ByThomas A. Garrett
Personal bankruptcies in the United States have had a dynamic history over the past 100 years. Bankruptcy filings in the first half of the 20th century averaged 0.15 per 1,000 people and grew at an average annual rate of 2.4 percent. Bankruptcies began to increase during the 1960s and have grown dramatically since 1980. Between 1980 and 2004, bankruptcies grew at an annual average rate of 7.6 percent a year. As of 2004, the filing rate was 5.3 per 1,000 people, more than four times the 1980 rate and nearly 80 times the 1920 rate.
These statistics, however, disguise the fact that personal bankruptcy filings are not equal across the country. For example, at the state level, Tennessee had the highest rate of personal bankruptcy filings in the nation in 2004, with more than 10 filings per 1,000 people (nearly twice the U.S. rate) whereas Massachusetts ranked last with 2.8 filings per 1,000 people. States in the Eighth Federal Reserve District had an average filing rate of 7.7 per 1,000 people in 2004, which is greater than the U.S. average, but the growth in bankruptcy filings in Eighth District states between 1980 and 2004 averaged 7.2 percent a year, slightly below the U.S. average growth of 7.6 percent a year.
The typical person who files for bankruptcy is a blue collar, high school graduate who heads a lower middle-income class household and who makes heavy use of credit. Research has found that the primary cause of personal bankruptcy is a high level of consumer debt often coupled with an unexpected insolvency event, such as divorce, job loss, death of a spouse or a major medical expense not covered by insurance.
Although negative income shocks (including recessions) are the predominant cause of bankruptcy filings, various economic, legal and institutional factors over the past 100 years are likely contributors to the rise in personal bankruptcy filings. These factors—such as the increased availability of credit, lower costs to file for bankruptcy and decreased consumer savings—do not cause most bankruptcies, but have made individuals more susceptible to negative income shocks, thus increasing their chance of filing for bankruptcy.
Personal bankruptcy filings per 1,000 people in the United States from 1900 to 2004 are shown in the figure. Bankruptcy filings were relatively low and steady from about 1900 to 1920. Filings increased slightly during the 1920s and 1930s, both as a result of increased economic activity and the Great Depression. Bankruptcy may increase during periods of economic growth as people become more confident in the future and are willing to take on a greater debt burden and finance their increasing obligations based on current income. However, as the supply of credit begins to tighten and interest rates and loan payments begin to rise, the financial strain can become quite large.
World War II saw a marked drop in filings, likely the result of increased employment in support of the war effort. Filings continued to rise at a somewhat greater rate during the 1960s. Two reasons for this rise were an increase in economic activity following World War II and the rise in federal and state transfer programs (i.e., Medicare, welfare and disability programs) that created an incentive for individuals to be less financially responsible given a government safety net.
A marked decrease in consumer saving and an increase in consumer debt correspond with the dramatic change in bankruptcy filings since the 1980s. For example, total saving as a percent of income averaged nearly 10 percent in 1980 compared with 0.1 percent in the second quarter of 2005. These figures include traditional retirement accounts like 401(k)s.
Although rising property values have likely led to a portfolio shift from traditional savings to investing in one's home, this latter option offers much less diversity, and thus higher risk, than traditional portfolio savings like 401(k)s.
Consumer debt as a percent of income increased from about 15 percent of personal income in 1980 to more than 20 percent of income in the second quarter of 2005. These statistics, combined with the saving statistics, reveal that Americans have been saving less and spending more (through debt) over the past 25 years. Both of these facts have made individuals more susceptible to income shocks and thus more likely to file for bankruptcy.
Bankruptcy law during the first part of the 20th century was established by the 1898 Bankruptcy Act, the first permanent bankruptcy law in the United States. Although this law dealt primarily with corporate bankruptcies, the legal provisions for personal bankruptcies, which were arguably weak, were of little concern because of the extremely low rate of personal bankruptcies during the first part of the century.
The rise in personal bankruptcies in the 1920s and 1930s, along with growing corruption and legal challenges regarding corporate bankruptcy filings during the Great Depression, prompted passage of the Chandler Act in 1938. The Chandler Act created a host of new options for those filing for personal bankruptcy, such as alternatives to complete liquidation (e.g., a repayment plan) and a greater ability to file voluntary petitions.
The increased availability of consumer credit, especially in the form of credit cards, has occurred since the 1950s. Although proprietary charge cards were available in the early 1900s, the use of these cards was traditionally limited to a single store. Also, many of these cards did not have the feature of revolving credit. The first general purpose credit card (BankAmericard, now known as VISA) was introduced in 1966. In 1970, only 16 percent of households had a credit card compared with over 70 percent of households in 2000.
The late 1970s saw numerous legal changes that likely had an impact on bankruptcy filings. First, the Bankruptcy Reform Act of 1978 revamped bankruptcy practices set forth under the 1898 act and the Chandler Act. Although the act was passed in response to the rise in personal bankruptcies during the 1960s, many provisions in the act made it easier for both businesses and individuals to file for bankruptcy.
A second legal change in the late 1970s was a Supreme Court ruling in 1978 called the Marquette decision. Prior to this time, many states had usury ceilings on credit card interest rates. The high inflation and interest rates of the late 1970s significantly reduced the earnings of credit card companies. As a result, credit card companies in relatively high-interest-rate states attempted to solicit their credit cards to people living in lower-interest-rate states, but charge the higher rate. Controversy over this practice culminated in the Supreme Court, which ruled that lenders in states with high-interest-rate ceilings could export those rates to consumers residing in states with more restrictive interest rate ceilings. The result of this ruling was a massive expansion in credit card availability and a reduction in the average credit quality of card holders.
The third legal change in the late 1970s was the Community Reinvestment Act (CRA), which was enacted in 1977. The purpose of this act is to encourage depository institutions to help meet the credit and financing needs of the community, especially low- to moderate-income communities. Because the act has increased credit flows to disadvantaged communities, is it possible that it also increased the number of bankruptcy filings by lower-income individuals? Research has suggested that the number of bankruptcies that result from CRA loans is much smaller than the aforementioned legal factors-at most, 3 percent to 4 percent of overall bankruptcy filings are a result of CRA loans.
Although some minor legal changes to the Bankruptcy Code did occur in the 1980s, the next significant change was the Bankruptcy Reform Act of 1994. Despite the rise in bankruptcies up to this time, the act actually encouraged bankruptcy by increasing personal property federal exemptions. Indeed, filings increased roughly 17 percent between 1994 and 1995 in the states affected by the higher federal exemptions. States with their own higher exemption rates were not affected by the act.
Personal bankruptcy filing rates have increased dramatically over the past 25 years. An unexpected shock to income is the predominant cause of bankruptcy filing. However, over the past 100 years, economic, legal and institutional factors-increased consumer debt, lower savings, lower costs to file for bankruptcy and increased access to credit-have likely contributed to the pattern of bankruptcy rates.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 is designed to decrease the growth in personal bankruptcies by increasing the costs of filing for bankruptcy, using income means testing in regards to liquidation and repayment, and requiring credit counseling. It is too early to tell whether the act has had its intended effects, but the number of bankruptcy filings soared several days prior to the act's effective date of Oct. 17, 2005.