Credit Cards and Bankruptcy
Todd J. Zywicki
Professor of Law, George Mason University School of Law
Research Fellow, James Buchanan Center for Political Economy
Abstract:
From 1980 to 2005 consumer bankruptcy filings increased five-fold. Conventional wisdom holds that a primary cause of rising bankruptcy filing rates was increased household financial distress caused by increased indebtedness caused in turn by increased credit card borrowing. In 2005, Congress enacted the bipartisan Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). The legislation was enacted in response to twenty-five years of rising bankruptcy filings and a perception of widespread fraud and abuse that threatened the fairness and integrity of the system. BAPCPA marked the most profound and far-reaching overhaul of America’s bankruptcy system in over a generation. In the two years since BAPCPA’s enactment, bankruptcy filings have plunged. From over 2 million filings in 2005, filings plummeted to less than 600,000 in 2006 and 800,000 in 2007.
Critics of the legislation argue that the drop in filings will be temporary, as the legislation does not address what they believe to be the underlying cause of the rise in bankruptcy filings in the 1980s and 1990s—excessive consumer debt caused by profligate lending by credit card issuers especially to risky borrowers. This article reviews three hypotheses about the relationship between credit cards and bankruptcy: the substitution model, the “distress” or “overindebtedness model,” and the “strategic model” and concludes that the conventional wisdom is flawed. A review of empirical evidence and available data indicates that in fact the growth in credit card lending has not led to an increase in the consumer debt service ratio or financial distress more generally, suggesting that the rise in credit card borrowing has been primarily a substitution from other traditional types of consumer credit, such as retail store credit, personal finance companies, friends and family, pawnbrokers, and other types of consumer credit.
The article then briefly examines the substitution hypothesis in more depth, describing how a substitution to credit card debt can bring about a rise in consumer bankruptcy filings even holding overall consumer debt obligations constant. Finally, the article examines the rationale and effects of the credit card provisions of BAPCPA for the substitution and distress models. To date, the response of consumers to BAPCPA has been consistent with the substitution model, suggesting that with respect to addressing particular problems regarding the relationship between credit cards and bankruptcy BAPCPA has been accomplishing its stated purposes.
Credit Cards and Bankruptcy
By Todd J. Zywicki[*]
From 1980 to 2005 consumer bankruptcy filings increased five-fold. Conventional wisdom holds that a primary cause of rising bankruptcy filing rates was increased household financial distress caused by increased indebtedness caused in turn by increased credit card borrowing. In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) by overwhelming bipartisan majorities in both houses of Congress.[1] The legislation was enacted in response to twenty-five years of rising bankruptcy filings and a perception of widespread fraud and abuse that threatened the fairness and integrity of the system. BAPCPA marked the most profound and far-reaching overhaul of America’s bankruptcy system in over a generation. In the two years since BAPCPA’s enactment, bankruptcy filings have plunged. From over 2 million filings in 2005, filings plummeted to less than 600,000 in 2006 and 800,000 in 2007.
Despite the overwhelming bipartisan support for the legislation in Congress and its apparent success in accomplishing its intended goals, BAPCPA has been criticized by many bankruptcy scholars and professionals. They argue that the rising trend in bankruptcy filings in the 1980s and 1990s was a manifestation of widespread consumer distress caused by excessive household debt obligations.[2] Although multipronged, a core element of the argument is that this economic distress was triggered by more widespread access to credit cards by higher-risk borrowers over the past three decades. Typically it is argued that credit cards combine high rates of interest with an “insidious” form of gradual and subconscious debt accumulation through many routine purchases that draw consumers into debt unconsciously[3] or that credit card issuers prey on consumers’ cognitive biases and errors to trick them into excessive debt.[4]
Both credit card use and bankruptcies have increased dramatically over the past several decades, and this rise in credit card use and bankruptcy appear to be correlated—at least prior to BAPCPA.[5] The raw numbers appear staggering at first glance. Consumers charge over 1 trillion dollars per year on their credit cards and revolve over $600 billion in credit card debt from month to month.[6] Seventy-five percent of American households have some sort of credit card, compared to seven percent in the 1960s.[7] Credit cards have transformed the way we live, shop, and travel. The ubiquity and importance of credit cards to the modern economy is summed up in the observation of economist Lewis Mandell that credit cards “have become an essential element of daily life. With a credit card, you can buy yourself a new car. Without it, you cannot even rent one.”[8]
But with credit cards has come a chorus of critics who argue that this growth in credit card ownership has come with an excessive social cost—too many consumers overburdened by debt and an annual bankruptcy filing rate that quintupled between 1980 and 2005. Much of the blame for this skyrocketing bankruptcy filing rate is laid at the door of credit card issuers who, it is said, have extended credit in a profligate manner to unworthy borrowers and have lured borrowers into financial misery with easy credit, high interest rates, and an array of hidden fees.
This article reviews the various theories that have been offered to explain the correlation between credit cards and bankruptcy. Conventional wisdom holds that the causal link is obvious: that the relationship between credit cards and bankruptcy is obvious—that the rise in credit card use has produced a generation of overburdened consumers driven into bankruptcy by profligate and abusive lending by credit card issuers. This article tests the conventional wisdom and finds it wanting. In particular, data indicate that credit cards have not in fact led to an increase in household economic distress for a simple and, upon reflection, obvious reason: The growth in credit card borrowing has been a substitution from other traditional types of consumer credit, such as pawnshops, personal finance companies, retail store credit, department store credit cards and gasoline cards, layaway plans, and other similar products. Moreover, this substitution has been driven by rational consumer demand. Credit cards offer lower interest rates, better terms, ancillary benefits, and move flexibility than any other type of consumer credit. Although this substitution has also had the unintended consequence of increasing bankruptcy filings, it has on the whole been a great boon to consumers and the economy and it would be unwise to try to reverse it. Although total household has increased, steady economic growth, record household wealth accumulation, declining interest rates, and the substitution of high-interest consumer debt with lower-interest debt has dramatically increased household living standards while leaving their debt service burden largely unchanged for over twenty-five years.
This article examines competing hypotheses regarding the possible link between credit cards and bankruptcy. After a brief background on the history of consumer credit in America and the rise of credit cards within this story, the article turns toward a detailed exploration of the competing hypotheses. After establishing the primacy of the substitution effect with respect to credit card credit, the article explores possible causal explanations for how a simple change in the composition of household credit holdings could lead to increased bankruptcies without an increase in the household debt burden. Finally, the article turns to the effect of BAPCPA on credit card debt to date and the implications for the future.
I. “Charge It”: A Brief History of Credit Cards in America
Although credit cards are a relatively new financial innovation, the use of credit is as old as human society and even predates money itself.[9] And as old as credit is the reality that some borrowers will be unable to repay all that they borrow and that many others will engage in hand-wringing about others’ excessive borrowing.[10] Lendol Calder refers to this as the “myth of lost financial virtue”—the belief that “earlier generations” were thriftier than the “current generation,” a refrain repeated steadily by almost every generation since at least mid-nineteenth century America.[11] In fact, credit cards have spawned simply the latest expression of concern about consumer overindebtedness and reckless lending that has recurred repeatedly in American history.
A. Consumer Credit in Early America
In pre-Civil War America, most Americans were farmers, living outside major population centers. Gold and silver coins were scarce. Personal credit, however, was not, and farmers relied on credit to smooth investment and consumption across the crop harvesting season. Credit was as important as the Conestoga Wagon in conquering the west.[12]
In the decades following the Civil War, a tide of immigrants swept into America, building the great cities. Most urban dwellers were unskilled blue-collar workers with unpredictable employment and income, thus the consumer credit industry emerged to cope with seasonal fluctuations in employment. The emerging American middle class became homeowners and home furnishers through mortgages and consumer installment credit. Overall, late nineteenth-century households sought financial assistance from five major credit sources: pawnbrokers, illegal small-loan lenders, retailers, friends and family, and mortgage lenders.[13] In post-Civil War New York City, for instance, two-thirds of the city’s total consumer lending came from small-loan agencies, including loan sharks and forerunners to today’s and “payday” or “wage assignment” lenders.[14] Pawn shops proliferated—in some neighborhoods virtually the entire population had a pawn ticket at all times and as many as twelve in the winter when factories typically closed down.[15] These various unlicensed lenders charged interest rates that approach 300 percent annually and resorted to embarrassing and aggressive collection practices to enforce repayment of these illegal debts.[16] Counterproductive usury regulations made operations unprofitable for legitimate lenders thereby driving many urban consumers into the hands of illegal lenders.[17] It was estimated in 1911 that 35 percent of New York City’s employees owed money to illegal loan sharks.[18] Reviewing the credit market of this era, former Federal Reserve Chairman Alan Greenspan has described the plight of lower-income wage earners subject to aggressive and overreaching creditors as one of “virtual serfdom.”[19]
Consumer credit expanded following World War I. Credit unions, small local savings banks, and a national network of licensed consumer finance companies such as the Beneficial Industrial Loan Corporation and the Household Finance Corporation, provided consumer loans.[20] These were installment loans (often referred to as buying on “time”) meaning that the consumer borrowed a fixed sum (plus interest) with an obligation to repay the loan over a fixed period in equal installments.[21]
Beginning with Singer sewing machines, installment credit soon spread to furniture, pianos, and household appliances, and finally automobiles.[22] By the 1930s, the majority of sales of household furniture, appliances, radios, cameras, and jewelry were credit sales, as were a substantial percentage of rugs, hardware, sporting goods, and books (such as encyclopedia and other book sets).[23] Financing these purchases through credit made it possible to acquire and use the goods immediately, rather than having to save for long periods of time to afford them. Between 1900 and 1939, total consumer nonmortgage installment debt quadrupled in real dollars, increasing 2-1/2 times during the decade of the 1920 alone. Martha Olney refers to this unprecedented twin boom in the purchase of consumer durables and consumer credit the “consumer durables revolution.”[24] David Caplovitz’s study of low-income households, published in 1963, found that retailers of consumer durables made on average 75 to 90 percent of their sales on installment credit.[25] Two-thirds of families who relocated into public housing projects in the 1960s purchased their new furniture and major appliances on credit.[26] Caplovtiz also found that more than 70 percent of households used credit to purchase a television set and that lower and higher-income families were just as likely to use credit to do so.[27] Overall, Caplovitz found that 81 percent of low-income families in his study made use of some sort of credit (including installment loans, revolving credit for clothing, buying from peddlers, or outstanding personal loans), and that 60 percent had consumer debts at the time of his interview with them.[28]
The expressions of concern heard today about credit cards were presaged in similar paternalistic comments about the spread of installment credit.[29] Installment selling was criticized for allegedly inducing overconsumption by American shoppers, especially supposedly vulnerable groups such as “the poor, the immigrant, and the allegedly math-impaired female.”[30] Rapacious installment sellers were accused of extending credit to unworthy borrowers, leading them to purchase unnecessary products and generating debts beyond their means to repay.[31] Department stores were criticized for “actively goad[ing] people into contracting more debt.”[32] In 1873 the New York Times expressed concern that Americans were “Running in Debt” and by 1877 warned that Americans were “Borrowing Trouble.”[33] In 1873 a labor leader bemoaned the improvidence of America’s consumers, “Has not the middle class its poverty? Very few among them are saving money. Many of them are in debt; and all they can earn for years, is, in many cases, mortgaged to pay such debt.”[34] An 1899 report concluded that installment selling “‘lured thousands to ruin’ encouraging people to buy what they could not pay for and making debt ‘the curse of countless families.’”[35]
And not merely the poor and improvident were lured into ruin, but upstanding middle class families as well, as they engaged in a heated rivalry of conspicuous consumption with their neighbors.[36] In 1949 Business Week asked, “Is the Country Swamped with Debt?” and by 1959 U.S. News and World Report worried that “Never Have So Many Owed So Much.” In 1940 Harper’s even feared that “Debt Threatens Democracy.”[37]
The criticisms of mid-century installment credit mirrored those of credit cards today: easy access to installment credit allegedly generated overconsumption, overindebtedness, and finally bankruptcy. Credit customers bought more goods than cash customers[38] and retailers were criticized for enabling shoppers to buy more on credit than they normally would on cash.[39] Installment selling was considered a “menace” that trapped Americans in “a morass of debt” and was the “first step toward national bankruptcy,” a further overture to today’s criticisms of credit cards.[40] “The youngest families,” Caplovitz writes, “Are apt to turn to stores for installment credit; as their debts mount and the payments become increasingly more difficult to meet, they are apt to obtain loans to pay off their other debts. In this way they obtain relief in the form of smaller monthly payments at the cost of a longer period of indebtedness.”[41] Moreover, although most Americans believed that installment selling was a “good idea” in general and were confident in their own ability to use it responsibly, three out of four also thought that their neighbors used installment credit excessively[42]—a judgment mirrored in modern surveys of consumers about credit card use, in which most consumers assert confidence in their own ability to use credit cards responsibly but express concern about the ability of others to do the same.[43] And as consumer bankruptcy filings rose during the 1960s, some commentators and politicians pointed the finger of blame at profligate installment lending.[44] These criticisms of installment credit provide ironic reading today in light of the modern claim that the ubiquity of credit cards—which have come to displace installment credit for many consumer transactions—allegedly has produced a psychology of consumer overconsumption.[45]