Lenders create a bankruptcy monster

By Liz Pulliam Weston

Consumer bankruptcy filings are on track to exceed 1 million this year, laying waste to the idea that bankruptcy reform changed anything fundamental about how Americans go broke.

Furthermore, lenders, not consumers, are the ones that seem to be abusing the system these days. According to U.S. Senate testimony, bankruptcy trustees are seeing "systemic problems" with mortgage servicers that:

• Tack on exorbitant fees.

• Miscalculate how much is owed.

• Refuse to communicate with borrowers or the court.

• Force homeowners into foreclosure without authority to do so, usually because the servicers can't figure out or prove who actually owns a mortgage, which has typically been chopped up and sold to investors.

In some cases, servicers have tried to push through foreclosures when the borrower wasn't even behind on payments, Indiana bankruptcy trustee Debra Miller told a Senate subcommittee last month. The servicers used the borrowers' bankruptcy filings, which were intended to erase other debt, as an excuse to try to take away their homes.

Bankruptcy Abuse Prevention Act, my foot

The upshot, according to some bankruptcy experts, is that the fairness of the system is being eroded.

"Each of these practices has been exposed in litigation in bankruptcy courts but continues to occur despite court rulings that such activity is unlawful," bankruptcy expert Katherine Porter (.pdf file), a University of Iowa College of Law associate professor, told the subcommittee. "The upsetting reality is that the current bankruptcy system routinely forces borrowers to pay bloated amounts and permits mortgage servicers to misbehave without serious consequence."

If you missed the irony, I'll spell it out. Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 because lenders had alleged that consumers were abusing the bankruptcy system.

Back then, those in a position to know rejected the idea that consumer abuse was widespread. Bankruptcy judges, trustees and attorneys generally agreed that most people, far from rushing to file, waited too long while struggling to pay impossible debts.

But the reform act itself touched off a land rush. More than 2 million cases, a record, were filed in 2005 as consumers tried to beat the October implementation deadline for the new law.

Then filings dropped like a rock, and lenders declared victory.

Which was entirely premature. Consider:

• Consumers filed 236,982 bankruptcy cases in the first three months of 2008, more than double the number filed in the same period two years ago.

• Filings have continued to rise. They were up 48% in April and 31% in May from the same months a year ago.

"We're on track to go over the 1 million milestone, definitely," said Sam Gerdano, the president of the American Bankruptcy Institute, a nonpartisan organization that tracks bankruptcy trends.

What's more, the percentage of Chapter 13 filings has returned to pre-reform levels. The bankruptcy reform law was designed to force more consumers into Chapter 13, which requires borrowers to repay at least some of what they owe, instead of Chapter 7, which allows borrowers to erase most unsecured debt, such as credit card and medical bills.

The law seemed to be successful, at first: Chapter 13 filings rose from their traditional level of about 30% of filings to about 40%. But Chapter 13 filings in May were back down to about 32% of the total.

Lenders created their own problem

What's driving the upsurge in bankruptcies isn't a mystery. Loose lending practices allowed many consumers to overdose on debt. For a while, many were able to postpone their days of reckoning by tapping into home equity to pay off their more burdensome bills.

Continued: Current situation

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