Last summer, Prof. Robert M. Lawless of the University of Missouri-Columbia published an excellent paper on the relationship between non-business bankruptcy filings and consumer debt load, including mortgages, titled The Relationship Between Non-business Bankruptcy Filings and Various Basic Measures of Consumer Debt (http://wwww.law.missouri.edu/lawless/bus_bkr/filings.htm).

Available data suggests that the current trend of increasing bankruptcies each year will not only continue but may accelerate. The last decade's economic boom may be followed by a consumer bust. The comparative data compiled in the tables at the end of this article should alarm the American populace, especially politicians and economists. It also echoes the concerns voiced by Sullivan, Warren and Westbrook in The Fragile Middle Class: Americans in Debt (Yale University Press 2000), and the conclusions reached by Prof. Lawless. Given the increased debt load incurred by the middle class, an acute lack of liquid reserves and a recessionary period, one of the hiccups in life that contribute to financial collapse—unemployment or underemployment—is a very real threat.

First, it is acknowledged that the analysis presented is not exactly scientific. The data was derived from different sources, and the data from one source was used for comparative purposes with data from another source. For example, in determining "average" household debt, the number of households was derived from the Bureau of the Census, while debt data were derived from the Federal Reserve. Whether Census households actually equate to total borrowers is problematic because the demographic bases differ. Thus, the "average" household debt used for each year may or may not be accurate. However, these inaccuracies should not detract from the basic premise of this article. The purpose of this article is to show a trend, and the source of data for each year was consistent throughout; therefore, any errors or inaccuracies are the same for each year used.

The "red flags" emanating from the 20-year comparative data compiled are as follows:²

1. Increasing consumer revolving debt from less than 16 percent to more than 42 percent of total consumer debt (a factor of 2.7). (Table 1)
2. Increasing consumer revolving debt, as a percentage of median household income, from less than 2 percent to nearly 15 percent (a factor of 7.8). (Table 2)
3. Increasing total consumer debt, as a percentage of median household income, from 12 percent to nearly 35 percent (a factor of 2.9). (Table 3)
4. Increasing home equity loans to nearly 13 percent of total mortgage loans.³ (Table 4)
5. Increasing mortgage debt, as a percentage of median household (homeowner) income, from 50 percent to 110 percent (a factor of 3.2). (Table 5)
6. Increasing total household (homeowner) debt, as a percentage of median household income, from 62 percent to 198 percent (a factor of 3.2). (Table 6)
7. Increasing total household (non-homeowner) debt, as a percentage of median household income, from 19 percent to 62 percent (a factor of 3.2). (Table 7)
8. Increasing non-business bankruptcies per 1,000 census households from 3.49 to 11.44 (a factor of 3.3). (Table 8)

Most troubling is the increase in consumer revolving debt in relation to total consumer debt, and home equity loans in relation to total mortgage debt. Between 1980 and 2000, revolving consumer debt in relation to median family income increased from 1.89 percent to 14.79 percent—nearly an eightfold increase. By the end of 2000, for the two-thirds of Americans who own their own homes, revolving consumer debt and home equity loans combined had increased to a staggering 35.64 percent of median annual income.⁴ During this period, not only were consumers going further into debt, apparently a significant part of the debt increase was incurred for consumables, not durable goods. Using debt to acquire consumables is analogous to buying a cake, eating it now and paying for it later. On the other hand, acquiring durables is like buying a cake now and eating it as you pay for it. In the former, the cake is consumed before it is paid for, and in the latter the cake is paid for as it is consumed. The problem stems from the fact that when one again desires cake, one must also acquire it on credit, but the first cake is not fully paid for—increasing revolving debt.

My hypothesis is that the current recessionary trend and earlier marked increase in revolving debt will cause an acceleration in the rate of bankruptcy filings: Not only will filings continue to increase, but the increases will occur at a faster rate. But the increase in revolving debt is not the only red flag. Relying on that factor alone would indicate that if consumer revolving debt were to remain static, the rate at which bankruptcy filings increase would likewise remain relatively static. Third-quarter Federal Reserve data indicate that the amount of revolving debt, having hit a high of $699.7 billion at the end of the second quarter 2001, dropped in the third quarter to $692.7 billion. Thus, if one relied on that factor alone, it would indicate a deceleration in the rate of increase in filings, not an acceleration. Although it may delay the acceleration and we may even see a temporary, short-term deceleration, I believe that in the long-run that will not be the case.

We need to examine the third quarter closer. During the same quarter, total consumer debt increased from $1,616.3 to $1,621.6 billion. Although revolving debt decreased $7 billion, non-revolving debt increased $12.3 billion. This indicates that credit purchases during the third quarter shifted from consumables to durables (probably due in large measure to automobile industry incentives that led to unprecedented sales of new automobiles). In addition, residential mortgage debt increased from $5,171.3 to $5,305.9 billion, of which home equity loans increased from $669.9 to $689.7 billion.⁵ Thus, in the third quarter, total household debt increased $139.9 billion.⁶

Before jumping to any conclusions, we need to look closer at the third-quarter home mortgage debt structure. In the third quarter, mortgage debt, exclusive of home equity loans, increased to $114.8 billion. To what was this attributable? It cannot all be attributed to home sales. Mortgage debt, exclusive of home equity loans, increased $190.4 billion in the first two quarters of 2001 combined. Yet sales of new and existing housing units for the first two quarters combined were more than double that of the third quarter (12.5 million units to 6.1 million units).⁷ The most logical explanation for the disproportionate increase in this component is refinancing to take advantage of lower interest rates. However, in so doing, as much as $20 billion in the equity in the homes refinanced may have been tapped and used to reduce revolving (credit card) debt. This may account, in part, for the unprecedented decrease in revolving debt. The other factor that no doubt contributed to the decline in consumer revolving debt is the record number of bankruptcies filed in FY01; charge-offs as uncollectible balances discharged in bankruptcy necessarily impacted outstanding balances.⁸

The data appear to indicate that through the second quarter of 2001, American consumers continued reducing the rate of increase in consumer debt (a trend that started around the second quarter of 2000). However, in the third quarter, we see strong indications of what has historically happened in recessionary periods: debt refinancing or restructuring. Middle-class consumers apparently started this process by tapping into home equities, taking advantage of both lower interest rates and the previously unrealized appreciated equity, using the proceeds in part to reduce revolving debt. Although in the short-run at least, debt service is lowered, debt load has not only not decreased, it continues to increase. Although it is too early to tell if the third quarter was an aberration or the start of a new trend, the data do indicate a probable restructuring or consolidation of debt that may delay, but certainly will not prevent, for many, the inevitable financial collapse.

The problem is exacerbated by the fact that it is far too late to innoculate against the disease, and the cure may be such that we are faced with a situation where the operation is a success but the patient nonetheless dies. To restore household economic equilibrium, a marked reduction in consumer debt is required. To reduce consumer debt, it is necessary to reduce spending. Therein lies a real problem: The American economy is driven primarily by consumer spending, and during the past 20 years consumer spending has, in turn, been supported by consumer borrowing.⁹ The American economy has been essentially a bubble or, perhaps, as Federal Reserve Chairman Alan Greenspan not too long ago characterized the stock market, based on "irrational exuberance."

If each consumer spent $10 of which $2 was borrowed, to reduce consumer debt by $10 the consumer must reduce spending by $12. Looking at the third quarter 2001 illustrates the existence of the problem. Consumer debt increased by $5.3 billion dollars, yet the economy was not exactly robust.¹⁰ Imagine the impact if consumers had not borrowed $5.3 billion but instead repaid $5.3 billion,¹¹ thereby reducing consumer spending by $10.6 billion. Indeed, fear that the consumer will cease spending (and borrowing) has politicians and economists trembling. If you doubt that statement, just consider the actions of the Federal Reserve during 2001: unprecedented interest rate reductions intended to encourage borrowing to prevent the recession from deepening and to expedite recovery. The 2001 tax act, titled in part "Economic Growth," was enacted in the hope that the American taxpayer/consumer would spend more for the same end.

For the past 20 years the middle class has been literally spending the future, increasing debt and betting on an ever-increasing income stream to continue the same lifestyle. They have been essentially spending unrealized or "paper" wealth, e.g., home equities and stock market investments, either directly through mutual funds or 401k plans. The past 18 months have devastated many stock market investments, and the past six months have seen layoffs and cutbacks in the employment market. Many middle class families are two-earner families, living at a level commensurate with the combined income. When that income drops, whether as a result of a layoff of one earner or simply a significant reduction in the income of one or both, the family can no longer continue to service debt and maintain their accustomed lifestyle. Thus, some are forced to resort to tapping home equities in an attempt to balance the budget. Unfortunately, a large percentage of these families suffer from what a bankruptcy judge before whom I appear regularly aptly terms "terminal optimism." It is human nature to be optimistic about the future. Couple that with human frailty—an inability to cease using "plastic" after debt consolidation using a home equity loan—and, as a consequence, the cutbacks in lifestyle, even to the extent they can be made, are not made until it is too late. Some even use credit cards to finance daily necessities, including medical bills, and use cash advances from one card to make payments on others. The result: bankruptcy.

But are consumers in a catch-22 situation? If consumers reduce spending significantly in order to reduce debt, the economy "tanks," reducing the income-generating capacity of the consumer to the point where sustenance and remaining debt service can not both be maintained. On the other hand, for many middle class consumers, failing to reduce consumer debt coupled with the inevitable occurrence of one of life's hiccups, maintenance of sustenance and debt service will also become impossible. In either case, if the consumer cannot repay debt, the only avenues for elimination are liquidation and/or discharge in bankruptcy. Thus, particularly when we consider the significant increase in mortgage debt compared to median income, an obligation that most, if not all, middle class people must give priority of payment to, we may have hit the point where bankruptcy becomes inevitable for a greater percentage of the middle class. Unless the Bureau of the Census and the Federal Reserve data are radically inaccurate, the increase in debt load during the past 20 years has far outstripped the increase in ability to pay. For millions of middle-class American families, sometime during the next five years the American dream may become a nightmare.

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Footnotes

¹ Thomas Yerbich is a private practitioner in Anchorage, Alaska, with 22 years of bankruptcy practice experience. He is vice-chair of ABI's Consumer Bankruptcy Committee and is board-certified in business and consumer bankruptcy law. Return to article

² As used in this article, "consumer debt" excludes mortgage debt and is divided into revolving and non-revolving, "mortgage debt" includes home equity loans, and "household debt" is consumer debt plus mortgage debt for homeowners and consumer debt plus one year median rental for non-homeowners. Return to article

³ No data are available for home equity loans in 1980. The first year this data were separately stated was for 1990. However, we know that home equity loans were not really a significant factor until the early to mid-80s. Consequently, the amount and, thus, the percentage of home equity loans in relation to total mortgage loans in 1980 was probably negligible. Return to article

⁴ Today it is almost considered "un-American" to live within one's means. Return to article

⁵ Increasing slightly to 13 percent of the total mortgage debt. Return to article

⁶ Compared to a combined increase of $388.2 billion in the first and second quarters. Return to article

⁷ As reported by U.S. Department of Housing and Urban Development, U.S. Housing Market Conditions Summary. Return to article

⁸ Because non-revolving consumer debt is more likely to be secured, it is less subject to charge-off in bankruptcy both as a result of the value of the collateral but also in the high percentage of reaffirmations that are executed by debtors seeking to retain automobiles and other hard goods or durables. Return to article

⁹ Total debt, consumer and home mortgage, increased by $4,765.6 billion between 1980 and 2000; an increase of 370 percent. Return to article

¹⁰ Compare this to the average 1997, 1998, 1999 $8 billion per-quarter increase in revolving debt, and $19 billion per quarter in total consumer debt. Return to article

¹¹ At the rate of $5.3 billion a quarter, it would take more than 75 years to repay the entire consumer debt without interest. Return to article

¹² Source: Federal Reserve. Series G.19 defines consumer credit as "most short and intermediate credit extended to individuals, excluding loans secured by real estate." Non-revolving credit "comprises automobile loans and all other loans not included in revolving credit, such as loans for mobile homes, trailers or vacations." By default, revolving credit is anything not included in the definition of non-revolving credit; presumptively, this includes credit cards.

¹³ Source of income and household data: Bureau of the Census. Household revolving debt is computed by dividing total revolving debt reported by Federal Reserve by number of households used by the Census Bureau.

¹⁴ Source of income and household data: Bureau of the Census. Household consumer debt is computed by dividing total consumer debt reported by Federal Reserve by number of households used by the Census Bureau.

¹⁵ Source: Federal Reserve.

¹⁶ Source of income and household data: Bureau of the Census. Household mortgage debt is computed by dividing total mortgage debt reported by Federal Reserve by number of households multiplied by the percentage of home ownership reported by the Census Bureau (1980 = 64.4 percent; 1990 = 64.2 percent; 2000 = 67.4 percent).

¹⁷ Source of income and household data: Bureau of the Census. Household total debt computed by dividing the sum of total consumer and mortgage debt reported by Federal Reserve by number of households used by the Census Bureau.

¹⁸ Source of income and rental data: Bureau of the Census. Rental is one year of median rental. Total debt is one year of rental plus the average consumer debt per household from Table 3.

¹⁹ Source: Administrative Office of the Courts. The number of filings data is the number of "non-business" filings reported during the year. For the purposes of this analysis, it has been assumed that these equate to "consumer" filings.