Volume 43 | Number 2 Spring 2008
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I. INTRODUCTION
Contrary to conventional wisdom, consumer over-indebtedness is not, by itself, a bad thing. Indeed, credit can be a good thing since it lets people pay for current expenses using future income. High current debt levels are acceptable for people who have good reason to believe their income will increase in the future. Over-indebtedness may also enhance the present quality of life of consumers who can afford to repay their debts with future income because it lets them splurge and occasionally buy luxury items. In addition to the benefits to the consumer, consumer spending (and high debt levels) also help develop a nation’s wealth and, in the case of the United States, has kept the nation’s economy from stalling.1 Of course, the reason for the current global consumer over-indebtedness problem is not because consumers are in debt. Or that their debts exceed their income. Rather, consumers are waaaaaaaaay in debt. They are drowning in debt and are not likely to receive relief under the present consumer insolvency statutes.
This Article will discuss overall consumer over-indebtedness in the United States and two specific types of credit that have increased consumer debt in the United States: credit cards and mortgages. It describes how the U.S. Bankruptcy Code allows consumers to rid themselves of some of their debts and then contrasts consumer over-indebtedness and the U.S. response to this problem to that in other countries. It concludes by suggesting ways that the U.S. Government could respond to consumer over-indebtedness and issues Brazil should consider in deciding how or whether to adopt a comprehensive consumer insolvency regime.
II. U.S. CONSUMERS AND OVER-INDEBTEDNESS
A. Going into Debt: In General
A recent article in the Harvard University alumni magazine observed that “[c]onsumerism is as American as cherry pie. Plasma TVs, iPods, granite countertops: you name it, we’ll buy it.”2 Americans are voracious consumers, but meager producers and savers. By way of contrast, the difference between what Americans produced and what we consumed in 2006 is about equal to the entire annual output of Brazil, which is striking since Brazil ranks tenth in the world in total GDP.3 Because the United States consumes much more than it produces, the U.S. economy relies heavily on imported goods.4 In fact, the U.S. economy is now based on providing financial services, not the production of goods. This shift from a manufacturing to a financial-services economy, often referred to as the “financialization of the American economy,”5 means that, instead of making money by making things, Americans increasingly make money by moving money around. Much of this “financialized” economy involves moving money from the financial services industry to consumers in the form of consumer debt.
In 2006, total U.S. household debt was $12.8 trillion, an increase of more than a trillion from total household debt in 2005.6 Debt has risen much faster than income for middle-income families in the United States and the ratio of debt to disposable income is now approximately 125 percent.7 Some of this debt level is no doubt attributable to the seemingly insatiable desire of U.S. consumers to have the latest gadgets, trinkets, and toys. But many Americans, especially lower- and middle-income Americans, borrow money and use credit to compensate for stagnant or declining wages and to pay for health care, spiraling college tuition8 and, increasingly, for housing.9 Rather than buying now knowing that they likely will be able to pay for those items later, consumers are using credit to finance present consumption even though they have no idea how they will repay those debts in the future.
The U.S. savings rate or, more accurately, the lack of consumer savings, is closely related to the problem of American consumerism and carries similarly broad implications for overall U.S. financial health. Since 2006, the United States has had a negative savings rate—that is, Americans save less than they spend on goods or services.10 One reason the U.S. savings rate is so low is because of the large number of “baby boomers” who are spending down their retirement income, i.e., dissaving.11 The negative U.S. savings rate has now made the U.S. increasingly dependent on non-U.S. funds. In fact, just as the financialization of the U.S. economy forces the United States to rely on imported goods, the United States must also import savings from other countries just to finance domestic business investments.12
B. Credit Card Debt
In the United States, just about anyone or anything can get a credit card. Indeed, former Federal Reserve Chair Alan Greenspan once commented that children, dogs, cats, and moose can get credit cards.13 In 2006, U.S. consumer credit debt (which includes credit card and other non-mortgage debt) totaled $2.4 trillion and U.S. residents had $745 billion in debt on general purpose credit cards.14 While it is clear that credit card debt is highly correlated with consumer bankruptcy filings,15 it is unclear why so many U.S. consumers are unable or unwilling to properly manage their credit card debt. Several factors are typically cited as the leading causes of increased credit card debt.
As a general matter, many people do not view credit cards as a form of borrowing, since these “loans” theoretically can be repaid in full without paying interest. Many of those who understand that a credit card transaction is a loan do not understand credit card billing terms because (a) pertinent information is not effectively disclosed (i.e., a lack of transparency); (b) the complexity of the terms makes it virtually impossible for the average consumer to understand the true cost of the credit; or (c) because the terms change frequently.16 Other consumers use their credit cards to balance their budget each month and make ends meet and appear to give little regard to the ultimate cost of that credit.17 Moreover, because of how issuers market credit cards and because certain people have a tendency to overestimate their ability to exercise self-control and borrow more than they can repay in the future, some consumers may find it hard to resist the temptation to charge, charge, charge.18
Credit card issuers, not surprisingly, target the customers they feel will be the most profitable. For example, issuers covet and aggressively pursue higher risk consumers such as college students, even though they have no income and have high rates of default.19 Despite their present risk of default, college students are ideal long-term credit card customers because they are comfortable with indebtedness (due to their student loans) and also because they theoretically will have higher incomes once they graduate and get jobs.20 Because most of the revenue credit card issuers receive comes from customers who do not pay their balances in full each month, issuers rationally prefer these customers because they make higher profits if the customer treats the transaction as a loan that will be repaid over time.21 Thus, even if college students or other high risk customers have shockingly high default rates, they are quite profitable to issuers as long as they continue to at least pay something most months. Similarly, credit card companies have now increased their direct mail credit card offers to subprime customers who have lost or likely will lose their homes in a foreclosure because these customers can no longer tap into the home’s equity for cash.22 Customers who have recently lost their homes are, ironically, good long-term credit risks because they can no longer access the equity in their homes, which gives them a strong incentive to take out cash advances on their credit cards.
C. Housing Debt
1. Benefits and Perils of the Democratization of Homeownership
Homeownership constitutes the largest component of household net worth for all populations in the United States, except perhaps the highest income groups.23 Housing prices more than doubled in some U.S. housing markets this decade and have tripled in some markets over the last thirty years.24 Americans have become over-indebted in the last few years almost exclusively because of the astronomical increase in housing prices and consumers’ increase in housing debt for the last twenty years.25 The acceleration in house-price appreciation, in turn, caused homeowners to increase their consumption based on their belief that they were wealthier and could spend more.26
Total U.S. home mortgage debt is staggering: in 2006, it was $9.7 trillion, an almost trillion dollar increase from 2005.27 Consumers over the last ten years eagerly took out large loans to buy homes because even with large “jumbo” mortgages28 homeowners’ monthly mortgage payments remained reasonable due to escalating housing prices and decreasing interest rates. Homeowners also used home equity loans to remove the equity they had accumulated in their homes, essentially treating their homes like an automated teller machine. When interest rates were low and housing prices were escalating, consumers removed equity to buy durables, to renovate their homes, to pay off higher interest credit card debt or other consumer loans, or to borrow money to pay for college tuition and expenses.29 Escalating housing prices also caused homeowners to stop saving, to stop contributing to retirement accounts, and to even withdraw funds held in their retirement accounts.30
Due to the encouragement of the U.S. Government, lenders developed innovative loan products to make mortgage credit more readily available to lower income, but often higher risk, consumers.31 This push for a greater democratization of credit32 generally resulted in lenders giving higher risk borrowers, a group generally characterized as “subprime” borrowers, greater access to credit in the form of non-traditional mortgage products. Financial institutions were eager to loan to homeowners, even subprime borrowers, because they viewed the loans themselves as low-risk. That is, as long as housing prices continued to rise and the loan originators could continue to quickly sell the subprime mortgage loans in the secondary market, the entities that originated the loans bore little risk that they would not be repaid if the borrower defaulted on the loan payments. In fact, the ability to originate but then quickly sell mortgages had the effect of decreasing the originating lender’s incentive to make careful lending decisions since the risk of default would pass from the loan originator to the investors that purchased the loan in the secondary market.33
The “affordability” products that lenders created to make homeownership more accessible to subprime customers changed traditional notions of home “ownership.” These products had several non-traditional features which, when layered together, made it easier for consumers to buy homes, but also made it more likely that the consumer would default and, ultimately, lose the home in a foreclosure sale. These include scenarios where borrowers were offered stated-income loans that were approved even though the borrowers provided no written proof of their income.34 These loans generally are referred to as low-documentation, no-documentation or “liar loans” because they gave borrowers an incentive to inflate their income in order to qualify for a larger loan.35 Borrowers could also get a mortgage to purchase a home without making any down payment.36 Because of the high transaction costs associated with purchasing a home (realtor and attorney fees), a borrower who makes no down-payment will have no equity in her home when the loan term begins, may not have built up any equity in the home even after making her monthly payments for the first few years, and may find that her loan balance is increasing (i.e., negatively amortizing), especially if the loan permits the borrower to defer interest payments.37 Finally, though mortgages traditionally have been for fifteen- or thirty-year terms, lenders offered forty- and fifty-year mortgage terms to provide a product with lower monthly payments, even though the length of the mortgage term effectively treated the “owner” as a long-term renter.38
Potential homeowners, especially subprime borrowers, were often offered adjustable-rate mortgages (ARMs) that had very low introductory interest rates and initial payments. Low payments (especially if combined with no down payment) made it possible for cash-strapped renters to “buy” a home. Once the introductory period passed and interest rates increased, however, borrowers’ monthly payments would increase often quite dramatically. Borrowers then found that they needed to refinance the ARM—sometimes more than once—to get a more affordable product.39 Because of the risks associated with subprime ARMs, bankers and consumer advocates alike have referred to them as “neutron” loans: they kill all the people, but leave all the houses.40
2. Current Crisis
Making homeownership more accessible to more potential buyers is not a bad thing, if done responsibly. Unfortunately, the current turmoil in the U.S. housing markets has revealed that many consumers were approved for loans they could not afford based on their actual income.41 Lenders appeared willing to approve these loans largely because housing prices were escalating and the escalating values protected their interest in the home. Even if the borrower failed to repay the loan, the lender could foreclose on the home and sell it or could convince the borrower to refinance the mortgage to get lower monthly payments. Likewise, borrowers seemed willing to buy houses they could not afford because of their overly optimistic assumption that housing prices would continue to escalate.42 In addition to misjudging the unaffordability of their loans, consumers also did not appear to fully understand the terms of the loan.43 Because many of the subprime ARM borrowers were first-time buyers, many of them did not appear to be aware of the additional responsibilities of home ownership, such as the need to put aside money in escrow for taxes and insurance if the lender did not automatically escrow.44
Because lenders approved non-traditional mortgages for borrowers with weak credit histories, many of those high-risk borrowers are now defaulting on their loans. In fact, much of the increase in foreclosure rates is attributable to non-traditional and subprime mortgages that originated in late 2005 and early 2006,45 and many loans were in default after borrowers made only one or two (or no) payments.46 For example, in the first half of 2007, 320,000 foreclosures were initiated in the United States.47 Since the average number of annual foreclosures for the last six years has been 225,000, the United States is on track to have almost twice as many foreclosures in 2007 as it has had on average for the last six years.48 Moreover, most economists and realtors are projecting that the decrease in home values and declining home sales will not recover until at least 2009.49
Recent changes to U.S. consumer bankruptcy laws, as discussed in more detail in Part III, make it harder for consumers to rid themselves of consumer debt. The inability to restructure debts in general and the virtual impossibility of restructuring mortgage debts in bankruptcy make the soaring foreclosure rate particularly problematic for consumers. To be sure, some state exemption laws do allow homeowners to prevent general unsecured creditors from seizing their homes—even large, expensive ones—after they file for bankruptcy.50 Moreover, U.S. consumers, unlike consumers in other countries,51 generally are not forced to use the equity in their homes to repay their debts.52 However, U.S. consumer insolvency laws have staunchly protected mortgage loans and make it virtually impossible to remove a lender’s interest in the collateral (i.e., the home) that secures the mortgage loan.53 Thus, consumers who are over-indebted because of mortgage loans may be able to discharge their personal obligation to repay the loan but, at least for now, it is almost impossible to use bankruptcy laws to modify or discharge the lender’s security interest in the borrower’s home.54