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Deathstar Arbitration

Posted: September 27th, 2007, 1:55pm PDT by Elizabeth Warren

Arbitration may seem like the Andy of Mayberry form of dispute resolution--folksy, cheap and fair. The data suggest, however, that it is Darth Vader's Death Star--the Empire always wins. A new report from Public Citizen shows that the consumer loses in 95% of arbitration cases--dominance that would have made the Emperor proud.

The Public Citizen report follows an earlier jaw-dropping report this summer from the Christian Science Monitor showing that the most frequently chosen arbitrators ruled against consumers and for the companies 98.4% of the time. After serving as an arbitrator, former judge Richard Neely described arbitration as full of "Godless bloodsuckers." (Gee, Judge Neely, tell us what you really think.) Several academic pieces of condemned the current use of arbitration clauses as well.

Public Citizen has picked a good target, and they have written a superb report. There is solid research to back up the claim that arbitration is systematically biased. Senator Russ Feingold has introduced legislation to ban mandatory arbitration clauses imposed on consumers. Will this be the first serious consumer reform initiative in more than two decades?

Any anti-arbitration initiative faces real problems. Mandatory arbitration clauses are hidden in the fine print. Most of us don't even know we are subject to them until we have a problem. Arbirtation doesn't sound bad--it sounds cheaper and fairer and more informal than going to court. And, most important for the legislative process, the industries that use mandatory arbitration have a lot more money for lobbying campaigns and make a lot more political contributions than the consumer groups. (Is it any surprise that Russ Feingold, the sponsor of a campaign finance reform effort, would also be the sponsor of a pro-consumer bill on arbtration? He's one person in Congress who isn't getting big donations from PACs.)

Consumers take it on the chin every day with hidden tricks and traps in credit card agreements, home mortgages, health insurance contracts, and dozens of other purchases. Public Citizen has focused on one way to clean up the fine print in those contracts. The studies are in place, and the advocates are ready to go. Will there be action?

Pre-testing Makes Perfect

Posted: September 26th, 2007, 5:49pm PDT by Elizabeth Warren

Anyone who does empirical work knows the importance of a pre-test. This is the time to figure out that a question is ambiguous, that a survey is too long, or that the survey plan will systematically miss certain people. Katie Porter can tell her tales about pre-testing the 2001 Consumer Bankruptcy Project in a cold Boston courthouse (and nearly giving up on empirical work before she started).

The Census Bureau is no exception. They have to work the kinks out of questions, survey techniques, and the newest technology just like the rest of us. They get one shot every ten years, and they need to make it right. Mistakes would echo through federal funding for local economies, representation in Washington, and just about every other study that involves the American population.

So it was a show-stopper for me this morning to learn that the Census may not have the money for a pre-test. Congress can't agree on a new budget, so it plans to hold spending "level" at the old dollar amounts. That may sound fair in most cases, but "level" funding means no new money to cover the cost of pre-testing the 2010 census.

There have been some bitter complaints through the years and even some litigation over Census techniques. Estimations (counting people whom the Census Bureau did not find) has been a particularly hot-potato issue. Some Census data are just plain puzzling. Why, for example, does my Statistical Abstract say there are about a million more married women in the US than married men? (And the reader who thinks, "Big Love," is watching way too much television.)

Anyone who has done empirical work has sweated out funding at one point or another. But this time we should all be sweating. The census needs money for its pre-test because we all need a good census count.

Put Down the Crow over AHM Escrows

Posted: September 25th, 2007, 12:49pm PDT by Bob Lawless

Loren Steffy, a business reporter for the Houston Chronicle, headlines a recent blog post with a suggestion that he'll eat crow over his previous commentary on American Home Mortgage. A reader had inquired whether his escrow payments were safe with bankruptcy-filer AHM. Steffy had responded that AHM's bankruptcy should have no effect on his reader's escrow. A few news stories have since appeared that AHM was bouncing checks to local taxing authorities, but, Mr. Steffy, I think you can put down that crow. The problem now seems to be fixed and attributable (I hope) to a temporary glitch involving the far-flung banking operations of a complex financial company.

Still, the story got me thinking a little bit about the consequences of AHM's bankruptcy filing on its escrow accounts.

Steffy was absolutely right in describing the legal effect of bankruptcy on the escrow accounts. Under state and federal law, AHM is required to keep the escrow accounts separate from its other funds. AHM holds the funds to pay the taxes and insurance for its loan customers; it does not own the funds in any way. A bankruptcy filing does not change that relationship. At the moment of filing, the bankruptcy estate is said to come into existence, but the bankruptcy estate only gets what the debtor had. Applying these basic principles to the AHM situation means that the bankruptcy estate does not include any funds the company held in escrow. Reading between the lines of the news reports, the bounced AHM checks appear to be a misunderstanding of these basic legal principles--the bank holding the escrow funds froze all of AHM's accounts on the mistaken belief that these accounts were AHM's property.

Legal principles are great, but what happens if a bankrupt mortgage company has dissipated the money in the escrow accounts? The money simply would be gone. Obviously, the customers would have a claim against the company, which would not be worth very much given the company would be in bankruptcy. Who is responsible in this case? There is no reason to suspect anything other than a glitch was responsible for AHM's recent problems, but with all the recent concerns over mortgage companies it is a reasonable question to ask hypothetically. Unfortunately, we can only answer that question generally because a lot would depend on the specifics of a particular case.

There are regulatory systems in place to ensure that escrow accounts are not violated. I would think that it would be difficult to circumvent these regulatory systems without some outright fraud by the mortgage company insiders. These individuals most likely would be facing criminal penalties. But, individuals who had relied on the mortgage company to hold the escrow would be out of luck. As the property owners, they would remain responsible for the taxes or insurance on the property. They could pursue the corporate insiders who had committed any fraud, but they would be unlikely to find much money for compensation. Fortunately, my sense is that it would be very difficult and hence unlikely that a mortgage company could simply deplete its escrow accounts. I would be interested in hearing from readers whether they share that sense.

The Benefits of Accepting Credit Cards

Posted: September 24th, 2007, 12:13pm PDT by Adam Levitin

In a previous post I wrote about the costs of accepting credit cards. It is important to note that merchants derive lots of benefits from card acceptance, including and lower credit risk (at least compared to checks), easier bookkeeping and currency conversion, lower theft risk (less cash in the till), and improved checkout speed. The most important benefit, though, is increased sales. (See an example of this claim here.) But is that right? Do consumers really purchase more because they are purchasing with credit cards? Put more technically, does price elasticity depend on payment method?

Consider what MasterCard and Visa state on their websites. Visa lists the following among the benefits of accepting its cards:

• There is an increase in average ticket size for card purchases
• Customers tend to purchase higher margin goods with cards
• Card acceptance increases your revenue and reduces losses

Likewise, MasterCard’s website lists "Increase Sales" as a benefit of accepting cards: “Consumers spend more when they're not constrained by cash on hand. You may see increased purchases of higher-margin products as well as specialty items. And customers may visit your store more often.”

Let’s unpack these statements. Does card acceptance really increase revenue? I have seen no published study to this extent. Instead, there’s a logic error occurring in statements attributing revenue growth to card acceptance. No one disputes that ticket sizes for credit card purchases are higher than those for cash (but less than checks). But this correlation hardly shows a causation, much less a direction for that causation. Do people spend more because they purchase with credit cards? Or are credit cards simply the payment instrument of choice for larger purchases (because of legal protections, convenience, security, etc.)? There’s surprisingly little evidence on this question. A few, rather studies indicate that price elasticity might vary by payment method, but only for luxury goods, but none of these studies look at data from a number of merchants before and after credit card acceptance. Instead, they use artificially created experiments.

Logic suggests that in most cases, larger ticket amounts for credit card purchases appear to be a function of a preference to use cards for large purchases. No one (in the US) wants to carry around thousands of dollars in cash (Japan is another story). And it's a lot easier to dispute a purchase made on a credit card than one made with cash. Consumers are more likely to be concerned with disputes over large ticket items. And so on. It seems likely that the correlation of large purchases and credit cards is explained by a causation flowing from purchase to cards, not cards to purchase. Instead of card use causing large purchases, large purchases cause card use.

Such a limited statement makes comports with common sense. Common sense tells us that cash consumers are limited to the cash presently in their pocket, debit consumers are limited to the cash presently in their bank account, check consumers are limited to the cash in their bank account in a couple of days, and credit card consumers are limited to their credit limit. Which of these will be the highest is uncertain, but credit limits seem like a reasonable guess. So, arguably credit card consumers are not as constrained in their immediate purchasing power as other consumers (although they will find themselves more constrained down the road if they do not pay their bill in full and on time). But, how many consumers will buy more milk (or buy it at a higher price) because they are paying by credit card? A consumer might splurge on luxury goods because of credit cards (strange to think that these are exactly the type of purchases that are non-dischargeable in bankruptcy), but is unlikely to purchase more staples because of credit cards. And it is only the cash-flow constrained consumer who will really purchase more because of credit cards even in these circumstances.

Of course rewards points tilt the scale slightly towards greater purchases. If I get 1% cash back, I might rationally purchase $101.01 with a credit card rather than $100 worth of goods with cash. But given that merchants pay well over $1.01 for the rewards card purchase, the rewards are actually a net loss for the merchant, not a benefit. If card acceptance merely shifts larger ticket purchases to cards (and to the most expensive cards), rather than generating larger ticket purchases, it is hardly a benefit for merchants.

To be sure, there are cases where card acceptance undoubtedly increases revenue. It’s hard to sell anything over the Internet without accepting cards. Start accepting cards as an Internet merchant, and its hard not to see a revenue increase because prior revenue was likely zero. And if a business’s competitors start accepting cards, then jumping on the card acceptance bandwagon might increase revenues, or at least offset some of the loss to competitors.

So does card acceptance really benefit merchants from increased sales? The jury is still out. But if anyone wants to have a better answer, here’s my bleg: I’m looking for a data set. If your company has recently started accepting cards and is willing to contribute its data to a study (with reasonable confidentiality) please _ _law.georgetown.edu">contact me.

Who’s Paying for Your Rewards Points?

Posted: September 20th, 2007, 10:16pm PDT by Adam Levitin

The relationship between consumers and credit cards gets a lot of attention. But merchants also have relationships with credit cards, and the dynamics of this relationship have significant effects on consumers’ use of credit cards as well as on the competitive landscape in the credit card industry. A lot of my academic work has related to this (I apologize for the self-promoting links), and this post is meant to provide a short summary of some of the issues that arise in this relationship. There are a lot of twists that I cannot convey in this blog posting, but I am happy to carry on a conversation in the comments and refer readers to my articles on the topic for more detail (the most recent papers are at the bottom of the linked webpage).

Merchants pay banks a fee on every credit card transaction. The fee is referred to varying as the "merchant discount fee" or the "interchange fee." Because of these fees, credit card transactions are much more expensive for merchants than transactions on most other consumer payment systems: cash, checks, ACH, PIN debit (but not signature debit). There is also significant cost variation among credit cards. Some cards, such as rewards and corporate cards can cost merchants twice as much as others. These fees (tens of billions of dollars) are vital to credit card networks’ profitability and have led merchants to attempt all sorts of strategies to minimize their payment costs.

The largest component of the fee merchants pay goes to finance credit card rewards programs, which in turn generate more credit card transactions. Although merchants finance the rewards programs, they derive little or no benefit from them. Rather than generating additional sales, rewards programs merely induce consumers to shift transactions from less expensive payment systems to more expensive rewards credit cards. So why, then, do all consumers pay the same price for purchases, regardless of the means of payment?

The answer lies in merchants contracts with bank members of the card networks. These contracts incorporate, by reference the networks’ operating rules. Incredibly, the complete network rules are not available for merchants to view (merchants are agreeing to terms that they don’t know!), but their contours are well known, and are substantially similar for all four major networks.

The key rules require merchants to accept all credit cards of particular brands (MC/Visa/Amex/Discover) for all transactions and on the same terms and forbid merchants from surcharging for credit cards. (Federal law gives merchants the right to discount, which is mathematically equivalent, but economically very different.) In short, credit card network rules (a/k/a merchant restraint rules) prohibit merchants from accepting certain credit cards selectively and from pricing according to cost of payment. Merchants find credit card acceptance an all-or-none proposition, and in order to accept the card transactions they want, they are forced to take the more expensive cards on the same terms.

Credit card network rules prevent merchants from signaling to consumers the costs of different payment methods. Accordingly, consumers never internalize the costs of their choice of payment system. Instead, they decide which payment system to use based on a comparison of benefits, not benefits net of cost. And credit cards, with rewards programs, rank higher in consumer preferences than they would if consumers had to internalize their costs. Credit card network rules thus encourage more credit card transactions at higher price than would occur in a perfectly efficient market. By encouraging overconsumption of credit cards as a transacting instrument, card network rules also foster higher levels of consumer debt. In short, some obscure credit card network rules are a factor contributing to more defaults and bankruptcy filings, decreased purchasing power, and inflation.

Credit card network rules also permit card issuers to externalize the costs of rewards programs (and credit cards in general) to merchants. Empirical evidence shows that merchants pass on a large part of this externality to to consumers who do not use reward cards or credit cards at all. The result is a highly regressive cross-subsidy of credit card users by non-card users. In its most egregious form, this means that food stamp recipients are subsidizing first class upgrades for platinum card users!. Essentially, the credit card industry has created a tremendous sub rosa subsidy for itself.

Lastly, credit card network rules distort competition within the credit card industry and among payment systems in general. Credit card network rules take away the cost efficiency advantage of other payment systems (a significant barrier to entry) and allow credit cards to compete on the basis of bundled rewards programs rather than on price. This helps maintain higher profit levels for the entire credit card industry.

How can this be? Surely there couldn't be a market failure on this scale. Impossible. Well, consider this: Even defenders of the four credit card networks (yes, there are only four quasi-competing networks in the entire market), are forced to rely on argument that credit cards are sui generis and have economics of "second best" efficiencies.

What is to be done? Congress has also held some hearings, but is unlikely to act, and the Fed claims (incorrectly, I believe) that it has no authority in the matter. But there’s some hope. Merchants have filed a number of antitrust suits against the card networks. (In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation (MDL 1720)). Former FTC Chairman Timothy Muris has referred to this litigation as the "largest private antitrust litigation in U.S. history." It's hard to calculate the potential damages, but a figure over a hundred billion is not unrealistic (remember, treble damages in antitrust!). Arguably, at stake is the continued existence of MasterCard and Visa. The litigation spurred the MasterCard IPO and Visa's pending IPO.

What would happen if merchants win in court? Would we suddenly be faced with surcharges for using credit cards or find that we couldn’t count on our cards being honored? Highly unlikely. Merchants would not need to surcharge because the threat of doing so (would you pay 4% more for using an Amex card?) would result in lower fees and less variation among cards. Rewards programs would be scaled back, which is a good thing—card users would have to pay their own way. Basically, credit cards would become what they should be—commodity products unbundled from the bells and whistles of rewards. And the result for consumers? Lower prices, less debt, and, hopefully, more innovative payment products.

Bankruptcy Claims Trading: Part I

Posted: September 20th, 2007, 8:18pm PDT by Adam Levitin

Let me turn to a true bankruptcy nerd topic tonight—corporate bankruptcy claims trading. Bankruptcy claims trading is the buying and selling of claims against a bankrupt corporate debtor. (Trading in consumer bankruptcy claims is an issue that has not been academically explored to the best of my knowledge.)

Bankruptcy claims trading is virtually unregulated in the U.S. Although claims trades can effect changes in corporate control, they are not subject to securities or mergers and acquisitions regulation. There is also little case law on bankruptcy claims trades; my next post will address a very recent decision in the Enron bankruptcy that is the most significant to date.

So who on earth would want to buy a bankruptcy claim?

The key point for understanding bankruptcy claims trading is that there is frequently significant value in a bankrupt company that can be realized through reorganization and/or asset sales. Claims trading is a way of investing or divesting in the company’s reorganization process. Essentially the course of a reorganization becomes a market in itself. There are significant risks, costs, and delays inherent in larger Chapter 11 bankruptcies. Payouts are speculative and can take years to receive. Selling a claim allows a creditor to cashout now at a certain price.

But who would want to buy into a Chapter 11? There are a few different (and non-exclusive) types of Chapter 11 investors. First, there are claims purchasers who are simply looking to capture a spread between the price they pay for a claim and the payout on the claim. Second, there are claims purchasers who are looking to acquire the so-called “fulcrum security”--the claims that will leave them the residual owners of the reorganized company. These purchasers are using claims trading as a way to acquire the reorganized debtor. Third, there are claims purchasers who are seeking to affect the course of the reorganization or simply acquire information about the debtor’s operations and assets, perhaps with an eye to purchasing specific assets or perhaps for competitive reasons. Finally, there are greenmailers, who purchase a blocking position (a plan of reorganization must be approved at least 1/2 in number and 2/3 in claim amount of an impaired classes of creditors) and use it to extract a greater payout in a plan of reorganization.

The advent of widespread claims trading means that membership in the community of creditors may vary throughout a bankruptcy, with significant effects on parties’ incentives and negotiation leverage. There’s a debate within the chapter 11 community as to whether claims trading is a positive development. On the one hand, it lets those creditors who want out to get out and lets parties who want in to get in on the reorganization. As I’ve pointed out elsewhere, the exit possibility created by claims trading has an important spillover effect on primary capital markets; the ability to avoid the uncertainty of being a creditor in bankruptcy increases the risk tolerance of originating lenders, which lowers the cost of capital. On the other hand it can be very disruptive to a reorganization. A debtor can reach a deal with a creditor one day only to find out the next day that the creditor has sold the claim to another party. And so the negotiation starts all over again.

The primary purpose of this post is describe the claims trading market, but that’s hard to do because there’s a lot we don’t know. Claims trading is an OTC market. No one has a handle on the size of the US bankruptcy claims trading market, either in terms of face value of claims trading hands or the volume of transactions. Academic articles from around a decade ago mention the hundreds of billions, but it is not clear how anyone could arrive at any number; the data simply doesn’t exist. There is broad consensus, though, that there is a large and growing market in claims.

The reason that we don’t know the extent of the claims trading market is because it is largely invisible in court records. Federal Rule of Bankruptcy Procedure 3001(e) requires that notice be filed with the court when a claim is transferred. Many types of claims are filed by the holder of the claims’ legal title, rather than beneficial interest. This means that beneficial interest can change hands without the claim itself being transferred. In other words, economic ownership can change hands without a Rule 3001(e) filing being necessary. For example most large loans are participated. Participations typically involve the agent bank retaining legal title to the entire loan, but keeping beneficial title to only a fraction of the loan’s value. The other participants in the loan can freely trade their beneficial interests. Likewise, bonds are often held in street name—State Street Bank or Merrill Lynch will be the registered owner—but the beneficial title (and economic interest) will be held by someone else. Accordingly, it is rare to see a Rule 3001(e) filing for either bank loans or bond debt. This means trades in two huge categories of claims are invisible to anyone but the parties to the trades.

What we can see are primarily trades of claims for unsecured non-bond debt—trade and vendor claims. My perusal of dockets in major chapter 11s indicates that there is an active market for these claims, which can range from the exterminators’ $40 claim to claims for hundreds of millions. It also appears as if trade claims have become a more active market in recent years, particularly in the automotive industry. (Hopefully I'll have this all fleshed out in a future empirical paper.) There are several companies that specialize in buying trade and vendor claims, but major financial institutions and investment funds also buy these claims as part of their investing strategies, especially if they appear to be the fulcrum security. It appears, though, that there are actually multiple overlapping markets for bankruptcy claims—there are different groups of purchasers looking to make money on the spread, some specializing in trade debt, some in bonds, and some in bank debt, and then more active purchasers, looking to obtain control, might be purchasing up and down the capital structure. We also see that some claims trade hands multiple times. Notably, the prices at which claims trade (and hence the profitability of trades) are almost never visible.

The mechanics of the claims market are not well known outside of the trading community. Some trading is direct between buyers and sellers, but some goes through brokers. There are no indices. Recently the Unsecured Creditors’ Committee in Dana Corp.’s chapter 11 began listing the contact information of claims purchasers on its website to help creditors obtain maximum value for their claims. (Full disclosure, when practicing at Weil, Gotshal & Manges, LLP I represented an OEM in Dana’s bankruptcy.) The Dana Creditors’ Committee’s actions raise the possibility of creditors’ committees creating clearinghouses for claims. There have been some attempts to standardize the documentation of claims trades. For loan trades the LSTA has standard transfer documents. I suspect there is similar documentation for bonds. Several of the major unsecured debt purchasers have also created standardized documentation.

What we have then, in corporate bankruptcy claims trading is an unregulated residual securities market in which virtually all purchasers (but not all sellers) are sophisticated parties. In my next post I’ll discuss the recent Enron decision and the problems that can arise in claims trading.

Watching TV for the Commercials

Posted: September 18th, 2007, 8:53pm PDT by Adam Levitin

I recently saw an amazing commercial on CNN Headline News for an operation called 1-800-Credit Card Debt. It appears to be some sort of debt adjustment agency. The CEO, a guy named, Tom Cooke, I think, was speaking and said "Don't let bankruptcy even enter your thoughts." I sure hope these guys are not allowed to serve as a BAPCPA credit counselor. (What I believe to be their website is a bit more balanced.) The commercial, though, raises the question of whether there are any ethical guidelines for credit counselors? What about liability? Malpractice? I would think that a credit counselor should be obligated to neutrally inform people of their full range of options under the law. For some folks, filing for bankruptcy is a wise decision.

Of course, this commercial was immediately followed by one for a Merrill Lynch Rewards Visa. From the commercial you’d think that Merrill was selling (or just giving away) rewards, not a payment product. The term the commercial used was “Earn points to use for rewards.” A more accurate phrasing would be buy points to use for things you would otherwise buy directly.” The combined message of these commercials—go out and earn rewards points, and when you get overextended don’t think about bankruptcy.

There’s a lot more to be said about rewards programs, particularly the question of who actually pays for them, but that’s for another post or two.

Credit Rating Agencies

Posted: September 18th, 2007, 8:20pm PDT by Adam Levitin

Credit rating agencies have begun to be scrutinized as the mortgage market struggles, but the scrutiny has been on corporate credit rating agencies that graded (and essentially blessed) securitized mortgage debt. But what about the consumer credit rating agencies?

Consumer credit ratings were necessary on the front-end of mortgage issuance, before loans were bundled and sold off to feed the ravenous cash flow beast. Were lenders lowering their standards or were consumer credit ratings off? My sense is the former, but it’s worthwhile thinking about these parallel systems of credit rating and their regulation. The corporate credit rating agencies are virtually unregulated; consumer credit rating agencies are subject to a little more regulation (FACTA/ FCRA). As long as policymakers are looking at the regulation of corporate credit rating agencies, it might be time to give consumer credit rating agency regulation another look, particularly as it is a central node in the fight against identity theft.

It’s also worthwhile highlighting how central credit rating agencies (consumer and corporate) have become to the functioning of the American economy. This has been a quiet and generally unremarked develop of the past few decades, but has been one of the key pieces in the development of a national consumer credit economy (with its benefits and problems). The centrality of credit ratings was recently brought home to me by a recent Visa USA survey (hit tip Payments News). The Visa survey press release emphasizes that “Americans Unaware That Employers Can Legally Refuse to Hire Job Applicants with Low Credit Scores.” This is true, but credit scores are designed to tell about an individual’s credit risk, which is rarely a job qualification. (Why is Visa touting this finding? It seems like a clumsy way of saying “you’d better pay your credit card bills or else...”) Still, what we see is credit rating agencies playing the role of paid job reference, which can certainly put a blemish on the “fresh start” of a bankruptcy discharge. Transparency seems to be one of my themes this week and consumer credit ratings are certainly an area which could use more, especially as they become used for more and more purposes.

Prospera's Experiment

Posted: September 18th, 2007, 11:58am PDT by Bob Lawless

A few weeks ago, the New York Times ran a story (reg. req'd) about GoodMoney, a not-for-profit, joint venture between Goodwill North Central Wisconsin and Prospera Credit Union. Through GoodMoney, Prospera is trying to provide alternatives to the payday lending industry in the Appleton, Wisconsin, area.

How is Prospera doing it? Somewhat nonintuitively, they provide payday loans as an alternative to payday loans. As a not-for-profit venture of a not-for-profit credit union, Prospera is doing the best it can to provide a low-cost, nonpredatory alternative to traditional payday lending products. Still, it has to charge $9.90 per $100 it loans. Over a two-week period, the annual percentage rate (APR) on such a loan is an eye-popping 252%. Still, consumers will find Prospera's prices and credit terms a vast improvement over those offered by for-profit payday lenders. For example, Prospera's customers roll over their payday loans an average of only four times as compared to the industry average of seven. Also, Prospera works with its customers to consolidate their payday loans with lower-interest term loans.

From time-to-time, Credit Slips contributors and readers have wondered about market-based alternatives to the payday lending industry. In fact, as Prospera demonstrates, market solutions are popping up here and there. Because Prospera could be a model for other credit unions, the NYT article caught my attention. Also, we lack good information about the payday lending industry, and as a nonprofit itself that is trying to find solutions to a troubling social issue, Prospera's openness offered the possibility of lifting the veil a little bit on how payday lenders operate.

Prospera president Ken Eiden and its director of marketing, Kristi Van Schyndel, kindly agreed to talk with me over the telephone about Prospera. They were very open about GoodMoney and Prospera's involvement in the joint venture. Candidly, I'll admit that I'm attracted to (but not yet persuaded by) stricter regulation and possibly price controls on short-term, high-interest consumer loans. Still, history tells us that the demand for this sort of credit will not go away. Strict regulation could just drive the activity underground with worse consequences. Yes, I am basically talking about organized crime but also about other socially undesirable activities. Eiden's and Van Schyndel's comments give us some insights into how the payday lending industry operates, and how we might craft reasonable social policies to address that industry's worst abuses.

Right up front, I asked about the delinquency rates in Prospera's GoodMoney program. Immediately after the NYT story on GoodMoney, the blogosphere seized on the 252% APR as evidence of what must be extremely high delinquency rates for payday lenders. Of course, the real reason the APR is so high is that the interest is incurred over a very short time period. In response to my inquiry, Eiden frankly responded that "delinquency is a major factor" in managing GoodMoney. He said that their delinquency rate (the percentage of money loaned for which the loan payments are behind) and their charge-off rate (the percentage of money loaned for which the loans have been written off) are basically the same for GoodMoney's payday loans. Both the delinquency and charge-off rates for GoodMoney's loans are about 5.0%. Thus, of the $9.90 GoodMoney collects for each $100 loaned, half of it goes toward covering bad debts.

As a point of comparison, the U.S. Federal Reserve reports that for credit cards current delinquency rates are 4.1% and current chargeoff rates are 3.8%. Another way to think about this is that for every twenty dollars GoodMoney loans, it will have to write off one dollar as uncollectible. For credit cards, banks write off one dollar for every twenty-six dollars loaned. These differences are not dramatic in absolute terms, but they are meaningful in relative terms. The charge-off rates in the GoodMoney program are about 20% higher than for credit cards.

Eiden said that GoodMoney does not do a traditional credit check as customers seeking a GoodMoney loan would not qualify for traditional consumer credit products. Instead, GoodMoney "clears" the customer with a widely used database in the payday lending industry--CL Verify. What this means is that GoodMoney checks to see if the customer is delinquent with other payday lenders. The same piece of software that checks the database then uses a proprietary algorithm to determine whether a customer qualifies for a GoodMoney loan. Eiden emphasized that, as a not-for-profit, Prospera's mission is to get its product used. They purposely keep the approval rate at approximately 95% so that the community will see GoodMoney as an available alternative.

I also wondered why Prospera chose to market a payday lending product. Why not offer a longer-term consumer loan that would have a lower APR? Eiden's answer struck me as the response of someone working with the daily realities of consumers seeking these loans--"You have to meet people where they are today. We want to meet them where they're at." My interpretation was that they use a payday loan product because their customer audience expects something that looks like a payday loan. Van Schyndel added the observation that the other credit unions working on similar projects generally have just altered current lending products. Such an approach, although the intentions may be laudable, does not tap into the market that expects to find something similar to a payday loan. As opposed to our academic models of rational consumer behavior weighing costs and benefits, Prospera's model struck me as one that embraces the way consumers actually make borrowing decisions.

Finally, the conversation turned to regulation. I asked Eiden what he thought of regulation as a solution to help fix the payday lending mess. "Regulation is not a good long-term solution," Eiden replied. For example, Eiden noted that there have been proposals that Wisconsin should look to Illinois for examples of payday lending regulation. Eiden wondered "Where do folks go without payday lending?" He seemed to share my skepticism that consumer demand for short-term credit would go away. In Eiden's words, his model is to "Make payday lending less profitable through competition." Both Van Schyndel and Eiden expressed hope that other credit unions throughout the United States would use Prospera's program to help provide alternatives in their communities.

For those who want to help fix the worst forms of predatory, short-term credit, the Prospera experiment is certainly worth watching. Prospera may not have all the answers, but it deserves recognition for trying to address predatory lending with realistic solutions. I asked Eiden to keep me posted on the program's progress, and I hope he takes me up on that invitation. I'll try to post updates here as I hear about them.

Bankruptcy Filing Figures Through August

Posted: September 18th, 2007, 10:21am PDT by Bob Lawless

Again, courtesy of the good folks at Automated Access to Court Electronic Records (AACER), here are some data about 2007 bankruptcy filing statistics through the month of August. According to AACER, there have been 537,712 bankruptcy petitions filed in the United States through August 2007. The total number of filings in August was 76,812 as compared to 69,016 in July. The difference is exaggerated because the foibles of the calendar meant July had two more workdays for the bankruptcy courts to be open than was true in August. On a "per filing day" basis, August had 3,340 filings per day as compared to 3,286 filings per day in July. Moreover, month-to-month variation in bankruptcy filings is more likely to be statistical noise than a meaningful difference.

For me, there are two interesting things we can take away from these data.

First, we're seeing another example of Ronald Mann's point here on Credit Slips that U.S. bankruptcy filings plateau the from April through mid-August. The graph above shows the 2007 filing rate per day for each month in 2007. Bankruptcy filings climbed dramatically from January through March 2007 but have leveled off since then. If past patterns hold, the graph will show a rise again when we begin to get figures for the rest of the year. Note Mann pegged the precise period of the plateau as running through "mid-August," and the filing rate shows a slight uptick in August, a small but intriguing piece of evidence that past patterns might again hold if filing rates increased at the end of August.

The second point I wanted to make with these data is that we can make a tentative prediction about where total bankruptcy filings for the year might end up. Using the algorithms from my previous post here about the July numbers, we can arrive at the following range of estimates:

794,000 if filings continue through the end of 2007 at the average rate for the first eight months of 2007
808,000 if filings continue through the end of 2007 at the rate for August 2007
864,000 if filings after August 2007 represent the same proportion of the total 2007 figures (about 62%) as the filings in August 2006 represented of the total 2006 figures

All of this is based on past performance which, as we all know from hushed television disclaimers read by fast-speaking actors, is not necessarily an indicator of future performance. Certainly, the huge increase in the number of U.S. foreclosures or the drying up of the credit markets might lead to more bankruptcy filings (see here) than past patterns might predict.

(What Determines) What's in Your Wallet?

Posted: September 17th, 2007, 6:37pm PDT by Adam Levitin

How do credit card companies make their lending decisions? Or more precisely, how do they decide who to target with which “pre-approved” offer or other solicitation? This is one of the major “known unknowns”. I'd like to give some intentionally provocative musings and hopefully start a discussion in the comments.

On a basic level we know the answer—lots of econometric analysis of consumer data, probably starting with Fair Isaac FICO scores or some equivalent. But credit scores are surely only the start. The card industry sent out some 6 billion solicitations in 2005. Solicitations are expensive—I’d guess that it costs at least 50 cents, if not over a dollar to send each individual solicitation when postage, paper, printing, data sorting and handling are added up. In spite of the myriad solicitations sent to minors and pets, the card industry is assuredly more sophisticated then sending out costly mass mailing barrages based solely on credit scores. Indeed, the solicitations to minors and pets indicate that credit scores are often not necessary for card solicitations. So what determines whether or not I get an offer for a premium Capital One Visa Signature Card or for a subprime First Premier Bank MasterCard offer?

My sense is that card issuers (and maybe the networks) undertake incredibly sophisticated analyses of consumer data probing for particular profit points (or put another way, for particular consumer vulnerabilities). The card industry is capable of gather more consumer data than virtually anyone else because it is involved in so many consumer transactions. It makes good business sense to gather up as much consumer data as possible and then analyze it for ways in which to maximize profit.

Perhaps the fact that someone purchased diapers and an infant card seat or that they regularly buy Goya products or kitty litter or red wine over the Internet says something about that person as a credit risk and causes that person to get certain solicitations, but not others. On the surface there's nothing wrong with such a system. It appears to cater to consumer preferences. If I like sailing, maybe I'd like a card that gives me rewards points toward a new yacht. But there's a potential flip-side: if I purchase items with certain class or other group-status implication, say pick-up trucks, perhaps I'll be targeted with more expensive card solicitations. Or perhaps my application for certain cards will be declined. Econometrics can easily bleed over into discriminatory practices like red-lining, as the history of the insurance and housing-lending have shown.

Unfortunately, there’s really no way of knowing what factors determine which solicitations I receive and which cards I am able to get or what credit limits. Does my race or my gender or family status or religion affect which credit cards are marketed to me and which I am able to obtain? I hope not, but I am confident that the fact that I make purchases at toy stores affects the solicitations I receive, just as my professional affiliations (e.g. ABA) do. Maybe my ZIP code, a potential proxy for race, is a factor. We simply don't know the factors going into credit card marketing and lending decisions, but it's a question worth asking: what determines what’s in your wallet?

ATM Surcharges and Bank Consolidation

Posted: September 17th, 2007, 12:16pm PDT by Adam Levitin

Last month Bank of America raised its ATM surcharge from $2 to $3. The surcharge is the fee charged to customers of other banks for using Bank of America’s automated teller machines (ATMs). Bank of America is the first bank in the United States to raise its ATM surcharge to the $3 level.

Why did Bank of America suddenly raise its ATM surcharge 50%? My theory is below the break.

BoA's surcharge increase clearly has no relationship to BoA's costs. My theory it is that it is a way for Bank of America to increase its depositary base (a low cost source of funds) and continue its leading role in consolidating the US banking industry.

Banks love deposits. Deposits are a really cheap source of capital. A deposit is an interest-free or low-interest loan to the bank, which the bank then reinvests at a much higher rate of return. Deposits fund banks lending operations, and as banks are finding themselves with more bad real estate loans on their books, they need to boast their deposit base to meet reserve requirements.

There are two ways a bank can grow its deposit base—organically and through acquisitions. Acquisition growth is limited, however, by the Riegle-Neal Act, 12 U.S.C. § 1842(d)(2)(A), which prohibits banks from entering into acquisitions that would result in their holding more than 10% of the deposits in the United States. In 2004, Bank of America came perilously close to the 10% limit, when it acquired Fleet Bank. Bank of America’s on-going attempt to acquire LaSalle Talman Bank in Chicago once again raise Riegle-Neal Act issues.

ATM surcharges encourage organic deposit growth at large banks. They do this by encouraging growth in ATM deployment, which in turn makes bigger banks more convenient because they are everywhere. Since state legislatures began banning ATM network no-surcharge rules in 1996, ATM deployment has soared. Banks are now willing to place ATMs in Podunk places because they can rapidly recoup the costs through surcharges since the out-of-the-way ATM is a local monopoly. And the increased scope of individual banks’ ATM networks adds to the convenience of banking at those banks. Not surprisingly, big banks have more ATMs on average than small banks. This means, that if you bank at Smallsville Bank, you know that you’re going to be paying ATM fees if you need to get cash outside of Smallsville. If you bank at Bank of America, though, you know you can find a (fee-free) Bank of America ATM relatively nearby in most locations. ATM surcharges increase large banks’ ATM deployment, which increases the convenience of these banks.

A bank’s ATM surcharges also raise the cost of doing business at other banks. Again, this accrues to the advantage of bigger banks (and does so regardless of whether the non-surcharging bank covers the ATM fee itself). So, it makes sense to be a front-runner on ATM fees like Bank of America. Bank of America won’t lose any customers because of its ATM fees because the fees only apply to non-customers. Instead, Bank of America makes itself more relatively more attractive to other banking options through its ATM fees. Indeed, ATM surcharges were a major (if not totally rational) factor in my own decision of where to bank. When I relocated to the DC area, I chose to give my business to a large national bank instead of the local bank, which has superior service, because I wanted to be able to access my funds easily and without a surcharge across the US. While I probably would not have incurred much in the way of fees had I gone with the local bank, I resented the idea that I would be paying a penalty.

ATM surcharges also help Bank of America grow without bumping into the Riegel-Neal limit on growth by acquisition. BoA’s ATM surcharge increase can be explained as an attempt to spur organic deposit growth--at the expense of smaller banks. If Bank of America can’t buy up the smaller banks, then it can accomplish much the same by siphoning away their business.

America’s banking system is unique in the developed world for its sheer number of banking institutions. The United States has around 8,600 federally insured depositary institutions. By comparison Germany has around 2,400 banks, France has about 850, the United Kingdom under 300, and Canada has 150. The large number of banks in the US are a result of historical banking regulations, which reflected a deep-seeded suspicion of accumulated capital, and prevented interstate branch banking until 1994. The banking industry is rapidly consolidating, however. There are now have only two-third as many federally insured depositary institutions as in 1993, when interstate branch banking restrictions were still in effect.

All of this raises the question of whether a concentrated banking industry is a good thing (and for whom). The question resembles the debates about the impact of Wal-Mart on the economy. There are cross-cutting effects of banking concentration. Bigger banks might be more fiscally sound, which is good for consumers who have deposits beyond the FDIC caps. Big banks are certainly capable of doing more things than smaller banks, including setting up independent credit card networks, which could benefit consumers. On the other hand, consumer service tends to suffer at bigger banks, and bigger banks also have more political weight on regulatory issues, usually against consumer interests. And to bring it all home to “credit” and “bankruptcy,” when banks grow their deposit base, it has the same effect as lower interest rates—lower cost of funds, which means that banks are more willing to make riskier loans, some of which will enable consumers to live out their dreams and some of which will end up in painful defaults.

Is BoA’s increased ATM fee going to fuel another glut of subprime lending? Of course not. But is it going to drive consumers from small banks to BoA? Certainly. And when an 800 lb. gorilla gets bigger, we should take notice.

I know this was a long post—thanks for staying with me all the way to the end. I’ll try to be more succinct in future posts.

Two Sides of the Coin: Payments and Lending

Posted: September 17th, 2007, 11:21am PDT by Adam Levitin

I’m thrilled to be able to join Credit Slips this week for my first foray into law blogging. I’m hoping to write a bit about credit card advertising, bankruptcy claims trading, reclamation rights, identity theft, and my pet topic of credit card merchant fees. Later this week I’m also hoping to post something timely about Yom Kippur and debts, which might put my background in Jewish history to use (I wasn’t always an attorney).

For my first substantive post, however, I’ve decided to write about ATM fees, although they are not a “credit” or “bankruptcy” issue per se. Nonetheless, I think they illustrate important themes in my work—the interconnectedness of different parts of the banking industry, particularly payments and credit, and how the competitive dynamics of the banking industry affect consumer lending and consumer behavior. Credit cards are surely the posterchild for the interconnectedness of payments and lending, an issue which I'll blog about later this week.

The ties between payments and lending go much further, though, as I hope my post on ATM fees will show. What banks do on the payments side of their operations (including ATMs) affects what they do on the lending side and vice-versa. Payments and depositary accounts fund lending operations, and the costs at which banks can raise funds affects how they lend out money; it’s a lot easier to make a risky loan if the cost of capital is low. Likewise, the consolidation and concentration of the banking industry focuses and increases the banking industry’s political power, which affects all types of banking and lending regulation. So, if we want to think about lending practices, it is also useful to think about what enables and drives those lending practices, as lending is only one part of bank economics.

Welcome to Adam Levitin

Posted: September 17th, 2007, 8:14am PDT by Bob Lawless

Credit Slips welcomes Adam Levitin as a guest blogger for the coming week. Professor Levitin is an associate professor of law at Georgetown University and a new face in the legal academy. He is already a prolific scholar, as a quick perusal of his SSRN page will show. His interests are widespread in the area of bankruptcy, having written on everything from equitable subordination to the credit card company/merchant relationship to statutory interpretation. Levitin has a number of interesting things to say about bankruptcy and credit topics in the news, and we hope you enjoy his contributions.

Theory v Data, Round XX

Posted: September 15th, 2007, 11:00am PDT by Elizabeth Warren

Economists often take the position that they would be glad to help poorer families, but that such efforts would either be a waste--or would make things worse. In the area of credit regulation, for example, the constant pitch from some academics (and echoed by the banking lobbyists) is that any constraints on credit cards, for example, will result in driving the country's most vulnerable citizens to far more dangerous lenders. The theory, called the substitution hypothesis, has been in vogue for two decades, helping to checkmate any serious effort to rein in predatory lending practices.

The theory sounds plausible, but a little evidence can shake up a lot of ideas. Angie Littwn has a terrific new piece that directly challenges the conventional wisdom regarding the substitution hypothesis, showing, for example, that those without credit cards simply have less total debt than those with credit cards--not that they take on "worse" forms of credit if they don't use credit cards. But the really unexpected zinger in Angie's paper is that, according to the families she studied, there were no credit options worse than credit cards. In other words, in the words of these struggling families, credit cards are as bad as it gets.

Options like pawn shops and rent-to-own, which sound terrible to my middle-class ears, were rated on par with credit cards. According to the actual experiences of the people who lived with such credit, the credit cards got low ratings because they were seen as much more dangerous and more costly than pawn shops and rent-to-own. To be fair, Angie's study came from residents of a state that has outlawed payday lending, so there still might be a lower-than-low rating for these lenders.

So what would low-income families do if they didn't have access to credit cards or payday lenders and they really, really needed money? Angie's subjects gave a resourceful answer: borrow from friends and family. In fact, respondents gave the friends-and-family approach a high rating. Low cost, low risk, but enough interpersonal pain to make people not to turn to it unless the need was high.

Angie's study has a small N (these are very expensive data to gather), and she is quite careful to call her findings "preliminary." But the work has broken open some new lines of inquiry. Most importantly, the substitution hypothesis that has been accepted as fact looks a little less steady than it did before her paper was posted.

A High Grade for High-Grade

Posted: September 14th, 2007, 3:06pm PDT by John Pottow

Apologies in advance for this post. When my co-bloggers and I brainstormed this site, we talked about trying to merge scholarly issues with accessibility. This post woefully shortchanges the latter. But I can't help myself -- I'm just too excited about the recent High-Grade opinion out of Judge Lifland's chambers.

One of the quiet successes of BAPCPA was finally getting Chapter 15 passed into law, which pertains to cross-border insolvency proceedings, an area that I write about a bit. Yet there have been fits and starts in some early opinions by courts who, how shall I put this in a politic manner -- seem to be struggling.

One of the big deals from the theoretical side is Chapter 15's embrace of an idea that goes by the label "universalism," which basically means we would be better off with a coordinated system of choice of law in cross-border proceedings following some jurisdiction-selecting rule, as opposed to reverting to the choice of law "state of nature" of territorial sovereignty. (Our European cousins are off and running with the centre of main interests test ("COMI") under their Regulation.) One of the necessary foundations of a universalist approach to regulating transnational bankruptcies is what I dub "jurisdictional hierarchy," recognizing that some jurisdictions are going to have to bite the bullet and bow to the laws of other jurisdictions in any given case.

Chapter 15 imposes such a jurisdictional hierarchy by requiring U.S. courts to distinguish between a "main" and "non-main" foreign bankruptcy proceeding when a U.S. Chapter 15 proceeding is opened. (A Chapter 15 is opened by a foreign representative, like a trustee, in a bankruptcy proceeding taking place abroad.) And yes, the COMI test is used: if the foreign proceeding is being conducted in the country that houses the debtor's COMI, then it is a foreign "main" proceeding. One reason it is important to get this distinction (i.e., is it a request from a main or a non-main (or possibly neither!) proceeding?) is because it signals the jurisdictional hierarchy. If the proceeding is recognized as a foreign main proceeding, that means the U.S. court will be mindful of its necessarily inferior legitimacy to legislative (and maybe adjudicative) jurisdiction over the dispute. If the proceeding is recognized as a non-main proceeding, the assistance offered to the foreign representative is curtailed, on the theory that he's not really the person who should be travelling abroad asking for help.

An ominous early case, SPhinX, tried to pooh-pooh the relevance of main vs. non-main, cavalierly implying it doesn't really matter because U.S. bankruptcy judges have such wide discretion they can shape and fashion almost any sort of remedy (and so get a non-main proceeding representative the sort of relief generally intended for a main proceeding representative). In addition to stumbling a bit doctrinally, the SPhinX case was worrisome for trying to scuttle the very foundation of jurisdictional hierarchy so central to universalism -- and so importantly advanced, albeit gingerly, in Chapter 15.

Enter High-Grade. In that case, the actual holding denied the (Cayman) foreign representative's request for assistance because it was found not only was the Cayman proceeding not a main proceeding (COMI of Bear Stearn's investment fund was, unsurprisingly, in New York), it wasn't even a non-main proceeding, because the connection to the Cayman Islands was purely a legal formalism devoid of economic substance (incorporating offshore for tax advantage). Yet what is so important about the case is that (arguably in obiter dicta) it goes through a thoughtful and careful analysis of the centrality of the distinction between foreign main and non-main proceedings and hence of the importance of jurisdictional hierarchy in a Chapter 15 world.

SPhinX's retirement will be welcome; I predict it is High-Grade that will get the cites. I just couldn't help but give it a "shout out" as it rolled hot off the presses.

Apologies again for readers who are now utterly bored. You were warned.

Visualizing Bankruptcy

Posted: September 13th, 2007, 6:00pm PDT by Elizabeth Warren

The variations in how people learn always amazes me. For some, a wordy explanation makes the brain smile. For others a mathematical formula sings out loud. For me, a good graph is better than a good glass of wine--interesting, complex, and just a surprising hint of color.

So I was tickled to see Lynn LoPucki's new, post-amendments Bankruptcy Visuals are out. Lynn has developed the most amazing single-sheet graphic on bankruptcy that I've ever seen. He has one for Chapter 7, one for Chapter 13 and one for Chapter 11, each showing a case from start to finish. The visual has an explanation of what happens at each juncture, complete with Code cites, which makes it a kind of one-page review of all of bankruptcy. But the part that makes it special is that by getting it all on one page and putting the pieces in chronological order, the relationships between the parts are all visible at once. The complexity--and the simplicity--of the system come to life.

No, I'm not Lynn's agent (he didn't know I was going to write this). But through the years, I've spent hours looking at earlier versions of this graphic. I've never unfolded it without saying, "Wow." I just saw the new version, so I thought it was time to share.

Surely there are some brains out there like mine that also love visualizing bankruptcy.

Secret Fees for Spokane Lawyers?

Posted: September 12th, 2007, 11:16am PDT by Bob Lawless

Our buddy, Buce, at Underbelly, notes the insightful comment of Credit Slips guest blogger, David Yen regarding the request of the bankruptcy lawyers for the Spokane diocese to close to the public the hearing on their $10 million fee request. The details about the underlying story are here. "All sides want to avoid a public battle with big headlines." I'm sure they do, but that's not how courts should work in a free society.

Note to Buce: Have you ever thought of switching the blog name and nom de plume so it would be Underbelly at Buce?

The Poop on Foreclosure

Posted: September 8th, 2007, 2:51pm PDT by Elizabeth Warren

A couple bought a house at a foreclosure sale, but when they got inside they learned it was full of live animals, dead animals and animal poop. The buyers are scrambling to get out of the deal, but, at least from the news report, there are no obvious grounds for reversing the deal.

The story is pretty gross, but it highlights something that lots of people don't realize: A homeowner is entitled to stay in possession of the home until after the foreclosure sale. No one --not the bank or the potential buyers--have any right to enter the house to see if the room arrangement is pleasing, the plumbing is functional or there isn't poop several inches deep on the floor.

As the subprime market continues its downward trend, think about the poop.

A foreclosure sale isn't like a regular sale, with all the attendant warranties. The owner can stay in possession and keep the door bolted, for clear policy reasons: Until the legal process is completed, the homeowner is the owner. Besides, there would be a huge cost imposed on struggling homeowners if the mortgage company could take the property away without giving the homeowner some kind of day in court.

But the consequence of the owner-in-possession rule means that mortgage foreclosure sales can bring a LOT less than the market value of the home. An angry, frustrated judgment-proof homeowner may destroy the property. Once a homeowner knows the house will be lost, any delays mean that the homeowner can live rent-free for a long time. I was talking with a mortgage lender last week who estimated that by the time the mortgage lender company paid expenses, that it would clear about 15-30% of the actual market value of the property.

Not everyone facing foreclosure is destructive (although some may be). Not everyone in foreclosure has a weird or ugly home inside (although some may). But the market analysts have told us that rational pricing and behavior should be all about risk management. A mortgage lender holding a $125,000 mortgage on a $100,000 home may have a lot of leverage against a homeowner who doesn't want to lose the house, but that if thelender has to push all the way to foreclosure, the leverage changes and the risk of write-down could be in the 80-90% range.

In past housing downturns, homeowners and their lenders often came to the table to negotiate. But as Gretchen Morgenson reported two weeks ago, the new asset securitization pools often mean fractional ownership and pooling arrangements that leave no one with authority or incentives to negotiate a deal that is better for the lender--and for the homeowner.

Foreclosure is in no one's interest. But this market seems to be stepping deeper and deeper in poop. (PS Thanks to Colin Marks at St. Mary's for the poop story.)

Bankruptcy Court Tells Debtors To Charge It

Posted: September 6th, 2007, 10:24am PDT by Katie Porter

My recent work has documented the targeted solicitations from lenders that consumer debtors receive after filing Chapter 7 bankruptcy and highlighted the industry's ability to profit from financially vulnerable consumers. One of that paper's findings was ubiquity of credit card solicitations. Over 92 percent of debtors interviewed in the Consumer Bankruptcy Project reported that they had received a credit card solicitation. If they live in New Hampshire, bankruptcy debtors may need to accept one of those postbankruptcy credit cards if they want to stay in the good graces of the New Hampshire Bankruptcy Court. Why?

The main parking garage for the U.S. Bankruptcy Court in New Hampshire will no longer accept cash as payment for parking in the garage. The garage owner (a private company) has installed machines that require payment with a credit card to lift the gate to permit patrons to park. Apparently, there is virtually no street parking and few alternatives for garage parking (but note that I have not been to New Hampshire to verify this). The Bankruptcy Code requires attendance at a meeting of creditors (called a 341 meeting after applicable statute) and these meetings are held in the same building as the U.S. Bankruptcy Court in Manchester, New Hampshire. In addition to the new BAPCPA requirements of credit counseling, financial education, pay stubs, tax returns, consumer debtors now may need a credit card to receive a bankruptcy discharge.

Consumer debtors can expect most of their credit cards to be cancelled when the creditor receives notice of the bankruptcy. These Americans are instantly cardless, and as a matter of policy, we may want them to remain that way--at least for a short period after their bankruptcy. Indeed, if the debtor requires Chapter 13 bankruptcy, they are required to seek the permission of the trustee before incurring new postpetition credit. In New Hampshire, will the chapter 13 trustee view the need to park when attending the 341 meeting or a plan confirmation hearing as a valid reason to let debtors get new credit? Should Chapter 7 debtors accept one of the dozens of credit card offers they get in the first month of their bankruptcy or should they walk, bike, snowmobile, etc to the bankruptcy court?

More Subprime Side-effects?

Posted: September 5th, 2007, 8:17pm PDT by Angie Littwin

When credit card borrowers have trouble paying their debts, issuers respond in a number of ways, but one of them is particularly surprising: they often extend more credit. According to the Boston Globe article Credit Card Companies Woo Struggling Mortgage-holders, issuers are extending this strategy to subprime homeowners as well. Globe staffer Robert Gavin reports on a study by Mintel International Group, which claims that as the subprime mortgage market continues to implode, credit card issuers are stepping in to offer more credit to struggling homeowners.

Or at least that’s what the headline says.

The reality seems to be a bit more subtle. I couldn’t obtain a copy of the study itself, so my understanding of it is based entirely on the Globe report. But even a close reading of the article indicates that the tie is not as clear as the headline makes it sound. The study appears to have found a strong correlation between the decline in the subprime housing market and an increase in credit card solicitations to subprime borrowers generally. Direct-mail solicitations to subprime borrowers were 41 percent higher in the first six months of 2007 than they were in the first half of 2006. At the same time, solicitations to the most credit-worthy consumers fell by 13 percent. And the numbers are even starker when you look at June of 2005.

This is indeed fascinating. But it’s not conclusive. These results appear to apply to all subprime borrowers. What the study did not seem to find is that borrowers struggling with subprime mortgages were singled out. As it stands, there’s another event that could explain these findings equally well – the U.S. bankruptcy law that went into effect in October of 2005. It could be the case that issuers are still adjusting their solicitation volume to account for the newly weakened bankruptcy protections available to their defaulting customers. On the other hand, issuers may very well also be hoping to cash in on the subprime mortgage crisis by providing cash for those who can no longer draw on their home equity or by encouraging struggling homeowners to use credit card debt to bridge the gap in their mortgage payments. Only a study specifically focused on subprime homeowners will tell.

Giving Congress What They Want, Not What They Wrote

Posted: September 4th, 2007, 12:49pm PDT by Bob Lawless

This morning, I was preparing for class with a new case that I had assigned, Perlin v. Hitachi Capital America Corp. (In re Perlin), No. 06-3199 (3d Cir. Aug. 3, 2007). Although the case came out a few weeks ago, I still wanted to post about it, because the case shows how the post-2005 U.S. bankruptcy law often can be a "heads I win, tails you lose" proposition for consumer debtors. The court seemed to go out of its way to interpret ambiguities in the statute against the interests of consumer debtors and hands large financial institutions a potentially troubling tool to use against consumers in bankruptcy court. With all of the lobbying that went into the 2005 bankruptcy bill, one might think that ambiguities would best be resolved against the consumer credit industry as they are the ones with the clout to get changes in the law. Interestingly, the court might have taken its cue from the position of the United States Trustee, who filed an amicus brief on behalf of the financial institution. (I wonder how many appellate court amicus briefs the U.S. Trustee files on behalf of consumer debtors?)

Because the case revolves around the interaction of several different subsections of the Bankruptcy Code, some explanation is in order. As Jon Stewart once said (paraphrasing here)--"Yes, it's boring. That's why they can get away with it." Nonetheless, I'll try to keep it brief.

Under section 707, there are two grounds to dismiss a chapter 7 bankruptcy case:

(a) in all cases including consumer cases--"for cause" including unreasonable delay, failure to pay fees, or failure to file required schedules
(b) in consumer cases only--for "abuse"

The means test, about which so much has been written, technically only creates a presumption of abuse if the debtor has (in most cases) $100 in monthly disposable income left to pay creditors, but it can be a difficult presumption to overcome. The means test itself is three pages of densely worded, complex statutory language that incorporates densely worded, complex regulation from the IRS. Debtors who fail the means test must convince the bankruptcy court that they had "special circumstances" that the law did not contemplate. (§ 707(b)(2)(B))

In Perlin, the debtors were not very sympathetic, which maybe influenced the court. One was a licensed radiologist earning over $370,000 per year on a part-time basis. As the court put it, "Together, the Perlins expended a considerable amount of money on certain luxury items, such as two Lexus automobiles and private school tuition totaling $5,000 per month." The Perlins had filed bankruptcy after their medical imaging business failed and after Hitachi Capital came around looking for them to make good on the guaranty they had signed to ensure payment on leased imaging equipment.

Hitachi Capital moved to dismiss the debtor's bankruptcy, not because a presumption of "abuse" had arisen under 707(b) but on the more general ground of "good faith" under 707(a). Under Hitachi Capital's reasoning, the debtors' ability to repay some of their debts meant their bankruptcy filing was in "bad faith." This would seem like a losing argument as ability to repay would seem to be covered under the "abuse" standard of 707(b). It was as if Hitachi Capital was asking the court to give creditors two bites at the apple--if the specific tests of 707(b) did not indicate an ability to repay, then Hitachi Capital wants to use 707(a) to create a free-floating test of substantial ability to repay that a bankruptcy court can use in its discretion to get rid of bankruptcy cases. Amazingly, the Third Circuit agreed with Hitachi Capital.

A major problem with Hitachi Capital and the court's position is that section 707(b)(3) already says that where the means test does not create a presumption of abuse, the bankruptcy court may consider bad faith or the totality of the circumstances to decide that abuse exists anyway. The court's decision makes 707(b)(3) superfluous. I cannot find a reference to that section in the court's opinion, which makes me wonder whether the court was aware of it.

One possibility does exist and that is to carefully note that the 707(b) test of abuse only applies in cases where the debt is primarily consumer debt. Because the Perlins had such a large guaranty connected with their business, it may be likely that they did not have primarily consumer debt. Then, the court should have limited its holding to non-consumer cases, although such a holding would leave a small business owner in bankruptcy in worse shape than a consumer (not something most members of Congress would have wanted).

As written, the court's opinion would apply to all bankruptcy cases, consumer and business, and would leave a free-floating "bad faith" rule in place with which creditors could deploy against consumers. This would not be the first time that a generalist appellate court has blundered with the specialized bankruptcy law, unwittingly creating precedent that gives creditors a huge hammer against consumers. On this occasion, we might be particularly concerned. In creating the means test, Congress was very careful in delineating who could bring motions for "abuse," limiting the ability to bring such a motion when the debtor fell below the state's median income. By creating a free-floating "bad faith" rule creditors can deploy outside the means test, the court gave creditors a weapon they can use against below-median income consumer debtors. To be fair, the court does not say that the ability to repay some debt is bad faith--the ability to repay would have to be substantial. The creditors may not win a lot of those cases, but it will be one more motion that large financial institutions can use to wear down consumers in bankruptcy court.

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