cards, and what they’re getting is more foreclosures.”

Washington Mutual, Bank of America Corp., JPMorgan Chase & Co. and Citigroup Inc. spent $25 million in 2004 and 2005 lobbying for a legislative agenda that included changes in bankruptcy laws to protect credit card profits, according to the Center for Responsive Politics, a non-partisan Washington group that tracks political donations.

The banks are still paying for that decision. The surge in foreclosures has cut the value of securities backed by mortgages and led to more than $40 billion of writedowns for U.S. financial institutions….

Even as losses have mounted, banks have seen their credit card businesses improve. The amount of money owed on U.S. credit cards with payments more than 30 days late fell to $7.04 billion in the second quarter from $8.37 billion two years earlier, according to data compiled by Federal Deposit Insurance Corp.

In the same period, the dollar volume of repossessed homes owned by insured banks doubled to $4.2 billion, the federal agency said. New foreclosures rose to a record in the second quarter, led by defaults in subprime adjustable-rate mortgages, according to the Mortgage Bankers Association in Washington.

People are putting their credit card payments ahead of their mortgages, said Richard Fairbank, chief executive officer of Capital One Financial Corp., the largest independent U.S. credit card issuer. Of customers who are at least three months late on their mortgage payments, 70 percent are current on their credit cards, he said.

“What we conclude is that people are saying, `Honey, let the house go,”’ but keep the cards, Fairbank said Nov. 5 at a conference in New York sponsored by Lehman Brothers Holdings Inc.

The new bankruptcy code makes it harder for debtors to qualify for Chapter 7, the section that erases non-mortgage debt. It shifted people who get paychecks higher than the median income for their area to Chapter 13, giving them up to five years to pay off non-housing creditors.

The court-ordered payment plans fail to account for subprime loans with adjustable rates that can reset as often as every six months, said Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys. Two-thirds of debtors won’t be able to complete their payback plans, according to the Center for Responsible Lending.

“We have people walking away from homes because they can’t afford them even post bankruptcy,” said Sommer, a Philadelphia- based bankruptcy attorney. “Their mortgage rates are resetting at levels that are completely unaffordable, and there’s nothing the bankruptcy process can do for them as it now stands.”

Four million subprime borrowers with limited or tainted credit histories will see their mortgage bills increase by an average 40 percent in the next 18 months, according to the National Association of Consumer Advocates in Washington. About 1.45 million of those will end up in foreclosure by the end of 2008, said Mark Zandi, chief economist at Moody’s, a research firm and unit of Moody’s Corp. in New York.

Lenders began the process of seizing properties on 0.65 percent of U.S. mortgages in the second quarter, a record in a quarterly Mortgage Bankers study that goes back 35 years. The percentage of subprime borrowers making late payments increased to 14.82, a five-year high, from 13.77.

Personal bankruptcies rose 48 percent to 391,105 in the first half of 2007 from a year earlier and Chapter 13 filings accounted for more than one-third of those, according to the American Bankruptcy Institute. In the first half of 2005, they were just 24 percent of the total.

Bad mortgages slashed Washington Mutual’s profit by 72 percent in the third quarter from a year earlier, the Seattle-based thrift said Oct. 17. Income from credit card interest rose 8.8 percent to $689 million in the period, helping to offset a loss the bank warned on Oct. 5 would be 75 percent.

Washington Mutual shares tumbled the most in 20 years yesterday after New York Attorney General Andrew Cuomo said the thrift had pressured real estate appraisers to assign inflated values to properties. Its dividend yield fell to 11 percent and the company traded at 0.74 price-to-book value.

Citigroup’s third-quarter earnings fell 57 percent on mortgage losses. Bank of America stopped so-called warehouse lending to mortgage brokers after its profit declined 32 percent in the same period.

JPMorgan reported profit growth of 2.3 percent in the quarter, the smallest in more than two years, after reducing the value of leveraged loans and collateralized debt obligations, investment packages of mortgages, by $1.64 billion.

Washington Mutual spokeswoman Libby Hutchinson in Seattle, JPMorgan spokesman Thomas Kelly in New York and Bank of America spokesman Terry Francisco in Charlotte, North Carolina, declined to comment on the bankruptcy law.

“The law had an unintended consequence of taking away a relief valve that mortgage borrowers used to have,” said Rod Dubitsky, head of asset-backed research for Credit Suisse Holdings USA Inc. in New York. “It’s bad for the mortgage borrowers and bad for subprime investors because it means more losses.”….

The House Judiciary Committee is working on legislation to let bankruptcy judges restructure home loans by lowering interest rates and reducing mortgage balances to reflect current market value.

Banks including Washington Mutual, Citigroup and Wells Fargo & Co. sent a letter to the committee opposing the change, saying such restructurings should be done privately.

Countrywide Financial Corp., the largest U.S. lender, said last month that it will modify $16 billion worth of adjustable-rate mortgages. Washington Mutual said in April that it will spend $2 billion giving discounted rates to help customers with subprime loans refinance at better terms.

So far, most lenders have been reluctant to change loan agreements. About 1 percent of mortgages that reset in January, April and July were modified, according to a Sept. 21 Moody’s Investors Service report that surveyed 16 subprime lenders that account for 80 percent of the market.

Congress probably will approve at least a limited measure to permit loan modifications, said Westbrook, the University of Texas law professor.

“They are going to have to figure out some way to address the problem,” Westbrook said. “I don’t think our economy or our consciences can handle the number of foreclosures we’ll see if they do nothing.”

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  1. James I. Hymas

    Is there any evidence of a direct causal relationship between the change in law and the increase of foreclosures? There’s certainly none mentioned in the article.

  2. kwark

    We weren’t supposed to feel any sympathy for the proverbial dead-beat credit card abuser because they were hurting those poor banks, boo hoo. Now that big money is really hurting Congress is poised to discover a conscience so that “homeowners” won’t face foreclosure. Right. If it was just homeowners feeling the pain we’d be hearing about those nasty deadbeat homeowners hurting the poor banks. But CONgress is likely to do something – I guess they’re just waiting to get the “right” legislation from Goldman Sachs and MBNA/BoA (again). And of course our dear president will gleefully sign said legislation because he’s SUCH a man of the people. OK, reduce sarcasm. . .

  3. Yves Smith


    Capital One is a credit card issuer, It isn’t exactly in their interest to say people are sacrificing their homes to avoid bankruptcy. I would assume the CEOs comments are based on what he sees in his customers’ behavior, and he specifically said they have consumers three months behind on their mortgages, which in most states means they are in default and subject to foreclosure, yet are current on their credit cards (Cap One is also known in the industry to be highly analytical). Similarly, the head of asset backed research for Credit Suisse, also quoted in the article, is an analyst, not a consumer advocate, and is of the view that the new bankruptcy law has led to more foreclosures.

    This development seems pretty obvious now that it is happening. Under the old law, if you got badly behind on your credit cards and saw no way out, you’d file for bankruptcy. The court would take whatever assets you had that could be applied to the debt, but in most states, homes were protected at least to a degree, some completely.

    By contrast, the new law is pretty punitive. You can’t use Chapter 7 if you income is above the average in your state. And the home is more subject to being seized in the new law under Chapter 7.

    Even though homeowners can theoretically avail themselves of Chapter 13 and keep their home, the court cannot change the terms of the mortgage. Thus if a homeowner is already on the verge of going under and faces a reset, the court can do nothing about it.

    In addition, even if the homeowner is not facing a reset, if he files under Chapter 13, the court sets a repayment plan for his debt. That is based on assumptions on what it takes for him to live on and the rest goes to debt service. The bankruptcy attorneys say the assumptions in the new law are unworkable for many people, and often don’t reflect real local costs. For example, a family of 4 in New York city is allotted only $200 a month for food.

    Oh, and you aren’t permitted to refile for bankruptcy if you fail to meet the terms set by the court. So it seems pretty plausible that people are choosing not to file for bankruptcy if they can avoid it. After all, that was the intent of the law.

  4. Yves Smith


    Agreed. As I said above, the reason I have never been sympathetic with the banks on the bankruptcy law is simple. If you are seeing more bankruptcies than you like among your cardholders, you need to improve your credit policies. But instead, they got a “get out of jail free” card from Congress.

    The industry screwed itself up with no fee cards. When they charged annual fees, customers who paid in full every month were attractive. But they wanted to expand their market, so the industry started offering no fee cards. That meant that they had a greater incentive to find customers who couldn’t pay their balance off and would pay interest.

  5. Anonymous

    “The House Judiciary Committee is working on legislation to let bankruptcy judges restructure home loans by lowering interest rates and reducing mortgage balances to reflect current market value.”

    don’t like this idea. sounds like a bailout move.

  6. Yves Smith

    Anon of 11:02 PM,

    The lowering mortgage balance bit may be to make Chapter 13 consistent with Chapter 11. Under Chapter 11, if you lease a building and its market value has declined, the mortgage principal amount will be reduced (not sure re how done, just the general concept).

    The interest rate reduction is another matter entirely….

  7. James I. Hymas

    Yves, thanks for the reply.

    I like to look at what people don’t say. The statement that “Of customers who are at least three months late on their mortgage payments, 70 percent are current on their credit cards” means little in isolation.

    Some people don’t have a balance on their cards. Having a mortgage – even one that’s resetting and that you can no longer afford – is not necessarily equivalent to being a financial profligate. Not all sub-prime mortgages were to the archetypal leaf-blower: a huge proportion were made to speculators who might well be expected to keep the rest of their lives in order, given that – from what I understand of the matter – US mortgages are generally non-recourse to the borrower.

    Many of the sub-prime mortgagees will have very low limits on their cards – the low limit having been set for the same reason that their mortgage is called “sub-prime”. It’s a lot easier to make a $100 payment to keep your credit card (with, say, a $2000 balance) current than it is to pay $1600 to keep your mortgage current.

    And, with respect to the 70% … what was the figure before the law? What is the current figure for those who are not delinquent, then and now?

    I’m not saying Mr. Fairbank is wrong; nor do I mean to imply that he has an agenda influencing his choice of words and statistics – but there’s a lot of evidence and argument missing here.

    I am sure as well that Mr. Dubitsky did in fact say what he was quoted as saying; but I am not sure what else he said that might be pertinent. His remarks as quoted do not amount to an argument.

    For all that being “Head of Asset Backed Research for Credit Suisse” is a very nice title, I’m not about to take his unsupported word for anything, let alone a matter of public policy.

    However, viewed in isolation, his remarks seem plain enough: effectively, mortgage debt used to be senior to credit card debt, now it’s parri passu. From the perspective of an investor who has some exposure to mortgages and none to credit cards, I’m willing to entertain the hypothesis that the change in law is regrettable.

    But I want to check all the data – or, at least, have its full analysis explained to me! The Law of Unintended Consequences is merely a special case of The Law of Sloppy Analysis.

    These gentlemen’s opinions may well have been filtered through a journalist’s lens. While Bloomberg is an excellent source of news, I have noticed that their stories on such issues tend to be even more reflective of the individual journalist’s views than most of the media sources I use. I don’t think they have yet perfectly established a cult of editorial indifference to policy.

    And, in any event, the question of greatest good has not yet been addressed. The reviled lobbyists were, presumably, hired in an effort to improve total recovery for the industry. If somebody has, say $20,000 credit card debt and an $80,000 mortgage on a $100,000 house then foreclosure will give greater recovery than old-style bankruptcy – even if the house sells for only $90,000.

    Any change in total recovery is not addressed by the article. It would be extremely difficult to estimate the effects of the change in law since the only period examined is, shall we say, rather unusual in terms of housing prices; but I’ll bet a nickel the major financial institutions have very well paid teams of statisticians working on the question. We hear nothing from them.

  8. Anonymous

    If you consolidate all of your debts with one financial lender 180 days before you file a Chapter 13 bankruptcy, will you automatically lose your house and car?

Comments are closed.