Personal Financial Planning :An "How-To" Guide (part 33)

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Bankruptcy: Paying the Ultimate Price for Credit Abuse

by

Charles Lamson

It certainly would not be an overstatement to say that during the 1980s and 1990s, debt was in! In fact, the explosion of debt that has occurred since 1980 is almost incomprehensible. The national debt rose from less than a trillion dollars when the 1980s began to about $21.6 trillion on October 28, 2018. Businesses also took on debt at a rapid pace. And not to be outdone, consumers were using credit like there was no tomorrow. So it should not be too surprising that when you couple the heavy debt load with a serious economic recession (like the one we had in 1990 to 1991) and a very slow economic recovery (from 1992 to 1993), you have all the ingredients of a real financial crisis. And that is what happened, as personal bankruptcies soared---indeed, nearly a million people a year filled for personal bankruptcy during that period. Even during the strong economic expansion from 1994 to 1997, the number of bankruptcies continued to climb.

When too many people are too heavily in debt, a recession (or some other economic reversal) can come along and push many of them over the edge. But let's face it, the recession is not the main culprit here, because the only way a recession can push you over the edge is if you are already sitting on it! The real culprit is excess debt. Some people simply abuse credit by taking on more than they can afford. Maybe they are pursuing a lifestyle beyond their means, or an unfortunate event---like the loss of a job---takes place.

Whatever the cause, sooner or later, they start missing payments and their credit rating begins to deteriorate. Unless some corrective actions are taken, this is followed by repossession of property, and eventually, even bankruptcy. these people basically have reached the end of a long line of deteriorating financial affairs. Households that cannot resolve serious credit problems on their own need help from the courts. Two legal remedies that are widely used under such circumstances include (1) the Wage Earner Plan and (2) straight bankruptcy.

Wage Earner Plan

The Wage Earner Plan (as defined in Chapter 13 of the U.S. Bankruptcy Code) is a workout procedure that involves some type of debt restructuring---usually by establishing a debt repayment schedule that is more compatible to the person's income. It may be a viable alternative for someone who has a steady source of income not more than $750,000 in secured debt and $250,000 in unsecured debt and a reasonably good chance of being able to repay the debts in  3 to 5 years. A majority of creditors must agree to the plan, and interest charges, along with late payment penalties, are waived for the repayment period. Creditors usually will go along with this plan because they stand to lose more in a straight bankruptcy. After the plan is approved, the individual makes periodic payments to the court, which then pays off the creditors. Throughout the process, the individual retains the use of, and keeps title to, all of his or her assets. Chapter 13 filings account for less than 30 percent of all personal bankruptcies.

Straight Bankruptcy

Straight bankruptcy, which is allowed under Chapter 7  of the bankruptcy code, can be viewed as a legal procedure that results in "wiping the slate clean and start anew." About 70 percent of those filing personal bankruptcy choose this route. However, state bankruptcy does not eliminate all the debtor's obligation, nor does the debtor necessarily lose all of his or her assets. For example, the debtor must make certain tax payments and  keep up alimony and child-support payments but is allowed to retain certain payments from Social Security, retirement, veterans', and disability benefits. In addition, the debtor may retain the equity in a home (up to $17,425), a car (up to $2,775), and other personal assets, such as clothing, books, and tools of his or her trade. These are minimums as established by federal regulation; generally, state laws are much more generous with regard to the amount the debtor is allowed to keep. The choice of federal or state regulations would depend on the debtor's assets.

Other Bankruptcy Options

Although most individual bankruptcies involve either straight liquidations or Wage Earner Plans, several other options have been added recently. To begin with, the U.S. Supreme Court ruled that individuals could now file for reorganization under Chapter 11 of the bankruptcy code---a type of bankruptcy that had been previously reserved mostly for businesses. Chapter 11 bankruptcy is for individuals who do not qualify for Chapter 13 reorganization---either because they exceed the debt limitations or do not have a regular source of income---but who want to try to restructure their debt. For these people, Chapter 11 is really the only alternative to straight bankruptcy. Like the Wage Earner Plan discussed above. Chapter 11 filers can restructure their debts, or a portion of them to be repaid over time. The big difference is that in Chapter 11 bankruptcies, the creditors vote on---and can possibly block---the restructuring plan. This, of course, means the reorganization process can drag on for years and and involve hefty legal fees, which probably explains why Chapter 11 is used in only about 1 percent of all personal bankruptcies.

The second alternative now available is a so-called Chapter 20 bankruptcy---it is labeled as such because it combines parts of both Chapters 7 and 13. Although not actually a part of the bankruptcy code, the procedure allows individuals to wipe out their unsecured debt as per Chapter 7, and then use Chapter 13 to restructure their secured debt, including mortgages, home equity loans, and nondischargeable debts, such as certain tax and child support payments.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005,  LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 265-267*

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