Recently in Insolvency Category

Insolvency makes people face a lot of difficult questions, and one of the most challenging is whether to pay off your debts now even if it virtually guarantees you'll be in financial trouble later. For example, if you're trying to deal with credit card debt and the only savings you have are in a retirement account, should you liquidate that 401(k) to pay off the credit cards?

For most people the answer is no. Even though credit card debt is expensive, the costs of borrowing from your 401(k) or IRA probably far outweigh what you'd save on interest.

More important, your retirement accounts are an essential asset that takes years to build. For most Americans, they're the only way they'll be able to pay their expenses once they retire, and the only way they'll be able to save enough for those years is to start early and save consistently over the years.

Consider the Net Costs of Cashing Out Your 401(k) Plan

The evidence of economic stress across the U.S. continues to build -- and the areas of our lives affected keep getting broader. Many economic problems work as part of vicious cycles: The mortgage crisis fed into unemployment, and job losses are feeding back into the high foreclosure rates. The 2008 stock market crash fed fears that investments were unreliable, which has kept investors from relying on the recent stabilization in stocks to bump up hiring and access to credit.

As you might expect, a lot of people are facing painful personal finance challenges in these economic times -- even if they haven't been laid off and aren't facing foreclosure. Last week Fidelity Investments reported that a record number of people are borrowing from their retirement accounts despite the expensive penalties for doing so.

This sign is particularly troubling because many of the people doing so are still employed. The high unemployment rate makes workers reluctant to leave their jobs, and many companies have cut back on overtime or even reduced salaries.

"People tend to be taking home less," says Beth McHugh, Fidelity's vice president of marketing insight. "As a result the percentage of individuals initiating hardship distributions is one of the things we're concerned about."

A Growing Number of Employed People Seeking Hardship 401(k) Withdrawals

A study released this week by the Center for Responsible Lending, a non-profit research and public policy group, shows that Latinos made up by far the largest group -- 48 percent -- of all those facing foreclosure in California.

The report, entitled "Dreams Deferred: Impact and Characteristics of the California Foreclosure Crisis," analyzed more than 500,000 foreclosures statewide and found 48 percent of those affected were Latino, while whites totaled 35 percent, African Americans 8 percent, and Asians 6 percent. The percentage of Latinos facing foreclosure far outstripped their representation in the population.

The report also found that Latino and African American borrowers were more likely than similarly situated whites to have been offered high-cost subprime mortgages, which had loan terms that increased their default risk. That is to say, when white and minority borrowers had the same credit and risk profiles, the minority borrowers were offered less favorable loan terms, on average.

Insolvency has also disproportionately hit minorities in the economic downturn, with a number of studies showing that African Americans and Latinos have been more likely to be laid off and less likely to find new employment during the crisis.

No "McMansions" for Most Victims of Foreclosure, Study Shows

According to statistics released by the American Bankruptcy Institute, a non-partisan insolvency research and education organization, California consumers and businesses filed by far the largest number of bankruptcies in the U.S. during the first quarter of 2010. The Central District of California, which includes the greater Los Angeles area, had the highest rates of any district in the nation.

The data collected reflects both business and personal bankruptcy filings under Chapter 7, Chapter 11 and Chapter 13 of the U.S. Bankruptcy Code.

The numbers appear to reflect a virtually unprecedented level of insolvency among California businesses and consumers. An astonishing 8.3 percent of the 388,148 bankruptcies filed in the U.S. in the first quarter were filed in the Central District of California.

A total of 32,236 bankruptcies were filed in the Central District between January and March. 60,523 bankruptcies were filed in California during that period. Florida, the state with the second highest total bankruptcy rate, didn't even come close to California's numbers: 26,404 bankruptcies were filed in Florida during the first quarter.

Data Shows Bankruptcy Filings Back Up to Pre-2005 Levels

According to analysis on several fronts, the average American now owes more in student loan debt than on credit cards. In an ideal situation, that would be a good thing -- it would mean that people were borrowing for the purpose of improving their lives and refraining from building up massive consumer debt.

Unfortunately, as record levels of insolvency across the board demonstrate, these are not ideal times. While it appears to be true that many U.S. consumers have substantially paid down their credit card balances, the real story is that student loans are increasingly the source of financial trouble for many people.

Mark Kantrowitz, publisher of the financial aid websites FinAid.org and FastWeb.com, calculates that Americans owe a total of $829.785 billion in outstanding student loan debt. For the first time, that total exceeds the total debt owed in revolving credit -- $826.5 in June 2010 (most revolving credit is credit card debt).

Nevertheless, mortgages and credit card debt receive the lion's share of media coverage. The nonprofit advocacy group Student Loan Justice points out that the media prefers stories about credit card debt to student loans "by a factor of approximately 15-to-1 based on unscientific news surveys conducted since 2007."

Perhaps America's astonishing addiction to consumer credit makes sexier news, but the pain inflicted by the student loan burden may actually be worse.

Under the 2005 bankruptcy law, student loans typically can't be discharged in bankruptcy. That means that if anything happens to interrupt the expected income benefits of a college education -- a disability, a poor economy, or another life event -- educational debt can become a millstone that can never be removed.

During this economic downturn, a lot of people are caught in a seemingly unbreakable cycle of insolvency. They're in financial trouble at least in part because of a job loss. When they try to get a new job, their financial woes keep them from getting hired.

According to the Society of Human Resource Management, 60% of employers nationwide perform credit checks on potential hires. A poor credit report may be the factor that keeps a promising applicant from being hired.

"There can be legitimate reasons to pull a credit report," says Larry Lambert, President of Employment Screening Services, Inc. "You wouldn't want to hire someone on the edge of bankruptcy to take care of your assets."

For most jobs, however, a credit report doesn't have such a direct connection to performance of job duties. Instead, employers use it much like a character reference -- extrapolating an applicant's probability of job success from a financial report.

Nevertheless, employers continue to pull credit reports on applicants -- many without really considering why.

"Sometimes it's because the employer believes in a made-up correlation between credit problems and general irresponsibility on the part of the job applicant," explains Liz Ryan, a workplace expert and former Fortune 500 HR executive.

FICO Inc., the company that provides the credit scores 90 percent of lenders evaluate consumer credit risks, just released a survey of Americans' credit scores as of April and how they compare to consumers' creditworthiness historically.

The report shows an interesting and disturbing trend: sharp growth in the percentage of consumers with very low or very high credit scores, and a corresponding collapse in the percentage of American consumers with average credit.

These numbers seem to indicate a trend in Americans' credit fortunes similar to the well documented growth in the divide between the extremely wealthy and the insolvent. Are we facing a "shrinking middle class" in the availability and cost of credit?

What Does FICO's Latest Analysis Show About Americans' Credit Scores?

The newest numbers from FICO represent April data. The up-shot of the report is that the percentage of consumers in the mid-range groups representing "fair," "moderate" and "good" credit scores is dwindling, from 45 percent of active consumers historically to only 37.1 percent now.

The La Mesa-Spring Valley, Oceanside Unified, Ramona and San Ysidro school districts in San Diego have warned the state that they face insolvency and may be forced into bankruptcy without state funding increases.

This announcement came on June 29 from the California Department of Education, which collects financial stability reports of the district and provides analysis for counties and the state. The four districts are among 160 that have been put on the "fiscal early warning list." Fourteen districts turned in "negative budget certifications," which means they are unable to meet their existing financial obligations.

The four San Diego County districts have said they will not be able to pay their bills through the next two years. La Mesa-Spring Valley and San Ysidro were also on the "fiscal early warning list" in 2008.

"Schools on this list are now forced to make terrible decisions to cut programs and services that students need or face bankruptcy," state Superintendent of Instruction Jack O'Connell said in a statement.

The rate of insolvency among school districts and education agencies has shot up 38 percent since January. This represents an "alarming spike," O'Connell said.

Cuts in State Funding for Education, Not Mismanagement, to Blame

"This is not a problem of district mismanagement. This problem has been passed on to school districts by the state," said Lora Duzyk, assistant superintendent of business services at the San Diego Office of Education, in a recent San Diego Union-Tribune story.

Despite nearly record levels of both insolvency and bankruptcy filings, many people who are in serious financial distress are unable to get bankruptcy protection.

According to a recent report in USA TODAY, many debt-laden Americans are finding the benefits of bankruptcy denied to them by the restrictions passed in 2005 -- or they simply can't afford to file. Here's why:

• The increased cost and complexity of filing for bankruptcy created by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) have meant many debtors are unable to afford to fight for certain bankruptcy protections that require a hearing, or can't afford to file at all.
• The real estate crisis prevents troubled homeowners from selling unaffordable homes, but debt secured by a principal residence is not dischargeable in Chapter 7 bankruptcy and, until this month, filing for Chapter 13 disqualified them from the federal HAMP program.
• The economic downturn has made it hopeless for many to find jobs with wages high enough to pay back educational debt, but student loans are virtually non-dischargeable in bankruptcy.

As a result, many financially strapped Americans are having to forego bankruptcy's promise of a fresh financial start. But postponing filing for bankruptcy is like delaying going to the doctor, according to law professor Robert Lawless of the University of Illinois -- you'll just end up in deeper and deeper financial trouble.

Debtors' prisons have been illegal in the U.S. since the 19th century. Not only was the practice of imprisoning people because they owed money cruel, it was also a pretty ineffective way of dealing with insolvency, since people in debtors' prisons were unable to maximize their earning capacity to repay their debts, if they were able to work at all.

It's not a crime to owe money, but major debt collection companies across the nation have found a way around that: debt warrants.

In a typical debt collection process, a debt collector gets a court judgment to force the delinquent borrower to pay. If the debtor doesn't comply with that order, the court may hold the debtor issue a contempt citation and a warrant.

According to a recent investigative feature in the Minneapolis Star Tribune, some debt collectors are taking these contempt orders to the police and having them enforced.

"The law enforcement system has unwittingly become a tool of the debt collectors," added Michael Kinkley, an attorney in Spokane, Wash., who represents arrested debtors. "The debt collectors are abusing the system and intimidating people, and law enforcement is going along with it."

Taxpayers foot the bill for the entire process, from the arresting police officers to jail accommodations and court expenses. "We hear every day about how there's no money for public services," one debtor who was arrested on a debt warrant pointed out to the Star Tribune. "But it seems like the collectors have found a way to get the police to do their work."