Personal Bankruptcy: Methodological Similarities and Differences in Three Reports on Debtors' Ability to Pay
Released: 1999-03-17T00:00:00

Letter

Personal Bankruptcy: Methodological Similarities and Differences in Three Reports on Debtors’ Ability to Pay

Mr. Chairman and Members of the Subcommittee: I am pleased to be here today to share our observations on the principal methodological similarities and differences of three reports on bankruptcy debtors’ ability to pay their debts. These reports endeavor to address an important public policy issue—whether some proportion of debtors who file for personal bankruptcy have sufficient income, after expenses, to pay a “substantial” portion of their debts.

The three reports were issued by the Credit Research Center (Credit Center), Ernst & Young, and Creighton University/American Bankruptcy Institute (ABI). Last year we reported on our analyses of the Credit Center and Ernst & Young reports. It is important to emphasize that our review of the ABI study is still underway. Consequently, it is too early for us to discuss the results of our analysis of the ABI report. Our objective in reviewing each of these reports has been the same—to assess the strengths and limitations, if any, of the report’s assumptions and methodology for determining debtors’ ability to pay and the amount of debt that debtors could potentially repay. We have used the same criteria to review each report.

year repayment plan would successfully complete the plans—an assumption that historical experience suggests is unlikely. However, the reports have some methodological differences, including different (1) groupings of the types of debts that could be repaid; (2) gross income thresholds used to identify those debtors whose repayment capacity was analyzed, (3) assumptions about debtors’ allowable living expenses, (4) treatment of student loans that debtors had categorized as unsecured priority debts; and (5) and assumptions about administrative expenses.

The remainder of my statement discusses in greater detail the similarities and differences in the findings and methodologies of the three reports. A summary of these similarities and differences is found in attachment I.

Background

Debtors who file for personal bankruptcy usually file under chapter 7 or chapter 13 of the bankruptcy code. Generally, debtors who file under chapter 7 of the bankruptcy code seek a discharge of their eligible dischargeable debts. Debtors who file under chapter 7 may voluntarily reaffirm—that is, voluntarily agree to repay—any of their eligible dischargeable debts. Debtors who file under chapter 13 submit a repayment plan, which must be confirmed by the bankruptcy court, for paying all or a portion of their debts over a period not to exceed 3 years unless for cause the court approved a period not to exceed 5 years.

Personal bankruptcy filings have set new records in each of the past 3 years, although there is little agreement on the causes for such high bankruptcy filings in a period of relatively low unemployment, low inflation, and steady economic growth. Nor is there agreement on (1) the number of debtors who seek relief through the bankruptcy process who have the ability to pay at least some of their debts and (2) the amount of debt such debtors could repay.

Several bills have been introduced in the 105th and 106th Congresses that would implement some form of “needs-based” bankruptcy. Each of these bills includes provisions for determining when a debtor could be required to file under chapter 13, rather than chapter 7. Currently, the debtor generally determines whether to file under chapter 7 or 13. Generally, these bills would establish a “needs-based” test, whose specific provisions vary among the bills. H.R. 3150, the bill used in the Ernst & Young and ABI analyses, would require a debtor whose gross monthly income met a specified income threshold to file under chapter 13 if the debtor’s net monthly income after allowable expenses was more than $50 and would be sufficient to pay 20 percent of the debtor’s unsecured nonpriority debt over a 5-year period. Debtors who did not meet these criteria would be permitted to file under chapter 7.

Under the bankruptcy code, a debtor’s debts may be grouped into three general categories for the purposes of determining creditor payment priority: (1) secured debts, for which the debtor has pledged collateral, such as home mortgage or automobile loans; (2) unsecured priority debt, such as child support, alimony, and certain taxes; and (3) unsecured nonpriority debt, such as credit card debts. In analyzing debtors’ ability to pay, the three reports have focused principally on the percentage of total unsecured nonpriority debt that debtors could potentially repay.

Shared Characteristics of the Three Reports

The Credit Center, Ernst & Young, and ABI reports have each attempted to estimate (1) how many debtors who filed under chapter 7 may have had sufficient income, after expenses, to repay a “substantial” portion of their debts, and (2) what proportion of their debts could potentially be repaid.

Each of the reports used to some degree data from the financial schedules that debtors file with their bankruptcy petitions. Although these schedules are the only source of the detailed data needed for an analysis of debtors’ repayment capacity, the data in the schedules are of unknown accuracy and reliability. There are no empirical studies of the accuracy and reliability of the data debtors’ report in their financial schedules, and the National Bankruptcy Review Commission’s report recommended that these schedules be randomly audited.

schedules, would remain unchanged over the 5-year repayment period. Historically, only about one-third of chapter 13 debtors have successfully completed their repayment plans, suggesting that for two-thirds of debtors something changed between the time the plans were confirmed by the bankruptcy court and the time the actual repayment plan was to be successfully completed.

The three reports focus on the potential debt that debtors could repay should more debtors be required to file under chapter 13. However, should the number of debtors who file under chapter 13 increase, there would also be additional costs for bankruptcy judges and administrative support requirements that would be borne by the government. This is because bankruptcy judges would be involved in debtor screening to a greater extent than they are now and chapter 13 cases require more judicial time than chapter 7 cases do. None of the reports estimated these additional costs, although the ABI report acknowledges that such additional costs could accompany means-testing of bankruptcy debtors. In addition, the Religious Liberty and Charitable Donation Protection Act of 1998 permits chapter 13 bankruptcy debtors to include certain charitable deductions of up to 15 percent of their annual gross income in their allowable living expenses. The implementation of this statute could affect the estimates in each of the three reports. The potential effect could be to reduce (1) the number of bankruptcy debtors who could be required under the “needs- based” tests to file under chapter 13 or (2) the amount of debt repaid to unsecured nonpriority creditors by those debtors who are required to file under chapter 13. The act was enacted after the Credit Center and Ernst & Young issued their reports. The ABI report noted the act could effect the results of debtor means-testing, but did not attempt to apply the act to its sample of debtors.

Methodological Differences Among the Three Reports

The reports differed in the types of debts that they estimated debtors could repay, their sampling methods, the calendar period from which each report’s sample cases were selected, and the assumptions used to estimate debtors’ allowable living expenses and debt repayments. The ABI report classified student loans differently than the other two reports. We have not analyzed the impact these differences may have had on each report’s findings and conclusions.

Differences in the Types of Debts Each Report Estimated Could Be Repaid

The Credit Center report estimated the percentage of chapter 7 debtors who could repay a percentage of their “nonhousing, nonpriority debt.” These debts included secured nonhousing debt and unsecured nonprority debt. The Credit Center estimated that 30 percent of the chapter 7 debtors in its sample could repay at least 21 percent of their nonhousing, nonpriority debts, after deducting from their gross monthly income monthly mortgage payments and monthly living expenses.

The Ernst & Young and ABI reports estimated the proportion of debtors who had sufficient income, after living expenses, to repay over a 5-year repayment period: • all of their nonhousing secured debt, such as automobile loans (debtors’ payments on home mortgage debt were included in the debtors’ living expenses); • all of their secured priority debts, such as back taxes, alimony, and child support (child support and alimony payments were assumed to continue for the full 5-year payment period unless otherwise noted in the debtors’ financial schedules); and • at least 20 percent of their unsecured nonpriority debts.

The Ernst & Young and ABI reports estimated that 15 percent and 3.6 percent, respectively, of the chapter 7 debtors in their individual samples met all of these criteria.

Sampling Differences

chapter 7 case filings from calendar year 1995 in 7 judgmentally selected districts. The Credit Center and ABI reports have one district—Northern Georgia—in common.

It is possible that there are differences in each sample’s debtor characteristics that could affect each report’s estimate of debtor repayment capacity. The differences could result from the different time periods and the different sampling methods for selecting districts and filers within each district. Such differences, should they exist, could have affected each report’s estimate of the percentage of chapter 7 debtors who could potentially repay a substantial portion of their debts and how much they could repay.

Differences in Assumptions Used to Estimate Repayment Capacity

Both the Credit Center and Ernst & Young reports assumed that debtors would incur no additional debt during the 5-year repayment period. The ABI report assumed that debtors could potentially incur expenses for major repairs or replacement of automobiles during the course of the 5- year repayment plan, but that they would incur no other additional debt.

The Credit Center report was completed before H.R. 3150 was introduced, and its repayment capacity analysis was not based on any specific proposed legislation. The Credit Center report analyzed the repayment capacity of all the chapter 7 debtors in its sample, regardless of their annual gross income.

The Ernst & Young and ABI report used the “needs-based” provisions of different versions of H.R. 3150 as the basis for their analysis of debtor repayment capacity. H.R. 3150 passed the House in June 1998. Under the provisions of H.R. 3150 as introduced and as it passed the House, debtors must pass three tests to be required to file under chapter 13: • debtors must have monthly gross income that exceeds a set percentage of the national median income for households of comparable size (debtors below this threshold are presumed to be eligible to file under chapter 7); • debtors must have income of more than $50 per month after allowable living expenses and payments on secured and unsecured priority debts; and, • debtors could repay at least 20 percent of their unsecured nonpriority debts over a 5-year period if they used this remaining income for such payments.

passed by the House of Representatives. The principal effect of using the two different versions of H.R. 3150 was that each report used a different threshold of gross annual income to screen debtors for further repayment analysis. In the Ernst & Young analysis, debtors whose gross annual income was 75 percent or less of the national median income for a household of comparable size were deemed eligible for chapter 7. Debtors whose gross annual income was more than 75 percent of the national median household income were subject to further analysis of their repayment capacity. In the ABI report’s analysis, debtors whose gross annual income was at least 100 percent of the national median income for households of comparable were subject to further repayment analysis.

Differences in Assumptions About Debtors’ Allowable Living Expenses

The three reports used different estimates of debtors’ allowable living expenses. The Credit Center report established its own criteria for debtors’ living expenses. Basically, the Credit Center’s analysis used the debtor’s living expenses as reported on the debtor’s schedule of estimated monthly living expenses. The Ernst & Young and ABI reports used the Internal Revenue Service’s (IRS) Financial Collection Standards, as specified in H.R. 3150. However, Ernst & Young and ABI interpreted them somewhat differently. The principal difference was for transportation expenses. Ernst & Young did not include an automobile ownership allowance for debtors who leased cars or whose cars were debt-free. ABI included an ownership allowance for leased cars and for debtors with debt-free cars. The ABI report noted that this difference in allowable transportation expenses accounted for “a substantial part” of the difference between the ABI and Ernst & Young estimates of the percentage of chapter 7 debtors who could potentially repay at least 20 percent of their unsecured nonpriority debt.

ABI also deducted from the debtors’ total unsecured priority debt the value of any student loans and added the value of these loans to debtors total unsecured nonpriority debt. To the extent this was done, it had the effect of freeing debtor income to pay unsecured nonpriority debt.

Finally, the ABI report assumed that administrative expenses, such as the trustee fee, would consume about 5.6 percent of debtors’ nonhousing payments to creditors under a 5-year repayment plan. The Credit Center and Ernst & Young reports assumed that none of the debtors’ payments would be used for administrative expenses, but that 100 percent of debtors’ payments would be used to pay creditors.

the number of debtors who would be required to file under chapter 13 and the amount of debt that such debtors could potentially repay. However, the assumptions and data used in these reports lead to different estimates of debtors’ repayment capacity and require the reader to use caution in interpreting and comparing the results of each report. The actual number of chapter 7 debtors who could repay at least a portion of their nonhousing debt could be more or less than the estimates in these studies. Similarly, the amount of debt these debtors could potentially repay could also be more or less than the reports estimated.

We agree that there are likely some debtors who file for bankruptcy under chapter 7 who have the financial ability to repay at least a portion of their debt, and that those who are able to repay their debts should do so. But we believe that more research is needed to verify and refine the estimates of debtors’ repayment capacity to better inform policymakers.

Mr. Chairman, this concludes my prepared statement. I would be pleased to answer any questions that you or other Members of the Subcommittee may have.