Bankruptcy Reform and The Impact on Consumer Credit Reports and Credit Scoring

The Current Status of the Bankruptcy Bill

On March 10, 2005, the Senate voted 74-25 in favor of a bill designed to reform bankruptcy. On April 14, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 passed the House 302-126. The bill is now making its way to The White House, where President Bush is expected to sign it into law. It is expected to take full effect soon thereafter.

While the merits of the bill have been and will continue to be debated, its effects are clear. Consumers who would have filed for debt relief in a Chapter 7 bankruptcy in the past will now have a much more difficult time doing so. Essentially, if your income is greater than the state median income, your motion to file Chapter 7 will be dismissed and you will be placed in a Chapter 13 repayment plan of five years. The new bill will result in more people having to file Chapter 13 bankruptcies, as opposed to Chapter 7.

The differences between the two bankruptcies are as follows:

• Chapter 7 Bankruptcy – A Chapter 7 bankruptcy essentially dissolves all debts that legally qualify for dissolution. It’s safe to say that many, if not all, debts incurred prior to filing a Chapter 7 are discharged. A discharge, when referred to in the context of bankruptcy, is when all personal debt liability is erased. In other words, the consumer is no longer required to pay off unpaid credit accounts.
• Chapter 13 Bankruptcy – A Chapter 13 bankruptcy is different from a Chapter 7 in that the consumer must pay off his debts over time. This option, mostly reserved for consumers who have a steady income, allows creditors to recover a portion of the money they are owed. Unfortunately, a significant percentage of the consumers who originally file a Chapter 13 are unable to continue to make their payments and will eventually convert into a Chapter 7.

The purpose of this article is not to argue the merits of the existing or proposed bankruptcy bills. Its purpose is to investigate the impact on consumer credit reports and credit scoring models.

Credit Scoring Models

Credit scores have been used as part of credit underwriting for nearly two decades. The most common type of credit scoring model is the credit bureau risk score. The scoring models reside at each of the three credit bureaus (also known as credit reporting agencies): Equifax, Experian and TransUnion. These models are used to score credit files that are delivered to lenders when a consumer applies for credit. Each of us has three credit scores that coincide with each of our three credit reports.

All credit scores have one thing in common: they read the data from your credit reports and predict your future credit performance. The scores indicate how likely you are to pay back your bills in a timely manner. Credit scoring models use complex algorithms to assign you points based on several different categories of criteria. These models are extraordinarily good at predicting what kind of credit risk you pose to potential lenders.

Likely Effect of Mandatory Credit Counseling on Credit Reports and Credit Scores

As part of the new law, consumers will be required to receive credit counseling from an approved nonprofit credit counseling agency. This counseling must occur within 180 days prior to filing for bankruptcy. The counseling that consumers will receive is not a Debt Management Plan (commonly referred to as a DMP), which is the core competency of credit counseling agencies. The counseling will likely be a group setting where consumers will learn about alternatives to bankruptcy and how to improve credit management skills. As such, it will have no direct impact on consumers’ credit reports or credit scores.

If, however, the consumer does enter into a debt management plan with an approved credit counseling agency, this action will be filed with the court and will eventually show up on a consumer’s three credit reports. This is still not likely to have an impact on the consumer’s credit score. Here’s why…

Several years ago, Fair Isaac, the company that created credit scoring, made a significant change to their credit scoring models. They reprogrammed the models so that enrolling in a debt management plan would not hurt a consumer’s credit scores in any way. The decision to do this was very much in the consumer’s favor. At one time, enrolling in a debt management plan had the same negative impact on credit scores as filing for bankruptcy. The change in the credit scoring models was fortuitous with respect to the credit counseling requirement of the bankruptcy bill. Today, consumers are not harmed by attending counseling sessions or by signing up for a debt management plan.

Likely Effect of the Bankruptcy Bill on Credit Reports

Both Chapter 7 and Chapter 13 bankruptcies will eventually show up on your three credit reports. Unlike the lending industry, which proactively reports its information to the three credit bureaus, bankruptcy data arrives differently. Courthouses and attorneys do not report the fact that you filed for bankruptcy. The credit bureaus have to hire companies to go to the courthouses and retrieve this public information. These companies are called Public Record Vendors. These vendors are also used to verify other public record information, such as liens and judgments, in the event that the consumer disputes the accuracy of the data as it appears on their credit reports.

The new bill will not effect whether or not a bankruptcy appears on your credit reports. However, it will most certainly affect how and how long the bankruptcy appears. Here is some background…

• Chapter 7 Bankruptcy – A Chapter 7 bankruptcy will remain on your credit files for no longer than ten years from the date it was filed. The accounts that are discharged as part of the bankruptcy will be removed no later than seven years after their activity ceases. Therefore, the accounts included in Chapter 7 bankruptcy will be long gone by the time the bankruptcy filing is removed.
• Chapter 13 Bankruptcy – A Chapter 13 bankruptcy will remain on your credit file no longer than seven years from the date of discharge or no longer than ten years from the date filed if it has not been discharged. This is important because it could take up to five years for the discharge to occur. As such, most Chapter 13 bankruptcies will stay on your credit file for ten years, unless you can expedite the discharge process. As with Chapter 7 bankruptcies, the accounts that are discharged as part of the bankruptcy will be removed no later than seven years after their activity ceases.

Consumers who wish to file for Chapter 7 will now need to prove that they are eligible to do so. This test will be based largely on a complex formula that determines your eligibility for Chapter 7 protection. Any of your creditors can dispute your request for Chapter 7 and can move that the request be denied in lieu of a five-year repayment plan under a Chapter 13 bankruptcy. Your income must be less than your state’s median income or you will have a hard time qualifying for a Chapter 7.

The obvious impact on credit reports is that more consumers will have to file for Chapter 13 rather than Chapter 7. As such, your creditors will continue to receive a partial payment from you each month, as opposed to nothing at all.

Likely Effect of the Bankruptcy Bill on Credit Scores

Any empirical study on this matter will likely involve tens of thousands of credit file records with some sort of simulated pre- and post-reform comparison. This collective, or aggregate-level, comparison will likely result in a negligible impact on a consumer’s credit scores. Aggregate-level comparisons have become so common that nobody really questions the methods for measuring the impact of controversial changes to consumer credit. For example…

• Credit Limit Suppression – Several years ago, a disturbing trend began where credit card issuers decided to withhold their customer’s credit limit from their credit reports. This was done in an effort to hide a customer’s true value to competing credit card companies. This practice spread like wildfire, and within six months it reached epic proportions as all the major credit card issuers began withholding credit limit data.
  
  The credit limit is a key component in credit scoring models. It gives them a way to calculate a consumer’s revolving utilization. Without this amount, the credit-scoring model could accidentally penalize a consumer’s credit score.
  
  Several studies were commissioned to measure the impact of this suppression trend. The results were shown at the aggregate level. While the impact on the population as a whole was shown as minimal, the reality is that at the individual level some consumer’s scores dropped by so many points that they failed to qualify for loans.
  
  This trend quietly corrected itself when executives from the credit reporting industry threatened to cut off access to valuable consumer credit information to any credit card issuer who chose to withhold credit limit data. There are, however, a few issuers who chose to continue to withhold credit limit data.
  


• The American Express Change from Open to Revolving – Several years ago, American Express changed how they reported their no credit limit accounts to the credit reporting agencies. For years, these account reported as open accounts. This allowed their credit cards to bypass important credit scoring characteristics. When they changed their accounts to report as revolving accounts, consumers were at risk of lower credit scores because of new revolving balances and misrepresented credit limits.
  
  In this case, a study designed to measure the impact of this new practice on a consumer’s credit score showed that the impact of this reporting change was negligible at the aggregate level. However, at the individual level some consumer’s scores dropped significantly.

The truth of the matter is that the bill will have no immediate impact on the consumer’s credit scores. Wait…read on. More people will file Chapter 13 than Chapter 7, but that doesn’t increase or decrease the impact on a consumer’s credit score. A Chapter 13 is just as bad as a Chapter 7, so there won’t be any situations where a consumer’s score was higher or lower because of the act of filing bankruptcy. Having said that, the byproduct of more Chapter 13 filings will be nothing short of disastrous for the consumer’s ability to reestablish credit at decent interest rates. This impact won’t be felt until several years after the bill has been in place.

Consumers who file for bankruptcy do so for various reasons ranging from medical costs, loss of job, death in family, divorce, or poor credit management. The credit reports of those who have filed look like a battlefield littered with late payments, collections, and judgments. The credit reports and credit scores of these people likely went through an excruciating process that looked somewhat like this…

Decent Credit Scores

Low Credit Usage

Higher Credit Usage

Missing Payments

Serious Delinquencies

Collections

Judgments

Bankruptcy

Very Low Credit Scores

The good news for consumers who filed for bankruptcy was that rebuilding their credit reports and scores was possible. As long as a consumer could reestablish credit and pay their bills on time, their scores increased significantly within a few years time. There were also plenty of reputable lenders who would do business with a bankrupt consumer because they realized that these people were now free of all of their debts. They also knew that most consumers who filed did so for reasons other than poor credit management skills, still making them good credit risks.

The new bill will change all of this. Consumers will still be saddled with their debts, and those lenders who had programs for bankrupt consumers will likely sit on the sidelines until consumers have paid well through their Chapter 13 bankruptcy. This will take up to five years in most cases, thus delaying the consumer’s ability to rebuild their credit and credit scores quickly. They will be forced to pay higher rates, or face outright declination for years. And there’s nothing they can do about it. All told, the new bankruptcy reform bill is a huge win for credit grantors and a huge loss for the vast majority of consumers who file for bankruptcy protection.