Only a fraction of those in need file for bankruptcy

Bankruptcy filings are nearing the record 2 million of 2005, when a new law took effect that was aimed at curbing abuse of the system. Filings could reach 1.7 million this year, says law professor Robert Lawless, but few experts believe that debtors are now gaming the system.

Instead, concern exists about a growing number of Americans who need bankruptcy protection but cannot get any benefit from it or simply cannot afford to file. As their financial problems worsen, that hurts everyone because it can hinder the economic turnaround.

"It's shocking that we are back to the 2005 level," says Katherine Porter, associate professor of law at the University of Iowa. "And the filing rate doesn't even begin to count the depth of the financial pain."

Bankruptcy laws changed in 2005 because filings skyrocketed and credit card companies and banks wanted to weed out deadbeat borrowers. The law made it harder — more expensive and more restrictive — for individuals to file Chapter 7 bankruptcy, which erases most debts.

Instead of seeking protection from bankruptcy, a number of debt-laden Americans have gone into a "shadow economy," or informal bankruptcy, according to some experts.

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The signs are there: Student loan defaults and home foreclosures are rising, and bank card loan defaults have increased from 7.7% in March to 9.1% in April, according to S&P/Experian Consumer Credit Default Indices. But during the same two months, bankruptcy filings fell by 4%.

Bankruptcy is supposed to provide a fresh start to people who are in serious financial distress. But only a fraction are filing, Porter says.

'My future is gone'

Carmen Gardiner, 25, a 2007 graduate of Louisiana State University, is weighed down by her private student loans. Her debt is now about $80,000, and her monthly payments are more than $600. Gardiner's undergraduate degree is in psychology. She lives with her husband, who is still in college, and earns $13 an hour at a call center in Atlanta. They have a 6-month-old daughter.

She hasn't defaulted on her student loan. But she doesn't see much hope. Bankruptcy would not discharge her debt.

"I'm completely sour about the whole idea of going to college," she says. "My future is gone before I have a chance to make one. But if I could discharge this using bankruptcy, it would be better than winning the lottery."

There is little information about unregulated private student loan debt. But during an investor meeting, Sallie Mae, the USA's largest private student lender, recently projected that 40% of $6 billion in subprime private student loans will default, according to Student Lending Analytics, an independent research company. That means 360,000 to 540,000 borrowers are likely to default on their loans, SLA said.

The only way that people with private student loans can get help in bankruptcy is if they can prove undue hardship. And to do that they have to go through a separate trial, which is an extra cost, involves witnesses, legal assistance and extra expertise, says Deanne Loonin, staff attorney at the National Consumer Law Center. It is a huge barrier.

But in April, both the Senate and House introduced legislation to allow for private student loans to be dischargeable in bankruptcy. Before the bankruptcy law changed in 2005, only government-issued-or-guaranteed student loans were protected during bankruptcy.

"The high interest rates on private student loans have made them incredibly profitable for loan companies and saddled students with crushing debt," said Sen. Dick Durbin, D-Ill., who first introduced this legislation in June 2007.

Filers pay now or pay later

Only a fraction of those in serious financial distress are filing for bankruptcy, Porter says. In January, she and Ronald Mann, a professor of law at Columbia University, released a paper, "Saving up for Bankruptcy," that probed why that is happening.

For starters, it's simply expensive to file. Attorney and filing fees have risen, and under the new law additional forms, paperwork and attorney liability have added to the cost, Porter says. In the first two years after the law changed, the attorney fees for filing Chapter 7 bankruptcy rose from $712 to $1,078, according to a study by the U.S. Government Accountability Office. And the filing fees increased from $209 to $299.

Many debtors have no choice but to delay filing for bankruptcy. Some wait until they receive a tax refund, and others cash out their retirement savings to pay for a lawyer.

But postponing filing is not good for debtors. It's similar to delaying going to the doctor, because you'll just end up with more problems, says Lawless, professor of law at University of Illinois.

The system is not just more costly, it is more complex. It requires pre-bankruptcy credit counseling. It requires six months of income information and two years of tax returns. And if the debtor holds off filing, a lawyer has to continue to gather new information.

"The paper chase gets greater, and then the fee goes up," says William Brewer, a bankruptcy lawyer in Raleigh, N.C.

Hanging onto their homes

Another reason: Many Americans who are trying to save their homes do not file for bankruptcy. Under the bankruptcy law, filers can protect their summer home and yacht, but they can't protect their primary residence, says John Taylor, president of the National Community Reinvestment Coalition, a non-profit organization.

That wasn't such a big issue when home values were rising. But during the recession, many homeowners are seeing values plummeting and their mortgage payments rising.

Home foreclosure filings have outstripped bankruptcy filings, Porter says. And foreclosure shows no sign of slowing down. In the first quarter of the year, foreclosure filings were 16% higher than the same quarter in 2009, according to RealtyTrac. And March was the highest month since RealtyTrac began issuing reports.

Cordell Brooks, 47, who lives in Temple Hills, Md., may soon lose his home to foreclosure. During the recession he was laid off from his job as a graphics designer. Since then, he has worked as a substitute teacher and now is a contractor with Prince George's County Housing.

"I've gone from earning $40 an hour to $17.50," he says.

Brooks, who has owned his home since 1989, applied for a federal program known as Home Affordable Modification Program (HAMP) but was turned down. He has few options. He doesn't want to file for bankruptcy. But even if he did, it wouldn't help him save his home.

"Bankruptcy is not very useful at solving this particular type of financial distress," Porter says.

Homeowners who applied for loan modifications could have been turned down if they also have filed for bankruptcy. But as of this month, a debtor who requests loan modification cannot be discriminated against because they have filed for bankruptcy, says John Rao, an attorney at the National Consumer Law Center, which specializes in consumer credit and bankruptcy issues. And that will help homeowners who are also overwhelmed by other debt.

Is it time for a change?

When the bankruptcy law changed in 2005, barriers were erected to prevent abuse. But it seems that many honest Americans who are in financial crisis are now running into obstacles. That raises questions about what can be done to prevent debtors from falling through the cracks.

Congress is considering legislation to help college graduates weighed down by private student loan debt. If passed, the legislation could roll back the bankruptcy law so that private student loans can be discharged.

The Treasury Department has agreed to revise the federal mortgage modification program so that people can't be turned down for HAMP just because they have filed for bankruptcy. But some say that this is just a Band-Aid. And now few homeowners are getting permanent mortgage modification.

The 2005 bankruptcy reform did not change mortgage debt. "Debt secured by a principal residence has not been dischargeable since 1978," says Philip Corwin, an outside bankruptcy counsel for the American Bankers Association.

Recent efforts to introduce legislation to allow bankruptcy judges to modify home mortgages have failed. "If Congress had had the wisdom to pass that three years ago we would have forced all the parties to the table to work out reasonable solutions," Taylor says.

The financial industry says that the bankruptcy law is not causing the shadow economy. People can still file for it, and if they can't afford the fees at least the court filing fees can be waived, says Scott Talbott, senior vice president of the Financial Services Roundtable. And people with student loans who have undue hardship are able to get financial relief.

But undue hardship is extremely hard and costly to navigate, says Lauren Asher, associate director of Project on Student Debt. There is no definition in the bankruptcy code of undue hardship, and the court decisions on it have been harsh, Corwin says.

Free legal services have been cut back during the recession and are not available for many debtors. It would help to roll back some of the changes that have increased legal paperwork and risk of personal liability, Lawless says.

The bankruptcy problems are not likely to go away anytime soon. If Gardiner's career is stymied because she can't afford to go on to graduate school and is burdened with student loan debt, doors may be closed to her.

"Not going on with her career and being stuck in a low-wage job hurts everyone and drags down the economy," Porter says. "It is not surprising that the bankruptcy code is not a fit for the problems of today. The 2005 amendment was a move in the wrong direction, and I think it's time to think about redesigning bankruptcy."