Is Bankruptcy Fundamentally Unfair To Your Creditors and to Your Fellow Citizens?

The Bankruptcy system in the United States is an essential part of the economy.  It is part of the system that regulates consumer transactions and handles the orderly default on loans and credit transactions.

In every consumer transaction the bank has built in the risk of default.  If a business knows they will only be paid on 98% of their jobs then they will charge a little more on every job they do to compensate for defaults.  If a bank loans money, the interest rate includes the time value of the money loaned, the cost of administering the loan, the rate at which similar loans default, and a profit margin. The cost of the default is built into the system as part of the interest rate.

As an example let’s imagine we have two people applying for a credit card and we want to know why they have different interest rates.  One of them is Mr. 750 Creditscore,  the other is Mr. 600 Creditscore.  Mr. 750 Creditscore is offered a credit card with a $5,000 limit at 4% interest rate.  Mr. 600 Creditscore is offered a different credit card with a $5,000 limit but 21% interest rate.

Let’s ask the following questions:  Is the time value of money different for these people? No, time value of money refers to what the money would bring in over time in an investment – the money loaned to Mr. 750 Creditscore and Mr. 600 Creditscore would both theoretically be in the same investment and therefore bring in the same amount of money.   What about the cost of administering the debt?  There could be slight differences in administering or handling credit for both of them, but this would probably be within a percentage point. What about profit margin?  Well, if we assume that the profit margin on the debt is no more than 4% (the maximum it could be for Mr. 750 Creditscore if the time value of money was 0% and the cost of administration was 0%) then for Mr. 600 Creditscore the entire additional interest rate is purely based on risk.

It is risk that you pay additional interest for – not the time value of money, not the cost of administration, and not the profit margin.  This means that the risk of default is built into the system.

Let’s look further at who actually uses the Bankruptcy process before we decide if the process is fair or unfair to creditors and fellow citizens. The vast majority of people filing bankruptcy have experienced a major life altering event – illness, divorce, death in the family, or job loss.  There are cases of money mismanagement but those are not as wide spread as one would imagine.

Most clients who come to us have the desire to repay their creditors they just legitimately do not have the ability to do so. Most clients wish they could do something else other than file bankruptcy.  Most often, due to circumstances beyond their control, they are unable to meet all the obligations.  Debt becomes so overwhelming that it is impossible to find a way out – many borrow more money to pay off older creditors and the cycle continues until they have exhausted all avenues. They end up at a bankruptcy attorney’s office as the last resort.

There are various public policy reasons for having bankruptcy laws in place. Without bankruptcy defaulting individuals would become hopeless and give up economically – meaning they would work under the table, change jobs regularly to avoid garnishments, even resort to criminal activity.  All these lead to decreased revenue for local businesses and increased costs to society.  Those individuals would not be paying taxes as they would be more likely to work under the table; they would not be purchasing as many new products and services.  This would eventually affect a large portion of the population.  If we look at the last 20 years approximately 2% of all debtors become delinquent on their debts at some point during any given year, and about 1% of all households filed for bankruptcy over the same period of time – that’s millions of people in the United States over the last twenty years.

Bankruptcy laws were not created for debtors alone. Bankruptcy laws also help creditors by making the process structured and fair in relation to one another.  Once the debtor is insolvent (meaning does not have enough assets to pay all creditors in full) creditors would be rushing in to seize what assets they can, and sell the assets as quickly as possible, which would result in lower liquidation values and would put creditors in conflict among each other.  The Bankruptcy process provides the priority structure for the debts – some debts do not go away (e.g. recent tax debts, child support, alimony), some debts have to be paid in order to keep the property (secured debts such as mortgages and car loans), some debts would not be paid at all or not paid in full based on the particular circumstances of the debtor.

Finally, and most importantly, the bankruptcy system is about forgiveness and redemption.  As a society we have made a decision that is in the best interest of the public to allow people another chance to succeed rather than for them to be crushed eternally under the weight of their debts.  It is the idea that we choose to be hopeful over vengeful that drives the bankruptcy system.  We want people to participate in the economy, to lean into their own productivity, to be given relief where none would otherwise be available.  We want people to be able to take some financial risk without the worry that the decisions they make will haunt them forever if something goes wrong.

The bankruptcy system is a blind system.  It does not know whether you were born with money, opportunity, or the lack thereof.  It is built on certain assumptions that are about us as a society more than you as an individual.  It can be hard to think of things this way, hard to see the forest for the trees.  It does take into account, specifically, each individual person’s case within the context of the law.  But it is fundamentally about fairness and equity.

If you have gotten this far and you think you need to get more information than contact us at no cost.  By the way, if you are interested in the History of the Bankruptcy laws in the United States, here is a good article to get you started.  http://www.law.du.edu/documents/registrar/advanced-assignments/2009-fall/Sousa-Bankruptcy.pdf