Bankruptcy law backfires on credit card issuers

By Liz Pulliam Weston

Credit card issuers and other lenders spent a small fortune to get bankruptcy reform legislation passed. Now the new law is costing them even more.

An unprecedented spike in filings before reform took effect in fall 2005 is chewing into lenders' bottom lines, and the subsequent lull is showing signs of being short-lived. Bankruptcy attorneys say their caseloads are starting to pick up, and credit counseling agencies -- which provide now-mandatory sessions for consumers who want to file -- say they're seeing significantly more people than they initially predicted.

All this is raising questions about whether lenders will profit as much from the new bill as they hoped.

It wasn't supposed to be this way. The new law contains a "means test" that was supposed to steer higher-income filers toward repayment plans. Lenders expected a rush of consumers trying to beat the bankruptcy deadline, but nothing like the surge that actually occurred. More than 500,000 bankruptcy cases were filed in the two weeks before the law took effect, compared with a normal weekly volume of 30,000 to 35,000. So far this year more than 2 million cases have been filed, 49% more than the same period last year and eclipsing all previous records.

"I think the actual magnitude really surprised some people," said Cynthia Ullrich, a director in the Fitch Ratings credit card group. "The feedback we received (from credit card issuers) is that it was larger than anticipated."

The hurting begins

Once a consumer files bankruptcy, lenders have 60 days by federal law to "charge off" the filer's accounts -- essentially recognizing that the debt is uncollectible and taking the loss. Fitch predicted the charge-off rate for major issuers could rise more than 30% to 7.5% in the next few months, compared with 5.7% of accounts currently.

Some issuers have already admitted their pain:

• J.P. Morgan Chase & Co., the nation's largest credit card issuer, said its charge-off volume would rise 44% in the fourth quarter to $2.3 billion from $1.6 billion for the same period a year ago.

• Capital One warned its charge-off rate could rise up to 1 percentage point from the year's previous range of 4.05% to 4.14%.

• Discover said it expected the bankruptcy surge to add $250 million to its costs.

Lenders initially said that the rush of filers merely accelerated losses that would have happened anyway -- that people essentially decided to file sooner, to beat the deadline, rather than a little later.

Indeed, filings dropped sharply to 9,447 the week following reform, according to Lundquist Consulting.

But the following week, filings rose to 14,291. Some of those cases appear to be backlog -- filings under the old law that courts are just getting around to reporting -- but the numbers are expected to climb as weeks pass. How far is the question.

Counselors see lots of traffic

Sam Gerdano, head of the nonpartisan American Bankruptcy Institute, said he wouldn't be surprised if filings remain extremely low at least through the first half of the year.

"We could be seeing records in the other direction," Gerdano said, "with filing numbers we haven't seen since the 1980s."

But some believe the respite will be shorter than lenders hope.

"There was a real lull for awhile, but we're starting to pick up again," said Los Angeles bankruptcy attorney Leon Bayer. "We're getting back to normal now."

Credit counselors report a similar uptick. Demand for pre-bankruptcy counseling, which is now required before consumers can file, has been unexpectedly strong at the 71 agencies affiliated with the National Foundation for Credit Counseling that have been approved by the Department of Justice to provide such services, said foundation President Susan Keating.

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