Personal Bankruptcy: The Credit Research Center and Ernst & Young Reports
on Debtors' Ability to Pay (Testimony, 03/11/98, GAO/T-GGD-98-76).

GAO discussed the results of its review of the Credit Research Center
report on personal bankruptcy debtors' ability to pay their debts and
observations on the February 1998 Ernst & Young report that also
examines debtors' ability to pay.

GAO noted that: (1) both studies share two fundamental assumptions that:
(a) the information found in debtors' initial schedules of estimated
income, estimated expenses, and debts is accurate; and (b) this
information could be used to satisfactorily forecast debtors' income and
expenses for a 5-year period; (2) these assumptions have been the
subject of considerable debate, and the researchers did not test their
validity; (3) with regard to the first assumption, the accuracy of the
data in bankruptcy petitioners' initial schedules of estimated income,
estimated expenses, and debt is unknown; (4) however, both reports also
stated that to the extent the data in the schedules were not accurate,
the data would probably understate the income debtors have available for
debt repayment; (5) with regard to the second assumption, there is also
no empirical basis for assuming that debtors' income and expenses, as
stated in their initial schedules, would remain stable for a 5-year
period following the filing of their bankruptcy petitions; (6) these two
assumptions--debtors' income and expenses remain stable and all
repayment plans would be successfully completed--could result in a
somewhat optimistic estimate of debt repayment; (7) neither report
allowed for situations in which the debtor's income decreases or
expenses increase during the 5-year period; (8) one difference between
the two reports involve the calculation of debtor expenses; (9) a second
difference between the two reports involves the calculation of mortgage
debt and family size; (10) a third difference between the reports
involves assumptions about repayment of secured, nonhousing debt; (11)
on March 10, 1998, GAO received an Ernst & Young report that used a
national sample of Chapter 7 petitions from calendar year 1997 to
estimate debtors' ability to pay; (12) the report appears to have
addressed many of the sampling issues GAO raised regarding the Center
report and February 1998 Ernst & Young report; and (13) however, the
March 1998 Ernst & Young report shares the fundamental unvalidated
assumptions of the Credit Center report and the February 1998 Ernst &
Young report.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-GGD-98-76
     TITLE:  Personal Bankruptcy: The Credit Research Center and Ernst & 
             Young Reports on Debtors' Ability to Pay
      DATE:  03/11/98
   SUBJECT:  Bankruptcy
             Personal liability (legal)
             Debt collection
             Financial analysis
             Financial management
             Statistical methods
             Income statistics
             Proposed legislation
             Data integrity
             Debt

             
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Cover
================================================================ COVER


Before the Subcommittee on Administrative
Oversight and the Courts
Committee on the Judiciary
U.S.  Senate

For Release on Delivery
Expected at
2:00 p.m., EST
Wednesday
March 11, 1998

PERSONAL BANKRUPTCY - THE CREDIT
RESEARCH CENTER AND ERNST & YOUNG
REPORTS ON DEBTORS' ABILITY TO PAY

Statement of Richard M.  Stana
Associate Director
Administration of Justice Issues
General Government Division

GAO/T-GGD-98-76

GAO/GGD-98-76T


(188638)


Abbreviations
=============================================================== ABBREV


PERSONAL BANKRUPTCY:  THE CREDIT
RESEARCH CENTER AND ERNST & YOUNG
REPORTS ON DEBTORS' ABILITY TO PAY
====================================================== Chapter Summary

Those who file for personal bankruptcy generally file under chapter 7
or chapter 13 of the bankruptcy code.  Those who file under chapter 7
generally seek discharge of their eligible debts.  Those who file
under chapter 13 submit a repayment plan, which must be confirmed by
the court, to pay all or part of their debts over a 3- to 5-year
period.  Personal bankruptcy filings have set new records in each of
the past two years, although there is little agreement on the causes
for such high bankruptcy filings in a period of relatively low
unemployment, low inflation, and steady economic growth.  Nor is
there agreement on the number of debtors who seek relief through the
bankruptcy process who have the ability to pay at least some of their
debts and the amount of debt such debtors could repay. 

Based on a sample of personal bankruptcy filings in 13 locations,
principally from 2 months in 1996, a study by the Credit Research
Center estimated that 5 percent of the chapter 7 debtors in the 13
locations combined would have sufficient income, after expenses, to
repay all of their nonpriority, nonhousing debt over 5 years and 25
percent could repay at least 30 percent.  The report estimated that
about 50 percent of chapter 13 debtors in the 13 locations combined
would have sufficient income, after living expenses, to repay all of
their nonpriority, nonhousing debt over a 5-year period; and an
additional 19 percent could pay 60 percent or more over the same
period.  The Center report also estimated that about 56 percent of
chapter 7 debtors and about 11 percent of chapter 13 debtors were
expected to have no income available to repay nonhousing debts.  A
February 1998 Ernst & Young study of chapter 7 personal bankruptcy
petitions filed mainly in 1992 and 1993 in four locations--two of
which were included in the Center report--found that under the income
and expense provisions of H.R.  3150, 8 to 14 percent of these
debtors would have been required to file under chapter 13, and these
debtors could have repaid 63 to 85 percent of their unsecured
nonpriority debt over 5 years.  Both studies represent a useful first
step in analyzing bankruptcy debtors' ability to pay their debts. 

However, both of these studies share two fundamental assumptions that
have not been validated:  (1) that the information found on debtors'
initial schedules of estimated income, estimated expenses, and debts
is accurate; and (2) that this information can be used to
satisfactorily forecast debtors' income and expenses for a 5-year
period.  In addition, both studies assume that 100 percent of
debtors' net income after allowable expenses would be used for debt
repayment, which does not reflect actual bankruptcy practice.  In
fiscal year 1996, 14 percent of chapter 13 debtor payments were used
for administrative costs, such as statutory trustee fees.  Also, each
report's estimate of potential debt repayment assumes that all
repayment plans will be successfully completed.  Data from the
Administrative Office of the U.S.  Courts shows that only about
one-third of 953,180 chapter 13 repayment plans terminated between
1981 and 1993 were successfully completed. 

Together, the two reports are based on data from 15 of the more than
180 different bankruptcy court locations.  The samples were not
designed to be representative of the nation as a whole or of each
city for the year in which they were drawn.  Therefore, the data on
which the reports were based may not reflect all bankruptcy filings
nationwide or in each of the 15 locations for the years from which
the petitions were drawn.  Even if a national representative sample
were used, any analysis that used the same basic assumptions as these
two reports would also share their limitations. 

For all these reasons, we believe it is prudent to interpret the
findings and conclusions of both the Center and Ernst & Young reports
with caution.  Although there may be a portion of chapter 7 debtors
who have the ability to repay at least a portion of their debts, the
actual number of debtors with an ability to repay, and the amount of
debt that could be repaid, may be more or less than estimated in
these two reports. 


PERSONAL BANKRUPTCY:  THE CREDIT
RESEARCH CENTER AND ERNST & YOUNG
REPORTS ON DEBTORS' ABILITY TO PAY
==================================================== Chapter Statement

Mr.  Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss the results of our review of
the Credit Research Center (the Center) report\1 on personal
bankruptcy debtors' ability to pay their debts and share with you our
observations on the February 1998 Ernst & Young report\2 that also
examines debtors' ability to pay.  Both reports represent a useful
first step in addressing a major public policy issue--whether some
proportion of those debtors who file for personal bankruptcy under
chapter 7 of the bankruptcy code have sufficient income, after
expenses, to pay a "substantial" portion of their outstanding debts. 
Specifically, you requested that we evaluate each report's research
methodology and formula for estimating the income that debtors have
available to pay debts.  On February 9, 1998, we reported the results
of our more extensive review of the Center report and selected data
to you and the Ranking Minority Member of this Subcommittee.\3


--------------------
\1 John M.  Barron, Ph.D., and Michael E.  Staten, Ph.D., Personal
Bankruptcy:  A Report on Petitioners' Ability-to-Pay (October 6,
1997). 

\2 Ernst & Young, LLP, Chapter 7 Bankruptcy Petitioners' Ability to
Repay:  Additional Evidence from Bankruptcy Petition Files (February
1998). 

\3 Personal Bankruptcy:  The Credit Research Center Report on
Debtors' Ability to Pay (GGD-98-47, Feb.  9, 1998). 


   BACKGROUND
-------------------------------------------------- Chapter Statement:1

Debtors who file for personal bankruptcy usually file under chapter 7
or chapter 13 of the bankruptcy code.  Generally, debtors who file
under chapter 7 of the bankruptcy code seek a discharge of all their
eligible dischargeable debts.\4 Debtors who file under chapter 13
submit a repayment plan, which must be confirmed by the bankruptcy
court, for paying all or a portion of their debts over a 3-year
period unless for cause the court approves a period not to exceed 5
years. 

Personal bankruptcy filings have set new records in each of the past
2 years, although there is little agreement on the causes for such
high bankruptcy filings in a period of relatively low unemployment,
low inflation, and steady economic growth.  The National Bankruptcy
Review Commission's report\5 discussed a number of factors that may
affect bankruptcy filings, such as rising consumer debt relative to
income, local legal cultures, the loss of medical insurance, and
divorce.  The Commission report concluded, however, that no one
explanation is likely to capture the variety of reasons that families
fail and file for bankruptcy. 

Nor is there agreement on (1) the number of debtors who seek relief
through the bankruptcy process who have the ability to pay at least
some of their debts and (2) the amount of debt such debtors could
repay.  One reason for the lack of agreement is that there is little
reliable data on which to assess such important questions as the
extent to which debtors have an ability to pay their eligible
dischargeable debts; the amount and types of debts that debtors have
voluntarily repaid under chapters 7 and 13; the characteristics of
chapter 13 repayment plans that were and were not successfully
completed; and the reasons for the variations among bankruptcy
districts in such measures as the percentage of chapter 13 repayment
plans that were successfully completed. 

Several bills have been introduced in Congress that would implement
some form of "needs-based" bankruptcy.  These include S.1301, H.R. 
2500, and H.R.  3150.  All of these bills include provisions for
determining when a debtor could be required to file under chapter 13,
rather than chapter 7.  Currently, the debtor generally determines
whether to file under chapter 7 or chapter 13.  Each bill would
generally establish a "needs-based" test, whose specific provisions
vary among the bills, that would require a debtor to file under
chapter 13 if the debtor's net income after allowable expenses would
be sufficient to pay about 20 percent of the debtor's unsecured
nonpriority debt over a 5-year period.\6 If the debtor were
determined to be unable to pay at least 20 percent of his or her
unsecured nonpriority debt over 5 years, the debtor could file under
chapter 7 and have his or her eligible debts discharged.\7 Another
bill, H.R.  3146, focuses largely on changes to the existing
"substantial abuse" provisions under section 707(b) of the bankruptcy
code as the means of identifying debtors who should be required to
file under chapter 13 rather than chapter 7. 

The Center report and Ernst & Young reports attempted to estimate (1)
how many debtors who filed for chapter 7 may have had sufficient
income, after expenses, to repay at "a substantial portion" of their
debts and (2) what proportion of their debts could potentially be
repaid. 

The Center report was based on data from 3,798 personal bankruptcy
petitions filed principally in May and June 1996 in 13 of the more
than 180 bankruptcy court locations.  The petitions included 2,441
chapter 7 and 1,357 chapter 13 petitions.  On the basis of the Center
report's assumptions and the formula used to determine income
available for repayment of nonpriority, nonhousing debt, the report
estimated that 5 percent of the chapter 7 debtors in the 13 locations
combined could, after expenses, repay all of their nonpriority,
nonhousing debt over 5 years; 10 percent could repay at least 78
percent; and 25 percent could repay at least 30 percent.  The Center
report also estimated that about 11 percent of chapter 13 debtors and
about 56 percent of chapter 7 debtors were expected to have no income
available to repay nonhousing debts. 

Ernst & Young's report was based on a sample of 5,722 chapter 7
petitions in four cities--Los Angeles, Chicago, Boston, and
Nashville--that were filed mainly in 1992 and 1993.  Ernst & Young
concluded that, under the needs-based provisions of H.R.  3150, from
8 to 14 percent (average 12 percent) of the chapter 7 filers in these
four cities would have been required to file under chapter 13 rather
than chapter 7, and could have repaid 63 to 85 percent (average 74
percent) of their unsecured nonpriority debts over a 5 year repayment
period.  The report concluded that its findings corroborated the
Center report's findings that "a sizeable minority of chapter 7
debtors could make a significant contribution toward repayment of
their non-housing debt over a 5-year period."


--------------------
\4 Eligible debts may be discharged in bankruptcy proceedings.  A
dischargeable debt is a debt for which the bankruptcy code allows the
debtor's personal liability to be eliminated. 

\5 Bankruptcy:  The Next 20 Years (October 20, 1997). 

\6 Under the bankruptcy code, debts are classified as secured (such
as mortgage and auto loans secured by property financed by the loan);
unsecured priority (such as certain back taxes, child support, and
alimony); or unsecured nonpriority (such as credit card debts). 

\7 By statute, some types of debts and obligations, such as alimony,
child support, some student loans and certain taxes, cannot generally
be discharged in bankruptcy proceedings.  The debtor remains
financially responsible for nondischargeable debts after the close of
his or her bankruptcy case. 


   SCOPE AND METHODOLOGY
-------------------------------------------------- Chapter Statement:2

In reviewing both reports, our objective was to assess the strengths
and limitations, if any, of the reports' assumptions and methodology
for determining debtors' ability to pay and the amount of debt that
debtors could potentially repay.  Our comments and observations on
the Center report are based on a review of the final version of the
Center report, dated October 6, 1997; some additional information we
requested from the report's authors; data and analyses provided by
the Federal Judicial Center on bankruptcy filings in the 13 locations
used in the Center report; telephone interviews with bankruptcy
judges and trustees; and our experience in research design and
evaluation.  The authors of the Center report declined to provide us
a copy of the automated database used for their analysis, citing
their interest in maintaining its proprietary value.  Our
observations on the Ernst & Young study are based solely on the
information provided in the report regarding the report's data,
methodology, and findings.  We have not requested any additional data
nor discussed our observations about the report with the Ernst &
Young study author. 


   SHARED CHARACTERISTICS OF THE
   TWO REPORTS
-------------------------------------------------- Chapter Statement:3

It is important to note that the findings of both the Center report
and Ernst & Young report rest on fundamental assumptions that have
not been validated.  Both studies share two fundamental assumptions: 
(1) that the information found on debtors' initial schedules of
estimated income, estimated expenses, and debts was accurate; and (2)
that this information could be used to satisfactorily forecast
debtors' income and expenses for a 5-year period.  These assumptions
have been the subject of considerable debate, and the researchers did
not test their validity. 

With regard to the first assumption, the accuracy of the data in
bankruptcy petitioners' initial schedules of estimated income,
estimated expenses, and debts is unknown.  Both reports assumed that
the data in these schedules are accurate.  However, both reports also
stated that to the extent the data in the schedules were not
accurate, the data would probably understate the income debtors have
available for debt repayment.  This reflected the researchers' shared
belief that debtors have an incentive in the bankruptcy process to
understate income, overstate expenses, and thereby understate their
net income available for debt repayment.  However, there have been no
studies to validate this belief.  It is plausible that, to the extent
there are errors in the schedules, debtors could report information
that would have the effect of either overstating or understating
their capacity to repay their debts, with a net unknown bias in the
aggregate data reported by all debtors.  One cause of such errors
could be that the schedules are not easily interpreted by debtors who
proceed without legal assistance.  In Los Angeles, a location whose
data contributed significantly to the findings of both reports,
Center data showed that about one-third of debtors reported they had
not used a lawyer. 

With regard to the second assumption, there is also no empirical
basis for assuming that debtors' income and expenses, as stated in
their initial schedules, would remain stable for a 5-year period
following the filing of their bankruptcy petitions.  Implicitly, the
debt repayment estimates of both reports assumed that 100 percent of
debtors who have the ability to repay at least a portion of their
debt would complete their assumed 5-year repayment plans.  These two
assumptions--debtors' income and expenses remain stable and all
repayment plans would be successfully completed--could result in a
somewhat optimistic estimate of debt repayment.  Neither report
allowed for situations in which the debtor's income decreases or
expenses increase during the 5-year period. 

Past experience suggest that not all future chapter 13 debtors will
successfully complete their repayment plans.  To the extent this
occurs, it would reduce the amount of debt that future debtors repay
under required chapter 13 repayment plans.  A 1994 report by the
Administrative Office of the U.S.  Courts found that only about 36
percent of the 953,180 chapter 13 cases terminated during a 10-year
period ending September 30, 1993, had been successfully completed. 
The remaining 64 percent were either dismissed or converted to
chapter 7 liquidation, in which all eligible debts were discharged. 
The reasons for this low completion rate are unknown, but this
illustrates the high level of discrepancy between the amount that
debtors could potentially repay, based on the data and assumptions
used in the two reports, and what has occurred over a 10-year period. 

Another assumption made in both reports is that 100 percent of
debtors' income available for debt repayment will be used to repay
debt for a 5-year period.  This assumption does not reflect actual
bankruptcy practice.  Chapter 13 repayment plans require greater
administrative oversight, and thus cost more than chapter 7 cases,
including periodic review of the debtors progress in implementing the
plan and review of debtors' or creditors' requests to alter the plan. 
In fiscal year 1996, for example, creditors received about 86 percent
of chapter 13 debtor payments.  The remaining 14 percent of chapter
13 debtor payments were used to pay administrative costs, such as
statutory trustee fees and debtor attorneys' fees.  Neither study
addressed the additional costs for judges and administrative support
requirements that would be borne by the government should more
debtors file under chapter 13. 

Finally, neither study used scientific random sampling techniques in
selecting personal bankruptcy petitions for review.  The Center
report was based on data from bankruptcy petitions in 13 locations
filed principally in May and June 1996.  The Ernst & Young report was
based on data from bankruptcy petitions filed in four locations,
principally in 1992 and 1993.  Together, the two reports included
data from 15 of the more than 180 bankruptcy court locations.  Both
reports included data from two of the same locations--Los Angeles and
Chicago.  The results of both reports are heavily influenced by data
from these two locations, which accounted for about 41 percent of the
total filings in the 13 locations in the Center study and about 85
percent of the total filings in the four locations in the Ernst &
Young report.  The samples were not designed to be representative of
the nation as a whole or of each location for the year from which the
samples were drawn.  Therefore, the data on which the reports were
based may not reflect all bankruptcy filings nationally or in each of
the 15 locations for the years from which the petitions were drawn. 


   DIFFERENCES BETWEEN THE TWO
   REPORTS
-------------------------------------------------- Chapter Statement:4

One difference between the two reports involves the calculation of
debtor expenses.  The Center's estimates of debtor repayment capacity
are based on the data reported in debtors' initial schedules of
estimated income, estimated expenses, and debts.  The Center report
calculated debtor expenses using the data reported on debtors'
estimated income and estimated expense schedules. 

The Ernst & Young report, whose purpose was to estimate the effect of
implementing the provisions of H.R.  3150, adjusted debtors' expenses
using the provisions of H.R.  3150.  Following these provisions,
Ernst & Young used the expenses debtors reported on their schedules
of estimated expenses for alimony payments, mortgage debt payments,
charitable expenses, child care, and medical expenses.  For all other
expenses, including transportation and rent, Ernst & Young used
Internal Revenue Service (IRS) standard expense allowances, based on
both family size and geographic location.  The impact of these
adjustments on debtors' reported expenses was not discussed in the
report.  However, to the extent these adjustments lowered debtors
expenses, they would have increased the report's estimates of
debtors' repayment capacity when compared to the methodology used in
the Center report.  To the extent the adjustments increased debtors'
reported expenses, they would have decreased the report's estimates
of debtor repayment capacity.  Also, to the extent that these
adjustments reduced debtors' reported expenses, the adjustments would
have corrected, at least in part, for what the report assumed was
debtors' probable overstatement of expenses on their schedules of
estimated expenses. 

A second difference between the two reports involves the calculation
of mortgage debt and family size.  The Center gathered data from
debtor bankruptcy petitions on these items.  However, because Ernst &
Young did not have data on mortgage debt or family size, both of
these factors were estimated for its report.  Based on data from the
U.S.  Census Bureau, Ernst & Young used an average family size of 3
for all married filers and 1.6 for single individuals or
single-parent families.  To the extent that the family size of those
filing for bankruptcy exceeded these averages, the report understated
allowable expenses, and thus overstated the debtors' ability to pay. 
Conversely, to the extent that actual family size was smaller than
these averages, the report overstated allowable expenses, and thus
understated the debtors' ability to pay. 

A third difference between the reports involves assumptions about
repayment of secured, nonhousing debt.  The Center report assumed
that debtors would continue payments on their mortgage debt and pay
their unsecured priority debt.  Unlike the Center report, the Ernst &
Young report appears to have assumed that debtors will repay, over a
5-year period, all of their secured nonhousing debt and all of their
unsecured priority debt.  The purpose of this assumption was to
estimate the amount of unsecured nonpriority debt that debtors' could
potentially repay after paying their secured nonhousing debt and
unsecured priority debt. 


   MARCH 1998 ERNST & YOUNG REPORT
-------------------------------------------------- Chapter Statement:5

On March 10, 1998 we received an Ernst & Young report that used a
national sample of chapter 7 petitions from calendar year 1997 to
estimate debtors' ability to pay.  Although we have not had an
opportunity to examine this report in detail, the report appears to
have addressed many of the sampling issues we raised regarding the
Center report and February 1998 Ernst & Young report.  However, the
March 1998 Ernst & Young report shares the fundamental unvalidated
assumptions of the Credit Center report and the February 1998 Ernst &
Young report.  These assumptions include (1) the data reported on
debtors' schedules of estimated income, estimated expenses, and debts
are accurate; (2) the data in these schedules can be used to
satisfactorily forecast debtors' income and expenses for a 5-year
period; (3) that 100 percent of debtors' net income after expenses,
as determined in the report, will be used for debt repayment over a
5-year repayment period; and (4) that all debtors will satisfactorily
complete their 5-year repayment plans. 


   CONCLUSION
-------------------------------------------------- Chapter Statement:6

The assumptions, data, and sampling procedures used in the Center
report and the February 1998 Ernst & Young report raise questions
concerning the accuracy of the reports' estimates and require the
reader to use caution in interpreting the types of firm conclusions
stated therein.  Neither report provides reliable answers to the
questions of how many debtors could make some repayment and how much
debt they could repay.  We do not disagree that it is likely that
there are some debtors who file for bankruptcy under chapter 7 who
have the financial ability to repay at least a portion of their debt. 
However, the actual number of chapter 7 debtors who could repay at
least a portion of their nonhousing debt could be more or less than
the estimates in these two studies.  Similarly, the amount of debt
these debtors could potentially repay could also be more or less than
the reports estimated. 

Finally, although the March 1998 Ernst & Young report is based on
what is apparently a national representative sample of chapter 7
petitions, to the extent that the report is based on the same basic
data (petitioners financial schedules) and assumptions as the Center
report and the February 1998 Ernst & Young report, it shares the same
limitations as these two earlier reports. 

This concludes my prepared statement, Mr.  Chairman.  I would be
pleased to answer any questions you or other members of the
Subcommittee may have. 


*** End of document. ***