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The number of people filing for bankruptcy could set records next year. And, while bankruptcy reform artificially spurred the 2005 record of nearly 2.1 million cases filed, this peak will be all about the reality of a Covid-19-blasted economy. That’s a bankruptcy tidal wave of a different color.
So far, 2020 has avoided a surge of personal bankruptcies. In fact, total bankruptcy filings year to date trail the 2019 figures.
This may be because of federal stimulus payments, mandated mortgage and other loan forbearance, unemployment insurance enhancement and the additional support provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act and other government programs. It may be because people are borrowing less. But, whatever the cause of the decline, bankruptcies still seem likely to rise if unemployment and loss of income persist.
Uncertainty, however, has been a hallmark of Covid-19 in 2020. With that in mind, perhaps it’s worth taking forecasts about bankruptcy filings with a grain of salt. There are at least two schools of thought about the future of bankruptcy. One predicts a bankruptcy surge as filings mushroom quickly to record levels. Another more measured view that says a moderate and gradual increase in bankruptcies seems equally, if not more, likely.
The Surge Hypothesis
There is little mystery about why a bankruptcy increase seems probable.
“All of us in the field are expecting bankruptcies to spike up dramatically, probably later this year and even more so into the New Year as the longer-lasting effects of the pandemic hit people in the wallet,” says Ike Shulman, bankruptcy lawyer and co-founder of the National Association of Consumer Bankruptcy Attorneys (NACBA), a Washington, D.C.-based professional group.
While the bankruptcy business has seen sharp increases in demand in the past—more on that in a moment—there is something different this time. “What we’re seeing with Covid-19 is that there are so many people that never dreamed they’d be talking to a bankruptcy lawyer or having to file bankruptcy. That wasn’t in their wildest dreams,” Shulman says.
Far from being extravagant spenders, 2020 bankruptcy clients are likely to be responsible, even thrifty people who had steady jobs and paid bills reliably until Covid-19 cast them into unemployment. “The rug got pulled out from under them by something they had no control over,” Shulman says. “It wasn’t bad financial planning or anything they could be prepared for.”
Business owners are feeling the pressures as well. Restaurants and retailers closed for months by government mandates—and now only able to serve limited numbers of customers due to social distancing requirements—are especially hard hit, Shulman says. “I’m getting calls regularly now from small businesses,” he says. “More and more of them are realizing they just can’t make it with Covid and they’ll be forced to close.”
Shulman also points to the approaching end of mortgage forbearance as a harbinger of a bankruptcy balloon. As legislated in the CARES Act in late March, lenders allowed homeowners with federally backed mortgages to stop making payments for periods of six months, with a possible extension of six additional months. Starting as soon as October 1, affected homeowners will not only have to resume payment, but banks could demand they immediately make up all the missed payments.
“If the lenders don’t work with them, that will trigger a wave of Chapter 13 bankruptcies,” Shulman says. Filing under Chapter 13 of the federal bankruptcy code allows debtors to set up a repayment plan usually allowing three to five years to catch up on payments.
A More Measured View
Uncertainty plays a bigger role in the expectations of some other observers of the bankruptcy scene. They include Robert Lawless, a bankruptcy researcher and professor at the University of Illinois College of Law, who describes his views as contrarian.
“Are bankruptcies going to increase? Probably,” Lawless says. “But people need to be more modest about their predictions. I think it’s pretty likely that bankruptcies are going to go up. I don’t think it’s an absolute certainty.”
Lawless says his research indicates that bankruptcy is tied to debt levels, not unemployment rates. “People like to talk about unemployment,” he says. “But if people don’t have debt, they don’t file for bankruptcy. It doesn’t put money in your bank account or food on the table or find you a job.”
On that point, the Federal Reserve Bank of New York has reported that, even as unemployment spiked to heights not seen since the Great Depression, household debt levels have been going down. In the second quarter, credit card balances fell by the largest amount since data began being collected. The number of new credit accounts being opened also fell by a record amount. The Fed explained this as a Covid-19 effect that went with the sharp decline in consumer spending due to Covid-19 stay-at-home and social distancing orders.
Lawless points to this decline in credit balances as a hopeful sign. “If people aren’t borrowing, and consumer credit has gone down, people don’t have as much reason to file for bankruptcy,” he reasons.
And, as noted, bankruptcy filings this year are down. According to statistics gathered by the American Bankruptcy Institute (ABI), a Washington, D.C.-based group of attorneys, lenders, auctioneers, judges, academics, accountants and others, year-to-date filings in state and federal district courts through August were down a robust 27% compared to 2019.
The ABI has also released a forecast: Chapter 11 filings by businesses will likely rise sharply—several large corporations have already sought Chapter 11 reorganization—and may conceivably best the 1986 record for filings under that chapter, the organization says.
However, Chapter 13 filings, which are often submitted by individuals with stable incomes and good prospects for eventually repaying creditors, will likely decrease in favor of Chapter 7 filings that don’t call for borrowers to repay debts. Overall, if the economy doesn’t recover and unemployment persists, bankruptcy records may be set in 2021, the organization forecasts.
Supporting Lawless’ tempered view is the research he has done showing consumer bankruptcy filings usually don’t happen overnight. “It’s easy to say that everybody’s out of work, so we’ll have a bunch of bankruptcy filings,” he says. “But most people struggle for two to five years before they file for bankruptcy. Bankruptcy has a long tail. The time line is going to be long. We’re not talking months but probably two or three years.”
Past Bankruptcy Booms
While Covid-19 is unprecedented, bankruptcy booms are not. It’s highly unlikely that even Covid-19 could produce anything like the historical peak in bankruptcy filings in 2005.
If you are straining to recall what economic cataclysm occurred that year, your memory is not at fault. On October 17, 2005, a new federal bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act, went into effect. Because the new law was seen as much less favorable to borrowers, people rushed to court before the effective date.
“We probably got a year or a year and a half of filings in a month,” Lawless recalls of the weeks leading up to October 17, 2005. “Then it dropped like a rock and filings stayed low until the housing bubble started collapsing in 2007.” The next peak, in 2010 as foreclosures skyrocketed, still fell short of 2005.
It may seem possible that Covid-wrought economic upset could bring about another peak that may match or exceed the 2005 annual total of nearly 2.1 million filings. But nobody’s expecting the monthly filing level to get anywhere near the 630,000 cases filed in October of that year, much less the daily spike of 150,000 in a single day (October 14).
And Lawless again points out that economic chaos and bankruptcy do not necessarily go hand in hand. For instance, he notes, a previous peak before 2005 was in the 1990s, a decade of almost uninterrupted economic exuberance. “People like to think of bankruptcy as an indicator of how the economy is doing,” he says. “It’s not.”
The Prospects for Reform
Although the framers of the U.S. constitution allowed for the making of bankruptcy laws, such laws began as a series of temporary measures. Modern bankruptcy in the United States started in 1898 when Congress passed the first enduring legislation to protect borrowers from creditors.
In 1938, the federal Chandler Act expanded bankruptcy and made it more attractive to debtors by giving them more choices in how they discharged their debts. A 1978 federal law replaced the 1898 one. The next major reform was the 2005 law that generated the filing frenzy among borrowers who wanted to avoid its more draconian requirements.
Bankruptcy attorneys and consumer advocates see 2020 as ripe for another reform, this one making bankruptcy friendlier to debtors. Shulman’s NACBA has been proposing a slate of changes, including a national floor of the minimum amount borrowers can protect from unsecured creditors in filings.
While federal law governs most of bankruptcy, state laws decide how much of a borrower’s assets creditors can go after. These laws vary widely. Some states let filers keep their homes of any value, for instance, while others have much more limited, or even no, protection.
Other reform proposals include higher limits for the amount of debt filers can have to qualify for filing under Chapter 13, which could particularly help small business filers because it is much less expensive than Chapter 11.
Reformers also want to protect people in bankruptcy from discrimination by the Small Business Administration, which routinely asks borrowers applying for government-backed loans whether they are in bankruptcy. Not least, they’d like Congressional action restoring the ability to discharge student loans.
Shulman is hopeful. “When I look at bankruptcy history, I see that the most meaningful changes came at times when the country faced its worst economic crises,” he notes.
Some of the proposed changes are already in the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, a piece of Covid-19 stimulus legislation approved in the U.S. House. But so far, unlike the CARES Act, it has not been taken up by the Senate.
Lawless agrees that reform could happen. Among other things, he declares current bankruptcy statutes are woefully outmoded, and not just because inflation has impacted the debt ceilings. “There’s one provision that still allows debtors to exempt a VCR,” he says. “That’s written in the bankruptcy code. There’s a lot of debris in the bankruptcy code like that that needs to be cleared.”
All this leaves us in what is, in 2020, a familiar place: with an ominous feeling but a lack of clarity about what exactly it portends. With considerable logic and evidence to back him up, Shulman has little doubt that the not-too-distant future will feature more bankruptcy filings than we’ve seen in a long time, if not ever. “All these things haven’t hit the fan yet, but it’s coming,” he promises.
For his part, Lawless’ view of the prospects of a bankruptcy boom is more circumspect, but still somewhat short of outright optimism. “The nature of the increase, the shape of the curve, is unknown,” he says. “It might just be a gradual run-up. You might just see bankruptcies build and build.”