Yesterday, I noted the U.S. bankruptcy filing rate of 2.38 per 1,000 persons is at historic lows. The next question is always why. In this post, I am going to try to walk through an explanation in four graphs. The upshot is that consumer debt is low but rising. As I like to say, it takes years of study to come to the conclusion that people file bankruptcy because they are in debt. This is not to say that other factors are not contributors -- unemployment, general economic conditions -- but the primary macroeconomic driver of bankruptcy filings is the amount of debt on household balance sheets.
The first graph shows total U.S. consumer credit. The consumer credit data come from the Federal Reserve's G.19 data series on consumer credit. The Fed's definition of consumer credit includes nonrevolving debt like car loans and revolving debt like credit cards. These figures do not home mortgage debt, which the Fed tracks elsewhere but also that I have found not to be predictive of bankruptcy filing rates. Even over the time periods in the graph, it is important to account for population increases and inflation. I use population data from the U.S. Census and the Consumer Price Index from the Bureau of Labor Statistics. (And, for those who did not know that, there is your fun fact for the day: the BLS is the government entity that calculates the inflation rate.)
Thus, this first graph shows per capita consumer debt adjusted for inflation, not including mortgages. That figure currently stands at $11,471 per person -- every man, woman, and child -- in the United States. (It would be better to use the adult population as the base, but that additional complication makes data-gathering more difficult without increasing the accuracy of our conclusions.) As the graph clearly shows, after a small dip in the Great Recession total consumer credit has been climbing. That would suggest the opposite of what we have been seeing -- increasing bankruptcy filing rates.
But, the consumer credit figure includes student loans. Bankruptcy generally is much less effective in dealing with student-loan debt. Absent a difficult showing of "undue hardship," student loan debt is nondischargeable in bankruptcy. Student loan debt is now the largest component of consumer debt, more than credit cards, and has been for some time. Therefore, to get an accurate picture of how consumer debt levels are interacting with the bankruptcy system, we have to back out student loan debt from the amount of consumer credit. The second graph shows consumer credit without student loans, again on a per-capita, inflation-adjusted basis. Now, the dip in consumer borrowing becomes more pronounced. But, still since 2013, consumer credit minus student loans has been rising. Bankruptcy rates have been filing.
The third graph adds the bankruptcy filing rate to the second graph. The left-hand axis is the same as before with consumer credit minus student loans. On the right-hand side is the daily bankruptcy filing rate adjusted for population, as shown by the red line. This third graph demonstrates what we already suspected. The consumer credit graphs and the bankruptcy filing rate graphs do not appear to be following the same trends when laid on top of each other.
But, we also know that people do not file bankruptcy the moment they incur new household debt. If a borrower is on the brink of imminent bankruptcy, many avenues of consumer borrowing are foreclosed. In any event, only in the fevered dreams of neoclassical economists do massive numbers of people borrow money with the intention of strategically defaulting immediately.
How long does it take for the effects of household borrowing to show up in the bankruptcy courts. My previous research suggests two or three years. The last graph takes the midpoint -- ten calendar quarters or two-and-a-half years--and lags bankruptcy bankruptcy filings. It matches up the household borrowing of, for example, early 2006 with the bankruptcy filing rate in mid 2008. Now, the trendlines match up more closely. The scales are not the same on the both sides as the graphs are not intended to show the exact point estimates for the relationships but the general trends in the data.
I have said it many times on this blog: bankruptcy filing rates are about the amount of consumer debt. These graphs are yet another way to understand that relationship. And, because consumer debt has been rising, we should expect bankruptcy rates to follow in the coming years.
Using data from Epiq Systems, we appear to be on track for 774,000 bankruptcy filings for the 2017 calendar year. That would basically be the same rate of filings as in 2016 when total filings were just under 772,000. This calculation comes from a simple extrapolation. There were just under 400,000 bankruptcy filings for the first six months of this year. To get an estimate of what filings will be for the entire year, we cannot simply double the six-month figure because bankruptcy filings tend to be higher in the first part of a year. In the past two years, the first six calendar months have seen 51.6% of the total filings for the year. Thus, just under 400,000 filings for the first six months of a calendar year would imply about 774,000 filings for the entire year.
As the table to the right shows, bankruptcy filings will be flat this year after six years of decline. Bankruptcy filing rates remain at historic lows. The current bankruptcy filing rate is 2.38 per 1,000 persons. Ignoring the statistical gyrations around the passage of the 2005 bankruptcy law, we have to go back to the late 1980s to see filing rates this low. Even in those statistical gyrations -- when filers surged into the bankruptcy courts to beat the law's effective date and then new filings plummeted -- the 12-month average filing rate never fell below 1.97 per 1,000 persons.
Back in January, I predicted 767,000 bankruptcy filings for the year. My margin of error then would be less than 1.0%. I don't like to point that out just to show I was right . . . . OK, yes I do. But, there is also half the year left, and I am not right yet. Committing to reviewing one's forecasts hopefully makes them better in the first place. There will be a time when my forecast is wrong, but for now the model seems to be working.
The number eleven has a lot of significance in the bankruptcy world. The Bankruptcy Code is, of course, title 11 of the United States Code. There is chapter 11. And, within chapter 11, one can make the eleven-eleven election under section 1111 -- an election that is as difficult to explain in a bankruptcy classroom as it is to understand it.
The number eleven has new significance. Credit Slips launched on this date in 2006, making us eleven years old today. I hope that doesn't mean we have to repeat middle school.
Today the CFPB finalized the most important rulemaking it has undertaken to date. This rulemaking substantially restricts consumer financial service providers' ability to prevent consumer class actions by forcing consumers into individual arbitrations. I believe this is by far the most important rulemaking undertaken by the CFPB because it affects practices across the consumer finance space (other than mortgages, where arbitration clauses are already prohibited by statute).
Let's be clear--the issue has never really been about arbitration vs. judicial adjudication. It's always been about whether consumers could bring class actions. I don't want to rehash the merits of that here other than to say that the prevention of class actions is effectively a license for businesses with sticky consumer relationships to steal small amounts from a large number of people. For example, am I really going to change my banking relationship (and its direct deposit and automatic bill payment arrangements and convenient branch) over an illegal $15 overcharge? Rationally, no, I'll lump it, not least because I have no easy way of determining if another bank will do the same thing to me. In a world of profit-maximizing firms, we know what will happen next: I'll get hit with overcharges right up to my tolerance limit. Given that consumer finance is largely a business of lots of relatively small dollar transactions, it is tailor made for this problem. Class actions are imperfect procedurally, but they at least reduce the incentive for firms to treat their customers unfairly.
The financial services industry seems to be circling the wagons for a last ditch defense of arbitration. There appear to be three prongs to the defense strategy. First, there will be intense lobbying to get Congress to overturn the rulemaking under the Congressional Review Act. There's a limited window in which that can happen, however, and it will be an uncomfortable vote for members of Congress, particularly with the 2018 election looming. This one will be an albatross for them. Second, there's an effort afoot to have the Financial Stability Oversight Council veto the rulemaking. And finally, if the rule isn't quashed by Congress or the FSOC, there will assuredly be a litigation challenge to the rulemaking.
I want to focus on the FSOC veto strategy, which has just popped up in the news.The FSOC veto strategy is really a legal hail Mary. The FSOC is an eleven member body that includes the heads of all of the federal financial regulatory agencies and an insurance representative. It's chaired by the Treasury Secretary. For the FSOC to veto a CFPB rulemaking, an FSOC member agency must file a petition with the FSOC within 10 days of the publication of the rule in the Federal Register. The Treasury Secretary may then stay the rule for 90 days, and the FSOC must decide whether to veto before the expiry of the stay. That means there are 100 days after the publication of the rule in the Federal Register for the FSOC to potentially veto the rule.
In order to veto the rulemaking, there must be a 2/3 vote of the FSOC, so it will take 8 of 11 votes. At present 4 of the FSOC members are still Democratic appointees, plus the insurance representative. If one more seat flips within 100 days, then the override would require only votes of GOP appointees. That's quite possible given the end of terms for the FDIC and CFPB Director Cordray's own uncertain plans. So the votes may well be there for an FSOC veto.
But here's the thing. The FSOC veto is subject to some legal procedures and judicial review, and I don't think it has a chance in hell of surviving such review, although it would buy the industry some time (and the affect of an overturned veto on the Congressional Review Act timeline is currently unclear to me). Here are the most immediate problems I see for an FSOC veto. First, the petitioning agency must have "in good faith attempted to work with the Bureau to resolve concerns regarding the effect of the rule on the safety and soundness of the United States banking system or the stability of the financial system of the United States." Presumably the OCC would be the petitioning agency, but I could see the NCUA also joining the petition given its current leadership.
I don't think either agency can show that it has "in good faith attempted to work with the Bureau to resolve concerns regarding the effect of the rule on the safety and soundness of the United States banking system or the stability of the financial system of the United States". The arbitration rulemaking was proposed in 2016. The CFPB is required to consult with the prudential regulators during the rulemaking process. Have either the OCC or the NCUA in that time weighed in with concerns to the CFPB? Apparently the Acting Comptroller recently wrote to the CFPB to raise "safety and soundness" concerns he had with the rule; I'm not sure that such an 11th hour letter is a good faith attempt. Moreover, just saying the words "safety and soundness" concerns doesn't mean that they are actually good faith concerns. It's hard to claim with a straight face that limiting class actions jeopardizes "the safety and soundness of the United States banking system or the stability of the financial system of the United States". To make that claim is to admit that the US financial system would be unsound or destabilized without the ability to rip off consumers via small dollar malfeasance.
Now I'm sure that the argument can get gussied up with some story about how the plaintiffs' bar will extort good institutions right and left, but class action waivers are (1) relatively new, and the world operated just fine before them and (2) the US mortgage market hasn't been crippled without them and (3) a number of card issuers had dropped their class action waivers as part of a settlement and don't seem to have gone belly up as a result. I'm skeptical that the rule will result in higher costs for consumers, but even if it does, that's not in and of itself a threat to safety and soundness or financial stability. Critically, I believe that the CFPB (or potentially intervenors) could sue to block the FSOC from voting on the grounds that the petition was not in good faith.
But even if that good faith showing about the petition can be made, however, there is still the matter of the FSOC's vote itself. The FSOC doesn't just vote. Each member must first be authorized to vote. That requires the member to have "considered any relevant information provided by the agency submitting the petition and by the Bureau" and to have "made an official determination, at a public meeting where applicable, that the regulation which is the subject of the petition would put the safety and soundness of the United States banking system or the stability of the financial system of the United States at risk." That "official determination" is another point that could be vulnerable to challenge, and separately for each agency, based on both the procedure for making the determination and the substantive support for the determination. (And if those determinations look suspiciously similar or if FOIA reveals a trail of arm-twisting from Treasury, etc....)
Finally, if there are enough FSOC members authorized to vote and the requisite majority of members serving (not members voting) vote to veto the rulemaking, the FSOC has to publish a decision "with an explanation of the reasons for the decision." I assume that among other things, that FSOC decision has to include factually supported findings that the petition was filed in good faith. In any case, any and all of the FSOC decision can itself be challenged under the Administrative Procedures Act, and you'd better believe that it would be. Given that there really is no connection between class action waivers and "safety and soundness" or "financial stability," I cannot see how an FSOC veto could possibly survive judicial review.
These are only the first level vulnerabilities I see with the FSOC veto strategy, but there's also a more general problem: no one really knows how the mechanics of an FSOC veto process work. The FSOC was supposed to adopt rules implementing the veto procedure, but it hasn't. That opens the door to lots of potential litigation challenges to the FSOC's procedure, and those challenges might well run the clock on the 100-day limit; there's certainly nothing in the statute that provides for an extension of the stay beyond that 100 days.
Bottom line is that the financial services industry is grasping for ways to stave off the arbitration rulemaking, but the FSOC route is unlikely to succeed and could result in a lot of egg on the face of Secretary Mnuchin if he wants to push ahead with it.
The very foundations of the Islamic finance world were shaken a few weeks ago when Dana Gas declared that $700 million of its Islamic bonds (sukuk) were invalid and obtained a preliminary injunction against creditor enforcement from a court in the UAE emirate of Sharjah. Like Marblegate on steriods, Dana made this announcement as a prelude to an exchange offer, proposing that creditors accept new, compliant bonds with a return less than half that offered by the earlier issuance.
Dana shockingly claimed that evolving standards of Islamic finance had rendered its earlier bonds unlawful under current interpretation of the Islamic prohibition on interest and the techniques Dana had used to issue bonds carrying an interest-like investment return. I had expected to read that Dana had used an aggressive structure like tawarruq (sometimes called commodity murabahah) that pushed the boundaries of what the Islamic finance world generally countenanced, but no. The structure Dana had used was totally mainstream, a partnership structure called mudarabah. Dana asserted that the mudarabah structure had been superseded by other structures, such as a leasing arrangement called ijarah, though in Islamic law as in other legal families, there are often multiple permissible ways of achieving a goal, not just one. And when an issuer prepares an Islamic finance structure like this, it invariably gets a sign-off from a shariah-compliance board of respected Islamic law experts (sometimes several such boards). For Dana Gas to suggest that its earlier board was wrong to the tune of $700 million, or worse yet that Islamic law had somehow changed in a few years through an abrupt alteration of opinion by the world of respected Islamic scholars is ... troubling.
The case in the Sharjah court will take some time, but I predict that this exceptionally aggressive attempt by Dana Gas to evade its bond obligations will fail. The bonds are governed by English law, and I can hardly imagine that there is anything so shocking in their terms that would prompt a level-headed UAE court to declare as a matter of a core principle of overriding Islamic law that the mudarabah structure is "illegal." This will be a case to watch, though, and a real test of a respected Middle Eastern court system in the eyes of western investors. The Islamic finance industry has exploded in recent years, with nearly $50 billion per year in new issuances. If Dana Gas gets away with this shocking evasion of its sukuk obligations, it will strike a death blow to an industry that developed to allow investors to engage with the world of commerce while staying true to their moral and religious beliefs. It would be a terrible shame if Dana Gas's venal sharp practices laid low such a beautiful idea.
Hat tip to Jay Westbrook for bringing the story to my attention.