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Stricter Bankruptcy Laws Holding Back Economic Recovery

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IRONY ALERT!
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It's one of the great ironies facing lawmakers: the bankruptcy reform that went into effect in 2005 is now holding back the recovery, even as insolvent banks benefit from fast and loose bailout policies.

Back in 2004 and 2005, banks lobbied hard for bankruptcy reform, pressing lawmakers to enact a legislation that would make it much harder for individuals to qualify for Chapter 7 bankruptcy. Under Chapter 7, individuals are allowed to wipe out virtually all of their debt and start over.  The reform pushed the majority of filers into Chapter 13, under which some debt is canceled, some assets are liquidated but much of the debt is restructured and placed on a five-year payment plan. The reform created a wave of fresh bankruptcy filings as individuals raced to file just ahead of the Oct. 17, 2005 deadline. (See chart via Bloomberg below).



As expected, the reform made it far more difficult for individuals to file for Chapter 7 bankruptcy, and because the cost of Chapter 13 bankruptcy remains severe, the relief in many cases hardly worth the effort, individuals are choosing to muddle through, many opting to go with for-profit debt negotiators rather than file for Chapter 13.

Fast forward five years and bankruptcy filings for individuals are similar to 2003 - 2004 levels, despite increasing joblessness, massive foreclosures, a real estate collapse, record consumer debt levels and the most intense recession in decades.

According to a piece on Bloomberg this morning by Ellen Beeson Zentner, Senior U.S.Macro Economist for Bank of Toyko-Mitsubishi UFJ Ltd., it's likely that the timing of the change in the law may be affecting filing levels. Under the new law, anyone who has filed for Chapter 7 must wait eight years to do so again, and four years to file for Chapter 13. "The surge in filings prior to the change in the law may thus be affecting the timing and type of consumer bankruptcy filings," Zentner wrote. "This timing also may
mean that with economic growth expected to remain weak in 2011, another surge in bankruptcies is likely next year."

OK, so how does this slow down a recovery? Simple, according to Zentner. "The faster an indebted household can wipe out its financial obligations, the faster it can get back to spending, and the return of robust consumer spending is the missing link in today’s nascent recovery."
POSITION:  No positions in stocks mentioned.

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