Charles Phelan

The one-year anniversary of the new bankruptcy law was October 17, 2006. What have we learned in the year since the new law went into effect?

The National Foundation for Credit Counseling recently released a report after one year of experience in counseling consumers under the new mandatory provision that requires a credit counseling session prior to filing bankruptcy.

The first obvious effect of the new law was a steep drop in the overall number of bankruptcies filed on a nationwide basis. From a record high of 2 million in 2005, filings are expected to top out around 600,000 for 2006, a 20-year low. However, we can justifiably shift around 400,000 filings from 2005 into 2006, since about that many extra filings took place right before the deadline when they would otherwise probably have been filed this year. The rate of filings has started to increase again, so “normal” filing levels will probably resume in 2007.

One of the most interesting statistics is the percentage of Chapter 13 versus Chapter 7 filings. Ignoring the skewed data in 2005, Chapter 13 filings typically averaged around 28-29% in prior years. In other words, approximately three out of every ten people filing individual bankruptcy did so under Chapter 13. For 2006, that ratio has climbed to more than four out of ten. However, this is based on a much smaller pool of people, so it’s probably still too soon to state categorically that the new law has caused a shift away from Chapter 7 to Chapter 13.

There is a further important point to be made on the subject of Chapter 13 versus Chapter 7 filings. Quite frankly, Chapter 13 sucks as a solution. Under Chapter 13, you are required to pay back a percentage of the debt (set by the court) over a five-year plan. This is not a very attractive option for most people. It’s one thing to have a bankruptcy on your record if you can at least wipe away the unsecured debts in full. It’s a totally different thing to get stuck with a five-year payment plan PLUS still have the BK on your record. My point here is that no one in the financial media who has commented on the lower filing numbers for 2006 has stated one obvious possibility: What we may be seeing is that people are determining in advance which Chapter they will fall under, and steering clear of bankruptcy if they don’t qualify for Chapter 7! We simply don’t know whether or not this is true, but it certainly makes sense based on the conversations I’ve had on a daily basis with struggling debtors. Virtually no one feels that Chapter 13 is a good solution, and many people are turning to debt settlement instead.

Aside from the above insights and speculations, one set of facts from the NFCC report jumped out at me. Consumers who sought credit counseling because they were required to do so before filing BK reported an average unsecured debt level of $38,472 against average annual income of $26,873, for a ratio of unsecured debt at 1.43 times annual income. Talk about being upside down financially! By way of contrast, “regular” credit counseling clients (who sought counseling because they were having financial troubles and not because they were about to file bankruptcy) reported an average unsecured debt level of $22,597 against average annual income of $31,143. This represents a ratio of unsecured debt at 0.73 times annual income. In other words, credit counseling clearly comes far too late in the process for people who are already seeking to file bankruptcy. Forcing people to have a credit counseling session just before they file for bankruptcy is like a doctor lecturing a patient about proper diet and exercise just before they are wheeled into the operating room for bypass surgery.

One final and very important point. Before the new bankruptcy law went into effect last year, I predicted that it would have no effect on debt negotiation and settlement. I’m happy to report that this has definitely been the case. Comparing settlement results for 2006 versus 2005, there has been no difference at all in the willingness of banks to settle. That’s because the bottom-line financial reasons for settlement are still in place. Simply put, it’s the “bird in the hand” philosophy, where it’s better to cut a financial loss with a known recovery amount than to risk recovering less or even nothing in the future.

Regular readers of this blog know that I often write about bogus “debt elimination programs.” I’m mainly referring here to those “legally walk away from your credit card debt” scams, where the perpetrators claim they have discovered a magic loophole that allows you to erase your debts. Supposedly, it’s all based on the theory that the banks “monetize” your signature when you apply for a credit card, so you’re really borrowing your own “money” when you use that little plastic credit card. I’ve written extensively on why this scheme does not work – so I won’t repeat that discussion here. See my earlier blog posts on this subject. What I want to focus on today is how to convince a potential victim of this scam that they are about to be ripped off.

As an industry expert who counsels debt-strapped consumers on a daily basis, one of the most frustrating situations for me is when I’m speaking with someone who believes in this “debt elimination” system. It’s almost as though they have joined a cult. Really, the depth of belief in the “evils of our monetary system” can be that strong. I have tried to use simple logic to dissuade people from using these programs, with mixed results. The problem is that many consumers desperately WANT to believe the smoke-and-mirrors nonsense is really true.

So I’ve finally hit upon a way of getting my point across. I’ll share it with you in this post, in the hopes that if you have a family member, friend, or loved one who is about to fall for this scam, maybe you can get them to see the light using this approach.

The key is to focus on how the fees get paid. These debt scams cost plenty. The con artists used to be content with “only” $2,500 in fees, but nowadays they often charge $5,000 or more, and I’ve talked with people who have lost more than $10,000 in this scam. So where does the money come from to pay those enormous fees when people are already struggling to pay their bills? Surprise, surprise. The sales agent gets the victim to TAKE A CASH ADVANCE on any open credit card account that still has unused credit! If the victim-to-be is maxed out on their credit cards, but still has a decent credit score, they encourage the person to OPEN A NEW CREDIT CARD ACCOUNT just to get the cash to pay off their huge fee. They tell the consumer they can do this without intending to pay the money back. Folks, this is FRAUD, pure and simple. There is no other word for such a sleazy technique.

So as I was politely debating this subject with someone who kept trying to convince me of the validity of this debt elimination approach, I asked a simple question that changed everything. It went something like this: “OK, let me see if I have this right. The person trying to sign you up says that credit card banks are operating illegally, and that there is no real money changing hands when you borrow against a credit card. So why do they want you to use this flawed and illegal credit card system to pay their fee? If that isn’t REAL MONEY, why do THEY want some of that funny money from YOU?”

Major light bulb effect. The person immediately understood that they were being conned. And that’s the gist of it, really. Most of the scam promoters crow about how they are “revealing the truth” to the American consumer, offering “freedom from debt slavery,” and so forth. It’s all bunk. If their true mission was really to help the consumer, why the giant fees? If money borrowed against a credit card isn’t real money, why do they want some of it? This shows the utter hypocrisy of these people. They whine about what a flawed financial system we have, and how the banks operate illegally, but they want the victims to pay their fees using that same “non-existent” money. If the promoters were true to their fine words, they would offer their services on a barter basis, or ask for payment in gold coins (i.e., “real” money). But no, they are quite happy with electronic currency. That’s because it IS real money, and they can pay their own bills with it just fine!

The United States Government Accountability Office (GAO) has issued a report that examines the interest rates, fees, and penalties of major credit card issuers. The title summarizes the conclusion of the report, “Credit Cards: Increased Complexity in Rates and Fees Heightens Need for More Effective Disclosures to Consumers.” The basic finding of the report is that the average consumer does not understand the interest rates and fees associated with their credit card account, and the disclosure statements issued to consumers are part of the problem.

Here are some interesting facts from the GAO report:

1. The number of credit cards in circulation in the U.S. is nearly 700 million.

2. Between 1980 and 2005, the amount that U.S. consumers charged to their cards grew from an estimated $69 billion per year to more than $1.8 trillion annually.

3. The increased use of credit cards has contributed to an expansion in household debt, which grew from $59 billion in 1980 to roughly $830 billion by the end of 2005.

4. In 2005, about 80 percent of the active credit card accounts (for the top six issuers) were assessed interest rates of less than 20 percent — with more than 40 percent having rates of 15 percent or less.

5. In 2005, 35 percent of the active credit card accounts (for the top six issuers) were assessed late fees and 13 percent were assessed over-limit fees.

6. The disclosure statements issued to consumers were found to have “serious weaknesses that likely reduced consumers’ ability to understand the costs of using credit cards.” The disclosures were found to be difficult to read — with large blocks of text in small font sizes — and poorly organized.

7. Late fees have climbed at a rate which greatly outpaces normal inflation, from $12.83 in 1995 to $33.64 in 2005, an increase of over 160 percent. A similar sharp rise also occurred for over-limit penalties.

While the report touches briefly on the effect of high default interest rates and penalties on the increase in consumer bankruptcy filings, it fails to reach any definitive conclusion in this area. “Some critics of the credit card industry have cited penalty interest and fees as leading to increased financial distress; however, no comprehensive data existed to determine the extent to which these charges were contributing to consumer bankruptcies.”

Sorry, but in my book, ‘absence of evidence’ is not the same thing as ‘evidence of absence’. On a daily basis, I talk to distressed debtors who have literally been pushed over the edge of a financial cliff by abusive interest rates and penalties. Consumers on a tight budget limp along from one month to the next, making the minimum payments. And then something happens to cause them to miss a payment here or there. All of a sudden their 9.9% interest rate jumps to 32%, and $39 late fees get tacked on. In many cases, this is the straw that breaks the camel’s back, leaving the consumer with no choice but to consider bankruptcy or debt settlement.

The report makes recommendations for improving the disclosure statements issued by the credit card banks. As it stands now, you practically need an electron microscope to read the fine print, and it’s nearly impossible to stay awake while reading the turgid legal text to get to the important information. Too much emphasis, the report says, is given to the initial interest rates, and not enough to what happens in the event of default. The report recommends that disclosure statements be revised to emphasize which consumer actions or behaviors will lead to penalty interest rates or additional fees. This will help, but it’s not enough. I think we also need to add a warning like they have on cigarette packs: “WARNING: Use of this product may be hazardous to your long-term financial health.”

There have been several interesting developments recently in the debt industry:

1. A large debt settlement company in California was targeted by the Federal Trade Commission and put under receivership, and the principal owner’s personal assets were frozen pending litigation by the government. A federal judge has granted the FTC a temporary restraining order against Homeland Financial Services and four other companies. (The multiple companies were really all part of the same operation.) As with most FTC press releases that pertain to debt settlement companies, it’s quite clear that the government doesn’t have a clue as to what debt settlement is really all about. However, in the case of this particular operation, it does appear that the enforcement action was warranted. Homeland Financial had generated hundreds of unresolved complaints with the Better Business Bureau. Most of the complaints related to the company’s reluctance to refund fee money to unsatisfied customers. This is a clear indication of arrogance and/or incompetence on the part of the owners or executives. It’s also a strong indication that the company’s representatives failed to properly explain the program to prospective clients. Complaints happen when people feel cheated, and when they don’t understand what they are signing up for. Since debt settlement is an alternative to bankruptcy, it has both positive and negative aspects. Unfortunately, it’s too easy for a sales rep to focus on the good features, and to downplay or omit discussion of anything negative. A company that endorses such a marketing approach is just asking for trouble. It’s unfortunate that the bad actors reflect poorly on the good players in the industry, many of whom are really working hard to adhere to rigid standards for business practices. I recently attended a trade conference hosted by TASC (The Association of Settlement Companies), where clear standards were one of the key topics of discussion. It’s too bad the folks at Homeland Financial ignored the need for standards, as well as participation in a trade association that’s working hard to clean up the industry.

2. In the wake of the recent 4-part series in the Boston Globe that exposed the underbelly of the Massachusetts collection industry, two of the collection companies cited in the series have closed operations in Massachusetts rather than go through the state licensing process. Boo-hoo. The bad guys had to leave town. Score one for the little guy. It’s great to see a serious piece of journalism actually accomplish a result like this. Hundreds of other collection agencies have been sent notices by Massachusetts authorities to get licensed or cease operations. Let’s hope major newspapers in other states catch on and start doing investigations of their own.

3. Congress passed, and President Bush is expected to sign, the Financial Services Regulatory Relief bill, which includes clarifications to the Fair Debt Collection Practices Act. Most of the updates deal with technicalities, such as the language of the “mini-Miranda” warning (“this is an attempt to collect a debt,” etc.), the rules regarding collection activity within the initial 30-day dispute period (collection activity is ok in the absence of a known dispute by the consumer), and whether or not certain forms of communication (privacy notices, 1099-C forms, etc.) constitute debt collection attempts. One of the most important provisions of the bill is the exemption of certain bad check collection firms will not be regulated as debt collectors under the FDCPA. (This is an incredibly bad idea. See my blog post of May 4, 2006 for further info on this point.) Naturally, there was nothing in the bill that benefited consumers in any way.

In a follow-up to a recent 4-part series on debt collection insanity in Massachusetts (see my blog entry for August 10, 2006), the Boston Globe has published a new article, “Debt Collectors Hunt the Innocent.”

The focus of this latest article is on the growing problem of collection agencies targeting the wrong person. As the debt purchasing industry grows, the sloppiness and ineffiency of the system becomes increasingly apparent. The article provides several examples of relentless collection activity against the wrong consumer, people who truly did not owe the debts in question. Mistaken identity does not seem to matter in this industry. With incorrect or incomplete information on debtors, collectors simply target any person with the same name without being certain they are dunning the correct person.

The message is loud and clear: Don’t think you are safe from the debt collection machine just because you pay your bills on time! If your name happens to be similar to someone who has skipped out on their bills, you too may be on the receiving end of such aggressive and misplaced collection activity. It’s probably true to state that such cases of mistaken identity are the exception rather than the rule. However, that is small comfort to those individuals on the receiving end of intense collection pressure on someone else’s bills!

You might expect a serious response to this article from the folks who speak on behalf of the collection industry. You would be wrong. The editorial response was even more pointless, arrogant, and unbelievably condescending in tone than the earlier one in response to the original 4-part series. The editor actually refers to the Globe series as a “jihad” against the collection industry. What an unbelievably cheap shot. If this is the best response the experts can manage, it’s small wonder that the debt collection industry is viewed with outrage and deep suspicion by the average consumer.

As I’ve stated before, the collection industry serves a legitimate function in our economy and creditors have a right to collect on delinquent debts. But the practice of debt purchasing clearly needs some regulatory attention.

The Federal Trade Commission and the Board of Governors of the Federal Reserve System have released their joint “Report to Congress on the Fair Credit Reporting Act Dispute Process.” The report makes for some pretty dry reading, even for someone like me who’s really into this stuff. But there are also some fascinating tidbits of information, and if you know anything at all about “credit repair” there is some useful material in the report as well.

When “the FACT Act” (Fair and Accurate Credit Transactions Act of 2003) was passed as an update to the FCRA (Fair Credit Reporting Act), one of the provisions was for this report to be provided by the FTC and Fed to Congress. Largely a paper exercise, the overarching conclusion of the report “…finds that, although the materials that the FTC and the Board reviewed indicated that most disputes seem to be processed within the statutory time frame, there is disagreement as to the adequacy of the CRAs’ and furnishers’ investigations.”

Translation: The credit reporting agencies (CRAs) do a good job of keeping the paperwork moving, so that disputes are responded to in a timely manner, but very little actual “investigating” is taking place in response to the disputes.

Some interesting facts: The three major CRAs (Experian, TransUnion, and Equifax) collectively manage data on 1.5 billion credit accounts spread over 210 million individual credit files, with more than 4 billion information updates hitting the bureaus on a monthly basis from more than 30,000 creditors (called “furnishers” in the report). That’s a mountain of data to keep under control, so it’s no wonder the system is rife with errors.

Ever wondered how public record items (such as bankruptcies, judgments, liens, etc.) get on your credit report? Many people think that the court system reports this information directly to the CRAs. Not so. “Because some public record information is accessible only by visiting courthouses and other government buildings in person, the repositories sometimes hire contractors to gather the information.” This leads to an important question. When you dispute a derogatory item on your credit report that stems from a matter of public record, does the CRA send one of their “contractors” back to the courthouse to verify the entry? This seems highly unlikely, given the cost and time constraints involved, although the report does not directly address this issue. This makes me wonder how the CRAs verify disputes at all when public records are involved.

Since this report was intended to specifically address the dispute process, it goes into great detail on the mechanics of that process:

Step A: Consumer Reviews Consumer Report and Conveys Dispute to CRA

In 2003, 57.4 million consumers were issued their credit reports. Of those 57.4 million reports issued, consumers entered disputes 21.8% of the time. So already we can see that 1 out of 5 reports were perceived by consumers to contain errors in need of correction.

Step B: CRA Processes Dispute

Here’s where it gets interesting. The CRAs have 30 days to investigate the dispute, and they are supposed to consider all relevant information supplied by the consumer. However, in a joint letter by numerous well-known consumer rights organizations, it is “asserted that CRAs fail to conduct meaningful reinvestigations and merely ‘parrot’ information received from furnishers as ‘verified’, without independently investigating the accuracy and completeness of such information.”

Step C: CRA Forwards Dispute to Furnisher

The credit reporting agency then supposedly provides notice of dispute to the company that furnished the credit data within five business days of receipt of the dispute.

Step D: Furnisher Investigates and Sends Response to CRA

This is where the system is truly broken. The law says that the furnisher is supposed to actually conduct an investigation in response to the dispute. So what constitutes an investigation? According to the watch-dog consumer groups, “furnishers are simply not conducting meaningful reinvestigations; they do not train their employees on effective reinvestigation procedures; and they repeatedly default simply to verifying the existence of an account.” In plainer language, when the original creditor gets a dispute notice from a CRA, they have some low-paid clerk verify that an account exists with the consumer. Then they respond to the CRA and say, “Yes, this person owes us money. Verified as reported.” And the CRA leaves it at that. This can be extremely frustrating to the consumer who has a bonafide dispute regarding a negative credit entry.

Step E: CRA Communicates Reinvestigation Results to Consumer

In one government study, of the consumers who filed disputes, 69% reported that the disputed information had been removed from their credit files. That’s pretty good odds in favor of the consumer who takes action to dispute the inaccurate junk on their credit report. Another interesting tidbit is that TransUnion reported that about 5% of disputes were repeats, where the consumer simply repeated the dispute with no new information. If you’ve ever looked at what credit repair companies do, it’s easy to spot their footprints here. (Credit repair outfits simply keep repeating the dispute process over and over again.) How likely is it for a consumer to simply repeat a dispute without providing new information? Not very likely in my view. So although this is a very rough approximation, this points to at least 5% of disputes as coming from credit repair companies. The actual figure is probably much higher, since the 5% only takes into account repeat disputes, and not the ones that succeed in getting the item deleted on the first pass.

Step F: Consumer Disputes Information Directly to Furnisher

This has been another weak link in the chain, but the FACT Act will require credit furnishers to investigate disputes conveyed to them directly by consumers, and it will be illegal for furnishers to report information they have determined to be inaccurate.

Although this report does not break any new ground or even recommend any specific actions, it provides a fascinating look at the tug-of-war going on between consumer protection groups and the financial industry. The bottom line is that the creditors and the CRAs don’t want the burden of having to properly investigate disputes, to the extent of providing supporting documentation. Meanwhile, the consumer groups continue to criticize the flaws in the current process. Both sides look to improvements that will come into force under the FACT Act as it modifies the FCRA, but it remains to be seen whether or not enforcement of the new rules will occur at a sufficient pace to ensure compliance.