Warning: Creditors Will Screw You

In a related pair of articles, we see that creditors are perfectly willing to play it fast and loose with debts that debtors don't actually owe to them. First, this report from Business Week that explains the growing market in discharged debts:

The case of Van Rathavongsa illustrates how canceled debts regain vitality. The Raleigh (N.C.) factory worker pulled himself out from beneath a mountain of bills by means of a bankruptcy proceeding that wrapped up in 2002. One of the debts the judge canceled, or "discharged," was $9,523 Rathavongsa owed to Capital One Financial (COF), the big credit-card company. But Capital One continued to report the factory worker's discharged debt to credit bureaus as a live balance, according to documents filed in U.S. Bankruptcy Court in Raleigh.

This kind of failure by creditors to update credit reports happens with some frequency, consumer lawyers and court-employed bankruptcy trustees say. And it can have consequences: In September, 2003, when Rathavongsa tried to close on a $274,650 mortgage for a new house, his would-be lender, Wachovia (WB), said he would either have to pay Capital One or show proof from the credit-card company that the debt had been discharged. Despite several calls and a letter from his attorney, he says, Capital One never revised the credit report. To obtain the home loan, Rathavongsa eventually did what many consumers in this situation do. He gave in and paid Capital One $9,523 he no longer legally owed.

Rathavoga got his money back, and fines to boot, but only because he was willing to go back to Bankruptcy Court and get a judge to force Capital One to acknowledge that his debt was legally discharged. But unbelievably, financial institutions are now trading in discharged debts:

Because of episodes like this, discharged debts have attracted the attention of little-known firms expert at buying and selling a range of delinquent consumer obligations. Back-due bills with a face value of billions of dollars change hands at a steep discount every year. Five of the companies in this business are publicly traded on Nasdaq. Others have large private-money backers. B-Line, in Seattle, was acquired last year by the Dallas-based hedge fund firm Lone Star Funds. The investment bank Bear Stearns (BSC) owns two bankruptcy-debt buyers: Max Recovery and eCast Settlement.

The very existence of this marketplace confounds even some veterans in the bankruptcy field. During a preliminary hearing in New York in March, U.S. Bankruptcy Judge Robert Drain asked a lawyer for JPMorgan Chase (JPM) how the bank had managed to sell consumer credit-card debts that had been discharged. "I don't know who would buy a discharged account," the perplexed judge said.

"Happens all the time, your honor," the Chase lawyer, Thomas E. Stagg, responded.

Once you complete bankruptcy proceedings and are granted a discharge (whether in Chapter 7, or at the end of a Chapter 13 repayment period) your legal liability for the debt is dissolved. In other words, you are no longer legally required to repay that debt, and creditors are not permitted to contact you in attempts to collect on the debt. So naturally, a bankruptcy court is going to be inclined to think that such a debt is worthless, since the owner of the debt can't legally collect on it and the debtor is no longer responsible for paying it. But of course, the debt gains value when a creditor or collector can actually coerce you into paying it, even if they're doing so illegally.

Congress, in drafting the bankrtupcy code, quite reasonably presumed that once they said a debt was worthless, it would actually remain worthless. For the longest time this has mostly been true, as sanctions for creditors that attempt to collect on discharged debts can be quite severe. Of course, if you acquire enough of these debts, and can con enough debtors into paying you even though they don't owe you the money, well then all of the sudden you have an instrument with value that is quite tradeable on the open market. Despite the fact that, of course, the value is premised on illegal behavior.

The only possible remedy is to punish transgressors even more severely for their bad behavior. And by severely, I mean as if God's wrath were coming down on their head. A corporate creditor will tolerate fines and sanctions and lectures from judges here and there on a few debts, if it can collect enough on the other debts it holds to make the whole adventure profitable. And it should be flat-out illegal to trade in discharged debts.

And in even more questionable behavior, mortage lenders are apparently tacking on fees and practicing poor book-keeping to get debtors whose homes are being foreclosed on to fork over even more money as they lose their family home:

Bankruptcy specialists say lenders and loan servicers often do not comply with even the most basic legal requirements, like correctly computing the amount a borrower owes on a foreclosed loan or providing proof of holding the mortgage note in question.

“Regulators need to look beyond their current, myopic focus on loan origination and consider how servicers’ calculation and collection practices leave families vulnerable to foreclosure,” said Katherine M. Porter, associate professor of law at the University of Iowa.

In an analysis of foreclosures in Chapter 13 bankruptcy, the program intended to help troubled borrowers save their homes, Ms. Porter found that questionable fees had been added to almost half of the loans she examined, and many of the charges were identified only vaguely. Most of the fees were less than $200 each, but collectively they could raise millions of dollars for loan servicers at a time when the other side of the business, mortgage origination, has faltered.

On Oct. 9, the Chapter 13 trustee in Pittsburgh asked the court to sanction Countrywide, the nation’s largest loan servicer, saying that the company had lost or destroyed more than $500,000 in checks paid by homeowners in foreclosure from December 2005 to April 2007.

The trustee, Ronda J. Winnecour, said in court filings that she was concerned that even as Countrywide misplaced or destroyed the checks, it levied charges on the borrowers, including late fees and legal costs.

“The integrity of the bankruptcy process is threatened when a single creditor dishonors its obligation to provide a truthful and accurate account of the funds it has received,” Ms. Winnecour said in requesting sanctions.

As you may recall, Countrywide got in a little bit of trouble for inducing some of those homeowners into bad mortgages in the first place. Apparently that's not enough for them, as they now seem to think they're entitled to skim a little bit off the top even as the debtor descends into bankruptcy:

“We’re talking about millions and millions of dollars that mortgage servicers are extracting from debtors that I think are totally unlawful and illegal,” said O. Max Gardner III, a lawyer in Shelby, N.C., specializing in consumer bankruptcies. “Somebody files a Chapter 13 bankruptcy, they make all their payments, get their discharge and then three months later, they get a statement from their servicer for $7,000 in fees and charges incurred in bankruptcy but that were never applied for in court and never approved.”

In bankruptcy proceedings, fees like this MUST be approved by the bankrtupcy court. Debts like this are as uncollectable as discharged debts. But the debtor who doesn't understand the process or doesn't want to have to fork over hundreds or thousands more to a lawyer to contest the debt, are more likely to simply pay up when they get a bill, even after they've been granted a discharge (which incidentally in a Chapter 13, can come as long as five years after filing.) Or, they can simply try to over-bill the debtor, hoping the court won't scrutinize the fees closely and will include them in the Chapter 13 repayment schedule. This won't work in a Chapter 7 where debtors get a discharge and pay little or nothing on most of their debts (unless of course they just send you a bill later, like the credit card lenders in the above article.) But lenders have every incentive to try and game the system, as they often fail to recoup the full value of their loan when they foreclose on a home.

Again, the only recourse for bad behavior like this is to punish lenders severely. Hefty fines, and subordination or avoidance of debt in the bankruptcy proceedings, will help corporate lenders understand that there is a price for illegality. It's absurd that there can be anything but a junk market for suckers in debts that can't be collected. Stories like these are simply unacceptable.