Melissa B. Jacoby is associate professor of law at the University of North Carolina at Chapel Hill, where she studies all aspects of business and personal bankruptcy and medical-related financial distress.
Over the past several years, millions of individuals and families with middle class attributes have found themselves doing the unthinkable: filing for bankruptcy. We can learn a lot about household risk from these bankruptcy filers. By tracing their paths to bankruptcy, we can also see how households cope with risk in ways that may exacerbate their difficulties in the long run.
The ability to use bankruptcy to diagnose the financial vulnerability of middle class families is a byproduct of bankruptcy’s social insurance function. Like other types of social insurance, however, bankruptcy’s continued existence in its current form cannot be taken for granted. New laws now coming into effect make the bankruptcy system more expensive and complicated and less generous. Taken individually, each discrete statutory amendment is relatively minor; only time will tell what their collective impact will be. Yet the changes on the whole suggest a decline in public support for a strong bankruptcy system as well as an erosion of governmental commitment to this form of mandatory risk management for individuals and families of modest means. We can assume that we have not seen the last of efforts to reduce bankruptcy protection. The challenge in the coming years is to evaluate the comparative efficacy of bankruptcy and viable alternatives.1 To the extent that bankruptcy is found to be a superior legal and policy intervention under some circumstances, it will be necessary to reframe debates about bankruptcy so that lawmakers and the public rediscover bankruptcy’s social insurance role.
Bankruptcy reveals a spectrum of risks to individuals and families
Financial fallout does not conform to commonly held expectations. Consider bankruptcies that arise in part as a consequence of illness or injury. Even as bankruptcy filers regularly report having health insurance, they confront financial problems closely tied to sickness that insurance does not cover.
Direct medical costs are but a subset of expenses arising from a medical problem. For example, a family might have relocated temporarily or have to travel frequently to a distant location because a child had a rare disease requiring specialized care. Or a disability might have required that the house be refitted for a wheelchair or that the family move elsewhere quickly. Managing these large expenses might have been plausible had the rest of the financial picture remained the same, but sickness does not confine itself to only one financial hit. Income loss has been a huge factor for bankruptcy filers who became financially distressed in the aftermath of illness or injury.2 In some cases, filers’ own health problems kept them out of work or required a job switch that had income and benefit implications, and access to disability insurance was all too rare. For other filers, the illness or injury of a family member produced lost income on a temporary or permanent basis. Giving birth to a baby with serious health problems, or caring for a disabled child, aging parent, or spouse can require time off from work without pay, prevent the acceptance of overtime or a more demanding job that would increase pay, or result in job loss altogether.
Non-medical costs and income loss could bankrupt someone of modest means before she even confronts a daunting pile of medical bills. Yet, even insured bankruptcy filers report out-of-pocket medical expenses for hospitals, doctors, lab tests, pharmacies, rehabilitation centers, health aid suppliers, and other sources that are quite significant relative to their incomes.3
In addition to revealing health-related financial risk, bankruptcy also reveals that homeownership offers stability and security to some but not all. We see many individuals and families enter the bankruptcy system each year trying to hold onto homes, or having already lost them.4 Sometimes a home was unaffordable from the start, but other times the terms of the mortgage loan turned out to be highly unfavorable, or external financial shocks rendered the costs of homeownership unmanageable.
Readers may be surprised to learn that bankruptcy has become a federal anti-home-foreclosure program. People use chapter 13 bankruptcy to fight for the right to continue repaying their mortgage loans. Even if the mortgage holder is anxious to pursue a foreclosure sale, chapter 13 bankruptcy halts that process and generally permits a homeowner to reverse the acceleration of the loan, reinstate monthly payments according to the contract, and cure the existing monetary default over time.5 The number of debtors who save their homes this way is unknown, although success is probably not the norm.
Even those who file for chapter 7 – which offers fewer tools for home saving – often face the prospect of home loss.6 Debtors who seek relief under this chapter may be trying to preserve more income for mortgage payments by discharging other liabilities. They may have conceded defeat on retaining their homes but want a trustee to sell the house in a process that will yield a higher price than a state foreclosure sale. Others who already have lost their homes may be dealing with residual debt, perhaps because a foreclosure sale fetched a low price.
The likelihood of home loss still may be small overall, but the risk is not to be ignored. Lord Alfred Tennyson’s oft-quoted sentiment that “‘tis better to have loved and lost than never to have loved at all” does not apply comfortably to homeownership. Losing a home and homeownership status can be a devastating blow.7
Coping strategies to stabilize finances that may increase risk
An individual encountering a financial problem often has no way to know how long it will last or where it will lead. The optimal moment for selling a house or making another large adjustment may seem apparent after the fact. In the throes of the situation, however, it will be unclear if a mother will find a new job quickly, whether a father’s recovery from a serious accident will take weeks or months, or whether spouses will reconcile after a separation.
Some popular coping strategies that bankruptcy filers have used to get through times of financial uncertainty can exacerbate the ultimate financial trouble. For example, consumer credit has become the de facto umbrella insurance policy for individuals and families hovering on the edge of financial instability. Observers critical of the availability of bankruptcy are sometimes quick to regard the debt burden of bankruptcy filers as evidence of willingness to spend beyond their means. Surely some bankruptcy filers fit that characterization, although their bankruptcy relief may be limited or denied if their circumstances attract the attention of courts or trustees. When talking about the general bankruptcy population, however, it is equally if not more plausible to posit that a high debt burden develops in part from an attempt to avoid financial defeat and bankruptcy. Families rely on consumer credit to fill in the gaps in their finances. They hope and believe that they will repay in full once the new job is found, or the medical crisis is over, or whatever other trouble has passed.
Borrowing money to smooth consumption is nothing new. Perhaps one difference is that the credit now available to financially strapped families comes with particularly high or unclear price tags, or prices that change over time. Although much of this credit is unsecured, lenders are increasingly ready and willing to get borrowers through hard financial times in exchange for a second or third mortgage on the family home. The interest rate may be lower than credit card debt or payday loans, but the risk of home loss from non-payment of a home equity loan is hardly a trivial consequence.
In addition, we now see loans marketed more expressly as private safety net credit. For example, some lenders are offering medical-specific credit cards, and hospitals might direct patients to a particular bank to finance the self-pay portion of an expensive medical procedure. Debit cards associated with health savings accounts and high deductible health plans may increasingly include credit extension opportunities to cover substantial out-of-pocket liabilities that exceed the account balance.
Whether or not they take on new financing, bankruptcy filers may also try to avert financial disaster by drastically reducing spending. This kind of belt tightening sounds practical until one considers the nature of the goods and services that the filers and their families go without. In trying to adjust to a crisis of unknown duration and severity, some financially strapped families reduced their costs by canceling or delaying doctors’ appointments, letting prescriptions go unfilled, buying less food, and delaying payment on insurance premiums.8 By trying to stem the growth of their liabilities in the short term, these families exponentially increased their risk of significant trouble in the long term.
The future of bankruptcy as social insurance
When debtors with problems and responses along the lines described above have declared bankruptcy, the system has functioned for them as a force majeure clause with respect to certain kinds of liabilities. Enduring features of our bankruptcy system have reflected a collective decision about risk allocation for nonpayment of financial obligations. Theoretical and empirical research comparing bankruptcy with other social insurance approaches is at a nascent stage, so we cannot be sure that bankruptcy is more efficient than other approaches or particularly well suited to the kinds of ongoing problems that filers face. Nonetheless, we often rely on second- and third-best solutions until we can develop better information, and sometimes long after that. For now, it is reasonable to conclude that the bankruptcy system has been preventing certain kinds of household risks from having even more damaging effects.
The continuing viability of bankruptcy protection is now itself at risk. In spring 2005, President Bush signed an omnibus bankruptcy bill, most of which will impact cases filed as of October 17, 2005. It would be a gross exaggeration to say that the bankruptcy bill shuts down the bankruptcy system – as some lawyers have misleadingly advertised – just as it would be wrong to say that the bill will have no effect on most filers, as all too many proponents of the bill have suggested. The true impact on the bankruptcy system will depend on how it is interpreted on a day-to-day basis, for these daily decisions will mute or magnify the statutory changes and yield local variation. The recent package of statutory changes dropped from Congress onto the bankruptcy system is unlikely to land intact.
However the amendments play out in practice, the assumptions motivating the legislation suggest that we have not seen the last of bankruptcy reform efforts. The broad legislative support for the bill was not a one-time fluke. Over the course of eight years, lawmakers endorsed the bill repeatedly by lopsided margins. In debates and hearings, lawmakers told the American people that they should object to paying the tax that bankruptcy imposes on households in the form of higher prices on credit, goods and services. Absent was any mention of what those households might have received in exchange. The implication was that they got nothing.
How comforting it would be if lawmakers’ honest and hardworking constituencies never found themselves on the brink of bankruptcy. This, of course, is a fantasy; nearly everything we know about the bankruptcy system contradicts it. The people who are most likely to feel the pain of a bankruptcy tax do not look very different in terms of basic socioeconomic characteristics from those who find themselves needing bankruptcy relief, just as people who struggle to keep up with their health insurance premiums resemble those for whom a good insurance policy prevents financial devastation. Nonetheless, the debates conveyed the message that our current bankruptcy system either creates too much moral hazard or functions as a subsidy for an undeserving group.
The last eight years’ worth of legislative bankruptcy discussions did not reflect a shared commitment to maintaining the bankruptcy system’s presence and viability. It is possible and even likely that there are better ways of managing household risk than a robust bankruptcy system. The danger for the middle class is that the bankruptcy system will fade away for the wrong reasons, and that there will be nothing to replace it.
1 Adam Feibelman, Defining the Social Insurance Function of Consumer Bankruptcy, American Bankruptcy Institute Law Review 13: 129-186 (2005).
2 Melissa B. Jacoby and Elizabeth Warren, Beyond Hospital Misbehavior; An Alternative Account of Medical-Related Financial Distress, 100 Northwestern Law Review (forthcoming 2005).
3 In the 2001 Consumer Bankruptcy Project, filers with private insurance at illness onset had on average $13,460 in out-of-pocket costs – higher than filers enrolled in Medicare ($8,118) or Medicaid ($8,195) or those who were uninsured at illness onset ($10,893). David U. Himmelstein, Elizabeth Warren, Deborah Thorne, & Steffie Woolhandler, Illness and Injury as Contributors to Bankruptcy, Health Affairs Web Exclusive W5-63 – W5-72 (Feb. 2, 2005). Although the highest expenses of the privately insured can be explained in part by the subsequent loss of insurance by some of the filers, even the lowest of the out-of-pocket estimates is difficult to absorb in a sample population in which the median income during the year before filing was about $24,000 and the 80th percentile was barely over $40,000.
4 In the 2001 Consumer Bankruptcy Project, over half the filers came into the process as homeowners, and about 12% of the non-homeowners had owned homes but lost them before filing. Elizabeth Warren, Financial Collapse and Class Status: Who Goes Bankrupt?, Osgoode Hall Law Journal 41: 115-146 (2003).
5 Home saving was never intended to be a stand-alone function of chapter 13. Congress apparently included home saving tools to encourage debtors to choose chapter 13 over chapter 7 with the hope that more unsecured debt would get paid.
6 Focusing on a nationally representative sample of no-asset chapter 7 cases closed between 1999 and 2001, researchers found that about 42% of the filers were still technically homeowners at the time of filing, although the rate varied widely by state. Ed Flynn & Gordon Bermant, Bankruptcy by the Numbers: Be It Ever So Humble, There’s No Place Like Home, American Bankruptcy Institute Journal (Sept. 2003).
7 Janet Ford, Roger Burrows and Sarah Nettleton, Homeownership in a Risk Society: A Social Analysis of Mortgage Arrears and Possessions (Policy Press 2001).
8 Himmelstein, at W5-68, exhibit 4 (reporting percentages of medical and non-medical filers who identified these privations in telephone surveys).