Lenders create a bankruptcy monster

But now we have:

• A troubled economy with rising unemployment.

• Soaring rates of foreclosure.

• Falling home prices.

• Tightening lending standards.

So we have more people turning to the relief that bankruptcy court offers.

Should people be smarter about debt? Of course. Anyone who carries credit card debt or agrees to an unaffordable mortgage is asking for trouble.

But most of those who file had willing accomplices in their lenders.

I've railed for years about what a terrible law the bankruptcy reform act is. It did nothing to curb lenders' worst practices while raising the costs and complications of filing for those least able to pay. And now we're seeing lenders abuse the bankruptcy system so they can inflict unfair fees and charges on borrowers.

It remains to be seen whether Congress or regulators will act to rein in mortgage servicers in bankruptcy court. But there are some interesting developments elsewhere. For instance:

Federal regulators are finally cracking down on credit card companies. Among other changes, regulators want to ban "retroactive pricing," the practice of jacking up interest rates on debt that's already been accrued. Any curbs on credit card issuers' practices may make credit less available, but it's also likely to reduce the need for bankruptcy relief.

A bankruptcy judge has opened a window for borrowers. In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored.

The couple had jobs as a delivery driver and for an auto-parts distributor but claimed on one loan application that they earned a combined $146,000 a year and, on another, filed six months later, that they made $191,000.

Tchaikovsky rejected the couple's contention that their mortgage broker and the bank had inserted the phony numbers into the application. But the judge nevertheless said the bank's reliance on those figures "wasn't reasonable" and held the bank responsible for failing to investigate the couple's finances.

Although Tchaikovsky's decision applies only to the bankruptcy court's Northern District of California, the American Bankruptcy Institute's Gerdano thinks other bankruptcy judges, weary of various lender abuses, may follow suit.

"Their patience wears out, and you get outcomes like this," said Gerdano, who noted that Tchaikovsky was a well-respected judge and "not just some nut job." "I think it will get the attention of other bankruptcy judges who might be willing to adapt the same reasoning."

And the impact could extend far beyond the so-called stated-income loans, also known as liars' loans, that have led to many foreclosures, Gerdano said. Credit card lenders, for example, rarely verify an applicant's income when they approve an account or increase a credit limit. Auto and home-equity lenders often don't check either.

If borrowers can lie on applications and walk away from the debt because the lender failed to investigate, the days of easy credit may be numbered.

"If stated income is no longer reasonable and the result is a claim disallowance" or the inability of a lender to collect on a debt, Gerdano said, "that's a San Andreas fault situation for the whole commercial credit industry."

That might initially be bad news for consumers. But over time, saner lending practices may accomplish what bankruptcy reform did not: fewer filings.

Liz Pulliam Weston's latest book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Published June 30, 2008

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