Volume 43 | Number 3

Consumer Over-Indebtedness: A U.S. Perspective

by A. Mechele Dickerson

Summary

Introduction
U.S. CONSUMERS AND OVER-INDEBTEDNESS
1. Housing Debt
  1. Benefits and Perils of the Democratization of Homeownership
  2. Current Crisis
U.S. RESPONSE TO OVER-INDEBTEDNESS
The Consumer’s Right to a Fresh Start

The Consumer’s Duty to Behave Responsibly: BAPCPA

BAPCPA’s Success?
COMPARATIVE PATTERNS OF INDEBTEDNESS
Going into Debt

Getting out of Debt
POTENTIAL SOLUTIONS FOR CONSUMER OVER-INDEBTEDNESS
1. U.S. Response to Consumer Over-Indebtedness
  1. Disclosure and Consumer Education
  2. Regulation
  3. Changing Issuer and Lender Practices
CONCLUSION

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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
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III. U.S. RESPONSE TO OVER-INDEBTEDNESS

A. The Consumer’s Right to a Fresh Start

Over-indebted U.S. consumers can seek formal financial relief by attempting to discharge some or all of their debts using the U.S. consumer bankruptcy laws.⁵⁵ Unlike a number of countries (including Brazil), the United States has had a formal consumer insolvency regime since 1898 largely because of the recognition that it is virtually impossible for an individual consumer to reach a global debt renegotiation with all her creditors unless a federal law forces the creditors to accept a particular payment plan. Historically, U.S. consumer bankruptcy law have given over-indebted consumers a “fresh start” that allowed them to discharge their debts and become productive members of the market economy.⁵⁶ Many have suggested that the best way to evaluate and respond to consumer over-indebtedness is to examine why consumers find themselves unable to repay their bills.⁵⁷ Others argue that the causes of consumer over-indebtedness should be addressed outside of bankruptcy, that consumer bankruptcy laws generally should not be viewed as being part of the protections provided by the welfare state, and that bankruptcy laws should largely be unconcerned about why people found themselves unable to repay their debts.⁵⁸ As we shall see in the following sections, a consumer insolvency scheme that ignores the causes of insolvency is unlikely to provide appropriate relief.

B. The Consumer’s Duty to Behave Responsibly: BAPCPA

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), enacted by the U.S. Congress in 2005,⁵⁹ significantly changed the U.S. Bankruptcy Code and moved U.S. consumer law policies closer philosophically to the European concept of an “earned” rather than “fresh” start.⁶⁰ European consumer debt adjustment systems appear to be designed to give consumers an incentive to modify their spending habits and to make wiser spending choices, but also to force them to live with the economic consequences of unwise choices.⁶¹ Many in Congress seemed to believe that earlier versions of the U.S. consumer insolvency laws were too lax and allowed too many people to discharge debts they could afford to repay.⁶² BAPCPA was designed to make it harder for people to file for bankruptcy and to give consumers an incentive to avoid over-indebtedness. Rather than use bankruptcy laws to provide comprehensive relief to over-indebted consumers, the U.S. Congress wanted consumers to understand that they have a moral duty to make responsible spending decisions and to at least attempt to repay their debts.⁶³

Before BAPCPA was enacted, consumers had almost complete control to decide whether they wanted to attempt to repay some of the debts over a three to five year period in a Chapter 13 debt repayment plan, or whether they wanted a quick discharge of their debts in a Chapter 7 proceeding and not even attempt to repay those debt.⁶⁴ To reduce the overall number of bankruptcy filings and to force more consumers into Chapter 13 debt repayment plans, Congress made a number of changes to restrict virtually all consumers’ access to bankruptcy. Perhaps the biggest change in the new law is a means test, a complicated quantitative test consumers must “pass” before they are deemed to have “earned” the right to a quick discharge of their debts in a Chapter 7 liquidation proceeding.⁶⁵ Until 2005, the U.S. approach had been to allow debtors a “quick” discharge if they had few assets they wanted to keep, or only had assets that they were allowed to keep statutorily (i.e., exempt) based on either applicable state or federal bankruptcy laws.⁶⁶ Consumers who fail this new means test either must attempt to repay some of their debts through a Chapter 13 debt repayment plan or must attempt to renegotiate their debts outside of bankruptcy.⁶⁷ Forcing consumers to prove that they are entitled to a particular type of debt relief moves the U.S. system a bit closer philosophically to the structure and substantive policies of debt adjustment systems in other countries.

The Code also requires all consumers to participate in mandatory credit counseling before they file their bankruptcy petition⁶⁸ and mandates that Chapter 13 debtors receive financial management training from an approved financial education provider before they can receive a discharge.⁶⁹ The number of documents consumers and their attorneys must provide to creditors before and during the bankruptcy case also increased under the new law.⁷⁰ Finally, because of the additional time lawyers must now spend on each case and because of higher filing fees, it costs more for consumers to get relief from their over-indebtedness.⁷¹

Making it harder for over-indebted consumers to avoid repaying their debts is easily justifiable if purchases of iPods, plasma TVs, Hummers, or sable fur coats cause most consumer over-indebtedness. But empirical data collected by prominent U.S. academics show this is not the case; medical debts, a divorce, or a job interruption cause most consumer bankruptcies in the United States.⁷² Although these life circumstances, rather than profligate spending, appear to trigger most bankruptcy filings, the U.S. Congress nonetheless found that only two groups of over-indebted consumers should be viewed charitably and favorably and should be spared from BAPCPA’s harsh consequences.

First, consumers who can document that they are in debt because of medical bills relating to serious medical conditions are largely unaffected by BAPCPA’s additional requirements.⁷³ However, consumers who chose to use their credit cards to make ends meet while they were injured and unable to work were not viewed as favorably. That is, if a consumer used credit cards to compensate for income a debtor lost while injured, such a person cannot easily avoid BAPCPA’s additional requirements (i.e., means-testing, mandatory credit counseling, additional reporting) since the credit card debt would not technically be medical debt. To a lesser extent, BAPCPA also favors certain members of the armed forces (current and retired) who can avoid having to comply with some of BAPCPA’s additional requirements.⁷⁴ The decision to favor members of the armed forces was, of course, an unabashedly political decision: no member of the U.S. Congress wanted to be viewed as penalizing consumers who are in debt solely because they had been deployed to fight in one of the many U.S.-led wars.⁷⁵

C. BAPCPA’s Success?

While BAPCPA has changed how and when people file for bankruptcy, it has also had unintended consequences and imposed additional administrative burdens and costs on consumers. The number of consumers who filed for bankruptcy relief plummeted after BAPCPA became fully effective: there were over 1.5 million filings in 2004,⁷⁶ over two million in 2005,⁷⁷ but fewer than 600,000 in 2006.⁷⁸ Given this dramatic drop, BAPCPA arguably succeeded in both making it harder for people to file for bankruptcy and also making people understand that they have a moral duty to repay their debts. However, many recognize that filing levels after October 18, 2005 remained low through mid-2006 because so many people rushed to file their bankruptcy petition before the effective date.⁷⁹ Indeed, of the over two million people that filed for bankruptcy in 2005, approximately 600,000 (or, stated differently, an amount equal to the total number of filings in 2006) filed in the weeks before BAPCPA’s October 17 effective date.⁸⁰ While consumer filings remained low for much of 2006, the numbers already have started to increase as there was a forty percent increase in consumer filings in 2007.⁸¹ While no one expects filings to return to the pre-BAPCPA apogee, filings appear to be headed toward the one million mark and total consumer filings likely will continue to increase for the next few years in large part because of the massive amount of consumer debt.⁸² Perhaps more importantly, while the number of consumers who filed Chapter 13 petitions increased after the new changes went into effect, fewer consumers are now filing Chapter 13 petitions relative to Chapter 7 petitions.⁸³ So, despite Congressional attempts to decrease bankruptcy filings, over-indebted consumers are still filing for bankruptcy and more of them are now seeking to discharge their debts rather than attempt to repay them.

One other post-BAPCPA development suggests that the revised consumer insolvency laws and the additional requirements BAPCPA imposes on consumers have not had their intended results. The evidence has shown that the credit counseling requirement to be an administrative obstacle to debtors, rather than a financially beneficial exercise.⁸⁴ The requirement that all consumers receive credit counseling before seeking formal debt relief is not, by itself, particularly objectionable or unusual. Indeed, debt counseling is common outside the United States and professional debt counselors in Europe historically have been very active in helping consumers restructure their debts and navigate formal debt adjustment procedures.⁸⁵ In imposing the new credit counseling requirement, however, members of the U.S. Congress assumed consumers would consult with an impartial counselor before they filed a bankruptcy petition and would then realize that they actually had the ability to repay their debts outside of bankruptcy in a private debt management plan.⁸⁶ Thus, the basic normative goal of the new credit counseling requirement is to make consumers understand that they have the responsibility to control and manage their financial affairs in a responsible manner. The specific goal of the counseling was to help potential debtors “make an informed choice about bankruptcy, its alternatives, and [the] consequences” of filing for bankruptcy.⁸⁷

Despite these admirable goals, commentators uniformly have concluded that pre-filing credit counseling is of little value to most consumers because, by the time most people are contemplating a bankruptcy filing, their financial situation is so dire that they have no realistic alternative but to file for bankruptcy.⁸⁸ For example, empirical studies conducted during the last two years have found that the overwhelming majority (approximately ninety-seven percent) of debtors who participated in pre-bankruptcy counseling simply did not have enough money to pay their bills, or do anything else except attempt to get relief for their over-indebtedness by filing for bankruptcy.⁸⁹ The futility of credit counseling is especially pronounced for Chapter 13 debtors since many of them are facing imminent foreclosures on their homes and can stall the foreclosure only by filing a bankruptcy petition.⁹⁰

Thus, the mandatory pre-filing counseling requirement has failed everyone involved: it has not helped consumers and it is not financially beneficial for credit counseling agencies either. Credit counseling agencies are not benefiting because Congress mandated that the counseling services be provided at a reasonable cost and that fees be waived for the poorest consumers (typically based on an amount that is well below the U.S. poverty line).⁹¹ Because of this, most agencies provide counseling on the Internet (the cheapest way) and many have eliminated face-to-face counseling (the most expensive way) even though counseling experts argue that the most effective way to counsel consumers is face-to-face.⁹² Because most credit counseling agencies charge consumers only fifty dollars, most are finding that even using the cheapest way to provide these services is not profitable.⁹³

The credit counseling requirement would have been profitable for these agencies if more consumers could afford to repay their debts in a debt management plan (DMP). Consumers who participate in DMPs are required to repay some of their unsecured debts over an extended period of time outside of a bankruptcy proceeding. DMPs are profitable because credit card companies typically give credit counseling agencies a percentage of the amount consumers pay to their creditors. However, there is virtually uncontroverted evidence that in just two years the pre-filing counseling requirement has diverted few potential debtors into private DMPs.⁹⁴ Thus, in addition to placing additional administrative burdens and unnecessary costs on consumers, the credit counseling requirement has failed to be a financially profitable venture for the credit counseling agencies who provide these services for the simple reason that most consumers are too over-indebted to benefit from anything other than discharging their debts in a bankruptcy proceeding.⁹⁵
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IV. COMPARATIVE PATTERNS OF INDEBTEDNESS

A. Going into Debt

Due in large part to the kindness and generosity of the U.S. financial services industry, consumers throughout the world now can experience the joys provided by the “democratization” of credit. Starting in the early 1980s, credit cards and other forms of consumer credit were deregulated in most global economies and consumer credit is now more readily available to middle- and lower-class consumers.⁹⁶ As is true in the United States, a greater access to credit is not necessarily a bad thing. For example, when the inter-bank interest rates dropped in Brazil a few years ago and lending laws were relaxed to make it easier for lenders to seize property pledged as collateral for loans that are in default, more of Brazil’s working poor gained access to credit and were able to buy their own homes.⁹⁷ Consumers in Brazil, Europe, and elsewhere (like their U.S. counterparts) now have staggering amounts of debt. For example, outstanding debt in British households is roughly 150 percent of personal income, which is actually higher than the U.S. figure of 125 percent of personal income.⁹⁸

Like U.S. consumers, world-wide consumers routinely spend more than they earn each year. Also, like U.S. consumers, over-indebted consumers in Brazil and other countries appear to be hopelessly in debt because they are attempting to make ends meet. Empirical studies conducted in Brazil appear to indicate that the same factors that cause consumer bankruptcy filings in the United States (medical debt, divorce, loss of job) also are the most common causes of indebtedness and that stagnant or declining wages cause many middle and lower income Brazilians and Americans to borrow money not to over-consume, but just to keep up with the cost of living.⁹⁹ Similarly, because of stagnant or declining wages, many consumers find themselves unable to pay their bills each month and they decide to use credit cards to help close the gap between what they earn and what they need to pay their bills.¹⁰⁰

Not surprisingly, these high levels of consumer indebtedness caused many European countries to face the same economic patterns at the end of the 1980s and the beginning of the 1990s that we are now facing in the United States: increased household debt followed by decreased personal savings and rising housing prices, followed by plummeting housing prices.¹⁰¹ This cycle then triggered a banking crisis in these countries, just as the subprime housing meltdown has created a financial crisis in the United States.¹⁰² In effect, once European consumers were told to “buy now, pay later,” they bought, but then found they were unable to repay when unemployment rates rose and there was a general slowdown in the European economies in the 1990s. Thus, as is true in Brazil and the United States now, the credit binging created a credit hangover.

B. Getting out of Debt

Despite the similarities of world-wide consumer behavior, the U.S. insolvency scheme is fairly unique. Most debt adjustment systems outside the United States are not as comprehensive as the U.S. consumer insolvency system either because they do not restructure all of the consumer’s debts or because they lack the ability to dispose of all the consumer’s assets. In addition, these systems generally are not designed to help the consumer discharge her debts. Instead, consumer debt adjustment systems outside the United States appeared designed to help creditors collect debts, to prevent over-indebtedness, and to enforce the societal norm that people have an obligation to honor their contracts and pay their debts.¹⁰³ Traditionally, non-U.S. consumer insolvency laws have not been designed to treat the problem or the causes of over-indebtedness.¹⁰⁴ This was the view that many in Congress held in enacting BAPCPA and making it harder for U.S. consumers to discharge their debts in bankruptcy.

V. POTENTIAL SOLUTIONS FOR CONSUMER OVER-INDEBTEDNESS

While it is unclear whether the U.S. Government should bail out consumers, investment banks, hedge funds, or any other entity that helped facilitate the massive amount of consumer over-indebtedness in the United States, one thing is clear: the current U.S. approach to handling consumer over-indebtedness is just not working. Consumer debt is at a record level, bankruptcy filings are increasing, foreclosure rates are astronomical and the subprime mortgage meltdown has caused chaos in the financial markets.

A. Need for Response

When foreclosure rates began to increase in early 2006, some questioned the wisdom of bailing out borrowers who were at risk of losing homes they should have known they could not afford and some politicians continue to argue against homeowner bailouts.¹⁰⁵ Preventing borrowers from fully internalizing the costs associated by their reckless behavior would, it is said, create a moral hazard problem. Because of the negative externalities associated with home foreclosures, however, the subprime mortgage crisis should not be viewed as an isolated problem that affects just the reckless, over-indebted homeowner. Even if individual homeowners should be forced to suffer the most harm (i.e., the loss of their homes and any equity they may have accumulated in those homes) from their own improvident credit decisions, the U.S. and global capital markets have an incentive to care about these borrowers because of the harmful spillover effects of consumer over-indebtedness.

Consumer over-indebtedness leads to greater credit card defaults and mortgage foreclosures; and increased foreclosure rates harm municipalities and neighboring property owners. Municipalities suffer whenever there is a real estate slump because they lose the revenue that is generated by the building or selling of homes (e.g., the issuance of building permits). In addition, property tax revenues fall because of the foreclosed homes and municipalities suffer a decline in revenue because of potentially lower real property assessments.¹⁰⁶ Lower tax revenues also affect cities’ ability to borrow cheaply¹⁰⁷ or to adequately fund schools and other public services, or provide other vital governmental services.¹⁰⁸ Additionally, though faced with declining tax revenues, cities are often required to increase police protection in areas with vacant homes to prevent vandalism and to prevent criminal activities from taking place in the homes.¹⁰⁹

Cities often respond to decreased revenue by passing the costs on to its citizens in the form of tax increases. For example, the City of Chicago recently requested a fifteen percent increase in property taxes as well as increases in sales, gasoline, and parking taxes to compensate for the lost revenue caused by flattening property assessments and rising mortgage foreclosures.¹¹⁰ Of course, just as cities likely will seek to increase property taxes to compensate for lost revenue, homeowners have an economic incentive to seek lower assessments and lower taxes to reflect the decrease in their property values caused by the mortgage foreclosures.

Studies consistently show that foreclosures impose costs on neighboring properties by lowering their market value.¹¹¹ Even if the owner of a neighboring home has not borrowed recklessly, the close proximity of foreclosed properties to property the owner wants to sell increases the risk that the responsible owner will be financially harmed because the neighboring foreclosed properties will negatively affect the sale price for her property.¹¹² In addition, depressed home prices make it harder for owners to refinance their existing loans or to obtain new financing, which then creates a “negative cycle of disinvestment.”¹¹³ The presence of foreclosed properties in a neighborhood also gives people an incentive to vandalize the vacant home, steal copper, or conduct criminal activities in the home.¹¹⁴ An increased risk of criminal activities in a neighborhood populated with homes that are in foreclosure stigmatizes the neighborhood. Once a neighborhood’s overall reputation for quality of life declines, the quality of schools and other neighborhood amenities and activities will likely decline.

In addition to the harm to individual homeowners or neighboring communities and municipalities, the subprime meltdown has detrimentally affected the U.S. and global capital markets. The subprime meltdown triggered a liquidity crisis that has harmed prime borrowers who sought to obtain mortgage credit and were not in default. Since 2006, lenders have been reluctant to initiate mortgage loans generally, and jumbo mortgages specifically, even to consumers and businesses with good credit ratings.¹¹⁵ This liquidity crisis also has harmed entities that invested, or sought to invest, in subprime mortgages because lenders restricted the credit available to hedge funds or private equity firms because of the risks associated with securitized subprime loans.¹¹⁶ This credit restriction has made investors less willing to buy mortgage-backed securities, which has decreased the issuance of these securities.¹¹⁷

To spark economic activity and prevent further damage to the economy caused by the tightening of credit and general chaos in the housing and credit markets, since October 2007, the Federal Reserve has repeatedly cut interest rates.¹¹⁸ The Chairman of the Federal Reserve also conceded that the gravity of the problems with the U.S. housing market has hurt the overall economy.¹¹⁹ A number of major retailers in the United States, including Home Depot and Wal-Mart, have reported lower corporate earnings because of slower than expected consumer spending; U.S. auto manufacturers lowered their 2007 sales forecasts as well.¹²⁰

Finally, the problems with the U.S. mortgage market have affected global financial markets. Despite interest rate cuts, the U.S. and global stock markets have been on an almost non-stop roller-coaster ride due in large part to the liquidity crisis caused by the subprime lending meltdown.¹²¹ Indeed, the liquidity crisis has caused the collapse of a major U.S. investment bank and several major U.S. hedge funds that had invested in securitized subprime loans, caused a run on at least one bank in Great Britain, lead to the termination of the CEOs of Citigroup and Merrill Lynch, and is wreaking general havoc with the global financial markets.¹²²

B. Crafting a Response: Recognizing Creditor Motivation

Neither creditors, who loaned recklessly nor debtors who borrowed recklessly should bear the sole blame for the current problems. However, as Brazil considers possible solutions to its increasing problem of consumer over-indebtedness generally, or the specific problems involving credit card or other forms of consumer debt, policymakers should carefully consider why creditors engage in certain behavior and why that behavior is not only understandable, but is actually quite rational. As market actors, businesses that provide credit to consumers have an incentive to act solely in the interest of maximizing their profits. Thus, it is not surprising that credit card issuers target U.S. college students since they are in the habit of being in debt and their potential future income makes them a lucrative customer base.¹²³ Likewise, while unsettling, it should not be surprising that credit card issuers have targeted undocumented workers¹²⁴ as well as homeowners who are facing a foreclosure and, thus, losing access to the equity in their homes,¹²⁵ since it is perfectly rational for companies to aggressively market to customers who have limited access to other types of credit.

Before the United States imposes additional regulations on the subprime lending market, or before Brazil or other countries decide what type of consumer insolvency system to adopt, policymakers must realize that, quite simply, it is extraordinarily profitable to do business with consumers with weak credit histories or who are perceived to be financially naïve or desperate. These customers can be charged higher interest and fees and, if they are given a credit card, are more likely to carry large credit card balances and to make only the monthly minimum payments.¹²⁶ In fashioning relief to over-indebted consumers, policymakers must understand that creditors generally will engage in acts that are not profit-maximizing only if there is a concerted effort to discourage consumers from participating in market activities that increase their over-indebtedness, or if judicial or administrative supervision, such as laws or agency regulation, force them to do so, or if some extra-legal cultural norm “shames” them into being benevolent. As discussed in the following sections, these factors of profit-maximization, social optimality, and regulatory pressure all appear to be at work as the United States considers how to respond to the current consumer over-indebtedness crisis.
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C. U.S. Response to Consumer Over-Indebtedness

1. Disclosure and Consumer Education

When the U.S. credit crisis started earlier in 2006, few members of Congress and no one in the current Bush Administration were willing to propose substantive, immediate solutions to the housing crisis. No one wanted to be perceived as arguing for a bailout of either homeowners or hedge funds. Instead, the most common response was to propose either additional homeowner counseling services or to suggest that consumers be given even more disclosures about the terms of their mortgages or credit cards.¹²⁷ In crafting a response to the problem of consumer over-indebtedness, policymakers in both the United States and in Brazil should avoid adopting a solution that merely increases the amount of information or disclosures that consumers receive before each credit transaction.¹²⁸ While disclosure information appears to be useful for higher income borrowers, consumer counseling organizations in the United States have generally found that consumers who have received counseling still are prone to succumb to the aggressive marketing and advertising of lending organizations.¹²⁹ Thus, additional counseling or enhanced disclosures by themselves are not likely to help resolve the problem of consumer over-indebtedness.¹³⁰

Counseling and additional disclosures are especially unlikely by themselves to help decrease consumer over-indebtedness because of certain cognitive biases people have. That is, people are prone to be overly optimistic about their financial futures and to systematically underestimate the risk that bad things will happen to them, such as an inability to repay their debts. People also tend to discount the harm that may occur to them in the future, such as default, because they tend to place a high value on positive current events: the ability to own their own home or to buy something with a credit card.¹³¹ Given this, it is unrealistic to assume that most consumers will consistently control the impulse to over-consume. Since some consumers (like college students) may have reason to believe that their incomes will increase significantly in a few years, providing additional disclosures will likely be meaningless in convincing them to temper their spending.¹³² Finally, shifting the burden to the consumer to understand the terms of complex credit transactions creates perverse incentives for creditors. That is, if the burden is placed solely on the consumer to comprehend the often complicated credit transaction, creditors have an incentive to provide long, confusing disclosures¹³³ and have an even greater incentive to target vulnerable populations like the elderly or college students who they conclude will not handle credit wisely.

2. Regulation

In response to the meltdown in the U.S. mortgage market, the U.S. Congress has held numerous hearings and has considered legislation designed to respond to the problem of over-indebtedness generally, and the housing crisis specifically. Unlike Brazil, the U.S. has a legal structure, namely the U.S. Bankruptcy Code, which can be used to enact laws that respond to new or existing problems involving consumer over-indebtedness.¹³⁴ Indeed, many of the bills that recently have been proposed are designed to weaken the protections mortgage lenders have in bankruptcy. For example, one bill would allow consumers aged fifty-five and older to exempt up to $75,000 in any equity they have in their homes.¹³⁵ Other bills would allow over-indebted consumers to waive the mandatory credit counseling requirement and seek immediate bankruptcy relief if they are filing bankruptcy in order to save their home from foreclosure.¹³⁶ One proposed bill also would let consumers discharge the entire amount of the mortgage loan if the lender engaged in certain fraudulent acts or violated certain state and federal laws.¹³⁷

Perhaps the most controversial aspect of the recent proposals is that they would protect consumers who find themselves “upside-down” on their home loans. That is, because of multiple refinancing, no down payments, and other exotic loan features, many homeowners find that they owe more than the home is worth.¹³⁸ Borrowers whose loans permit them to defer interest or pay significantly lower interest rates than the stated rate in the loan have found that their loan has negatively amortized since their principal loan balances would increase because of their failure to pay all accumulated interest. Proposed legislation would let a borrower who sought relief in Chapter 13 reduce the amount of the lender’s interest in his home to the value of the home, and also would let the consumer modify the terms of the loan to make low initial payments, then a large “balloon” payment in three to five years in anticipation of a loan refinance when interest rates (hopefully) drop.¹³⁹

Allowing courts to reduce the value of a mortgage holder’s interest to the value of the home would be a dramatic shift in U.S. policy since mortgage holders have always been favored under U.S. bankruptcy laws even if the mortgage debt did not enable the consumer to purchase the home and, instead, was used to repay other debts or to purchase consumer durables. ¹⁴⁰ While opponents of the bill have argued that it would make it even harder for borrowers to get mortgages,¹⁴¹ this would at least be one way to give lenders a strong economic incentive to take greater care when approving mortgage loans or buying those loans in the secondary market. Since lenders appear willing to expand credit only if they can be sure that they can repossess the collateral that secures the loan, it is likely that they will take greater care in extending credit if they think that their security will not be protected in an insolvency proceeding.

In addition to these proposed changes to the U.S. Bankruptcy Code, the Office of the Comptroller of the Currency and other federal banking entities¹⁴² have proposed agency guidelines to address the homeownership crisis and problems created by exotic loans generally, and the particular issues involving subprime loans.¹⁴³ These proposed guidelines are designed to ensure that the terms of nontraditional lending products are consistent with prudent lending practices and that these standards help prevent borrowers from experiencing a substantial increase in their monthly loan payments. The guidelines address the need to help borrowers understand the loan terms and to determine whether they can afford the loan at the time and will be able to make loan payments if the loan balance increases because of negative amortization. The guidelines also are designed to help borrowers understand whether they may be placing their homeownership at risk by using one of these products.¹⁴⁴ The agencies specifically discourage the use of liar loans and urge mortgage originators to require borrowers to produce employment verification statements (i.e., W-2 statements), pay stubs, or tax returns.¹⁴⁵ Regulators also would require that mortgage originators verify the “reasonable ability” of the borrower to pay the principal and interest on the loan, real estate taxes and homeowners insurance; would require lenders to consider the borrower’s ability to pay the loan after the rates reset; would eliminate liar loans; and would deem mortgage brokers to be in a fiduciary relationship with the potential borrower.¹⁴⁶ The Federal Reserve Board also has proposed changes to the regulation that governs credit card disclosures, commonly known as Regulation Z. The proposed changes are designed to make credit card disclosures more comprehensible and require issuers to give consumers longer notice of any proposed changes to the credit card terms.¹⁴⁷

Lenders opposed not only the housing loan guidelines enacted in response to the U.S. housing crisis and regulations that would impose on them any duty to evaluate a borrower’s ability to repay a housing loan, but also the proposed changes to the U.S. Bankruptcy Code.¹⁴⁸ Undeterred by this opposition, the Chairman of the U.S. Federal Reserve has stated that the Federal Reserve is looking closely at some mortgage lending practices, including the appropriateness of evaluating a borrower’s ability to repay a loan at the time the loan was made.¹⁴⁹ Moreover, the U.S. Congress continues to hold and to threaten to hold additional hearings to examine the practices of credit card companies. Scrutinized practices include the marketing of credit cards to college students, unilaterally changing the terms of credit card agreements, and treating a consumer who has not missed any payments on Credit Card A to be in default simply because the consumer is in default on Credit Card B, a practice known as universal default.¹⁵⁰

Though this has not yet happened, the United States and Brazil should carefully consider the concept of responsible lending, a policy that has been considered but not adopted by European countries,¹⁵¹ and also the notion that the consumer should be guided to “good loan” products.¹⁵² Responsible lending suggests that well-functioning credit markets need rules that both make credit available to all people, thus embracing the democratization of credit, and protect the consumer who is vulnerable to exploitative lending practices. Similarly, the concept that the consumer should be guided to “good loans” is based on the belief that all parties involved in the mortgage market should ensure that borrowers have access to a loan that is transparent and fairly priced, provides benefits to the consumer, and does not expose the borrower to unexpected foreclosure or default risks.¹⁵³ Of course, it is a challenge to craft rules and regulations which ensure both consumer access to credit and that this credit does not overwhelm or confuse the consumer. Yet, the United States and Brazil should nonetheless consider these policies since they are consistent with the economic reality that some amount of legal intervention will be necessary to give creditors an incentive not to take advantage of vulnerable customers or of customers’ behavioral biases.

3. Changing Issuer and Lender Practices

Consumer advocates have urged credit card issuers and mortgage lenders to adopt basic principles that would govern the way they market these products to the vulnerable consumer.¹⁵⁴ While this is not in the economic interest of the financial industry, the fear that administrative agencies or Congress will enact new regulations or laws gives lenders an incentive to unilaterally change their practices to avoid additional agency or legislative oversight. This appears to have happened with some of the changes financial institutions have made recently concerning their credit card and mortgage practices.

For example, consumer advocacy groups have applied intense pressure on universities to restrict credit card issuers’ access to their students and at least some states have passed legislation to regulate credit card marketing on campuses.¹⁵⁵ In addition, the public outcry about subprime loans in the United States combined with the number of Congressional hearings that have been held over the last few years as well as the fear of additional or more burdensome regulation appears to have caused mortgage lenders to voluntarily change some of their lending practices. U.S. mortgage lenders have agreed to reduce the number of liar loans they will approve and many have stopped offering loan products that had very low interest rates for the first few years, then dramatically higher rates for the remaining years (typically twenty-seven to twenty-eight years).¹⁵⁶ In addition, some credit card issuers have voluntarily agreed to abandon the practice of universal default, though it is unclear whether it is a complete abandonment of this practice.¹⁵⁷

VI. CONCLUSION

In fashioning relief for unsophisticated over-indebted consumers, the United States and other countries should consider ways to ensure that lenders will not act in ways that are designed to take advantage of vulnerable consumers in credit transactions. Lenders will likely continue to oppose attempts to regulate their lending practices, and likely will argue for increased disclosures, more consumer literacy programs, or other market-based approaches. These approaches have not, by themselves, worked in the past and there is no reason to think that they will work in the future. Given the harm that consumer over-indebtedness and, more specifically, the subprime housing and credit card crises have had on the United States and global capital markets, Congress should enact laws that shift at least some of the burden of conducting responsible credit transactions to the lender and away from the consumer. And, Brazil and other countries that are enacting or revising their consumer insolvency laws should ensure that these laws give both consumers and lenders economic incentives to behave rationally when entering into a consumer credit transaction.

Footnotes

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Texas International Law Journal