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The Calm Before The Storm?

Bankruptcies Have Leveled Off, But Experts Warn Of A Possible Explosion Unless The Economy Picks Up


August 26, 2004
Copyright © 2004 CARIBBEAN BUSINESS. All Rights Reserved.

Good News And Bad News

At around 14,000 new filings a year, the number of local bankruptcies is twice as high as in the early ‘90s

The good news is that the number of annual bankruptcies in Puerto Rico has remained steady over the past four years. The bad news is that the number is twice as high as it was in the early ’90s.

Worse news is that the number of bad bankruptcies filed annually—where the individual or business must opt for total liquidation under Chapter 7, as opposed to a payment plan under Chapter 13 or a reorganization under Chapter 11—has tripled in the past four years!

The worst news is that although the total number of new bankruptcies filed annually has leveled off at around 14,000 during this period, experts indicate this may just be the calm before the storm.

Capitalizing on the prevailing low interest rates of the past couple of years, individuals and businesses have refinanced their properties, taking equity out and converting it into cash, which they have spent or used as working capital in their businesses. Unless the economy picks up soon, however, many of those individuals and businesses may find it increasingly difficult to pay off debts or secure new debt, forcing them into bankruptcy.

"The refinancing rush of the past few years may have had the effect of postponing many bankruptcy petitions," said Madeline Soto, partner at law firm Lube & Soto and president of the Puerto Rico Bankruptcy Bar Association. "Consequently, an increase in bankruptcies could be expected as the credit benefit wears out."

Consistently higher numbers

According to the U.S. Bankruptcy Court, the total number of new bankruptcy filings from 2000 through 2003 fluctuated between 14,891 and 14,236, a variation of 5%.

This year is on track to see similar or better numbers. There were 6,942 filings through June 30, virtually no change from the 6,948 recorded in the first half of 2003.

"Compared with the U.S., we are doing well down here," said Chief Bankruptcy Judge Gerardo A. Carlo. "Bankruptcies are trending down. The Administrative Office of the U.S. Courts has processed local filings at a rate of 3.7 per 1,000 inhabitants, compared with 5.6 per 1,000 inhabitants on the U.S. mainland."

Bankruptcy filings may have declined in recent years, but they haven’t gone anywhere near the low levels of the mid-’90s. In fact, the number of new bankruptcies annually has risen 103% over the past decade, from 7,025 in 1994 to 14,236 in 2003.

According to the U.S. Bankruptcy Court, the island accounts for about one-third of all the bankruptcies filed in the First Circuit, which also includes Maine, New Hampshire, Massachusetts, and Rhode Island. For the 12 months ended on March 31, 2004, Puerto Rico generated 14,518, or 31%, of the 46,496 new bankruptcy filings by all five jurisdictions.

Throwing in the towel

A worrisome development in the past few years has been the explosion in the number of filings under Chapter 7, which provides for total liquidation, relative to Chapter 13, which gives the petitioner some relief from creditors by allowing him or her to work out a debt-repayment plan.

Historically, and unlike most stateside jurisdictions, local bankruptcy filings under Chapter 13 have far outpaced those under Chapter 7. In the past few years, however, more petitioners have resorted to Chapter 7.

"In 2004, Chapter 7 has demonstrated a relative gain over Chapter 13," said Judge Carlo. "It is of concern because liquidations tend to strangle the economy, as there is no recovery of debts on final settlement. But, obviously, the increased use of Chapter 7 is becoming commonplace because of the times."

According to the U.S. Bankruptcy Court, annual filings under Chapter 7 have increased 189% over the past decade, from 1,460 in 1994 to 4,221 in 2003. More significantly, the proportion of Chapter 7 filings to total bankruptcy filings has increased from 21% in 1994 to 30% last year, while the percentage of Chapter 13 filings has decreased from 77% to 69%.

It appears the shift from Chapter 13 to Chapter 7 may have been driven in part by the recession that started in 2001. Many people were laid off or had to settle for lower-paying jobs, yet many kept spending and maxing out their credit.

"The filing ratio could have changed from 1:10 [one Chapter 7 filing to 10 Chapter 13 filings] to 4:6," said Soto. "With home-equity borrowing capacity used up, fewer bankrupt property buyers, and dwindling incomes, there is limited staying power through Chapter 13. People are turning to Chapter 7 in an attempt to save their homes."

Chapter 7 may exempt a petitioner’s main residence from the assets to be liquidated to pay off creditors. Although practical and popular in Puerto Rico, Chapter 13 still requires a petitioner to have disposable income to qualify for a payment plan and be able to retain his or her assets.

The causes

Home refinancing, encouraged by the low interest rates of the past couple of years, may turn out to be a double-edged sword. Equity loans have been used to consolidate debts, make home improvements, finance businesses, and take long vacations.

What isn’t clear is the effect home refinancing could have on consumers’ credit once the cash flow from the equity loans trickles to a stop. After all, the newfound money from the equity loans will still have to be repaid.

Consumer credit could be reaching its limits after almost four years of intense home-equity borrowing. This would make it more difficult to stick with a debt-repayment plan under Chapter 13, which in turn would make Chapter 7 a more attractive, home-saving alternative. Even if all past debts were paid with the money from the equity loans, there is still doubt about consumers’ repayment capability.

In other words, where will consumers get additional cash now that most home-equity loan money has been exhausted? Many wonder if the situation could trigger a new round of bankruptcies on the island.

Not everyone is concerned, however. The prevailing interest rates on mortgage loans remain under 7%. Considering that home values on the island could appreciate between 5% and 8% annually, the mortgage rates are still attractive for new-home purchases and home refinancing, even for people who may have refinanced just a few years ago.

"Equity has combined with low interests to give consumers a workable solution to a variety of money issues," said Mario Ruiz, executive vice president of R-G Premier Bank. "The prevailing mortgage rates should continue to attract consumers to transfer unsecured debt [such as from credit cards] to secured debt [such as from home mortgages] through refinancing.

"The mortgage cycle remains very strong," continued Ruiz. "Even people who refinanced just a short while ago have refinanced again because of the attractive low rates and our ability to make it a simple process. I believe that even if interest rates go up, customers will be redirected to other credit sources."

The bankruptcy curve

The pattern of bankruptcies in Puerto Rico over the past 10 years looks almost like a bell curve. Consumers and businesses went on a borrowing spree during the first part of the decade and hit a peak, after which the pace of bankruptcy filings began decelerating.

The U.S. economy, including Puerto Rico, experienced one of the longest periods of expansion in history in the early ’90s. This expansion planted the seed for bankruptcy problems in the middle of the decade. The number of bankruptcies in Puerto Rico neared 18,000 in 1999, the year after Hurricane Georges hit.

According to the Administrative Office of the U.S. Courts, there were 7,025 personal and commercial bankruptcy filings in Puerto Rico in 1994. In just five years, the number had jumped by 155% to 17,911. Four years later, in 2003, the number was down to 14,236, a 103% increase from 1994.

Factors such as the role of finance companies (financieras) and the lack of advanced technology in the mid-’90s played a big hand in shaping the bankruptcy curve. Finance companies were at the height of their popularity, providing attractive and flexible credit offers and making for easy access to money. As for technology, finance companies and banks generally lacked modern monitoring systems to keep close track of customer accounts.

"Regardless of pattern, bankruptcies need to be analyzed within a historical context," said Fernando Batlle, senior executive vice president of FirstBank. "Financial institutions have achieved a high degree of lending sophistication that wasn’t available even five years ago. Delinquencies management has been turned into a precise and day-to-day tool.

"True, bankruptcies went very high at one point, but I find it unlikely they will find their way back there," said Batlle. "First, our credit procedures and management services have become highly sophisticated. Second, the finance companies have modified their lending standards."

Financial entities went from having open, even flexible, lending standards in the early ’90s to having stricter credit policies. With this has come an increase in the use of workout & debt-restructuring programs and in the monitoring of delinquent accounts.

To the rescue

Some credit the financial sector’s more-rigid lending practices for the recent stability in bankruptcies, while others attribute it to programs that educate consumers on managing credit and debt and help them avoid filing for bankruptcy.

"We have found that bankruptcy isn’t really related to income level or the distribution channel that brings the client in," said Carlos Gaviria, Citibank Puerto Rico’s collection manager for retail banking. "In tracking delinquent accounts daily, the deterioration of the customer’s credit pattern could indicate a future bankruptcy profile."

Consumer Credit Counseling Service of P.R. (CCCS) is one of the resources available to indebted consumers. According to the nonprofit organization, most of its clients don’t need to file for bankruptcy. In fact, only 30% of the people it interviews require a debt-management program. Others make needed adjustments to their financial situations and others, with some coaching from the CCCS, enter into acceptable agreements with creditors on their own.

"Consumers’ lack of credit awareness may be a critical aspect of the problem," said CCCS President Roberto Baerga. "Take, for example, a low-wage earner who buys a car and adds aluminum wheels and other optional items. It is free buying without consideration of the consequences. Education is key for future generations."

In its 14 years in operation, the CCCS has helped arrange 24,000 payment plans and recovered over $122 million for creditors. Demand for credit education and counseling also rose at the height of Puerto Rico’s bankruptcy curve. By 2001, the CCCS alone had processed some 28,000 applications for credit assistance.

"We collaborate with the Puerto Rico Bankers Association, which has its own credit-related initiatives. It seems, according to an Internet source, that most nonbusiness credit problems [63%] stem from the improper use of credit cards," said Baerga.

Baerga and many others in the bankruptcy business believe locals generally have good judgment and intend to repay their debts. Although locals are perceived to have a high loan-delinquency rate (mostly on mortgages) compared with people in the States, they are also known to have a high rate of loan repayment.

The magic of Chapter 13

From 1994 to 2003, bankruptcy filings under Chapter 13 rose 83% to 94,337 while filings under Chapter 11 fell 19% to 1,112.

"The decline in Chapter 11 filings is mainly attributable to the increase in the debt limit in Chapter 13, which made it available to small businesses," said Jose R. Carrion of the Office of the U.S. Trustee, a division of the U.S. Department of Justice.

Although filings under Chapter 13 outnumber those under Chapter 11, the cases under the latter are more complex and involve higher debt. According to the Puerto Rico Commerce & Export Co., commercial-bankruptcy filings under Chapters 7 and 11 numbered only 3,998 between 1994 and 2003, for a yearly average of about 440.

Chapter 12, an option exclusively for farmers, has been in limbo since its legal status expired in December 2003. Efforts are under way in Congress to pass an amendment by October that would reactivate the chapter.

"Chapter 13 can accommodate different petitioners for different reasons such as divorce, illness, and unemployment," said Carrion. "At the core is always a financial crisis, which the bankruptcy process helps to stabilize."

Chapter 13 has become a darling of creditors because it allows for debt recovery. Secured creditors (mortgage banks, auto dealers, furniture and appliance stores) are repaid 100% of the debt under Chapter 13, directly or through a repayment plan. Unsecured creditors (credit-card companies, personal-loan providers, retailers, and service providers) obtain partial repayment in most cases.

There is much less likelihood of debt recovery under Chapter 7. Currently, some 95% of Chapter 7 cases are categorized nonassets, meaning there is nothing left at the end of the bankruptcy process for creditors to collect on.

With repayment completed in an average of five years under Chapter 13, Puerto Rico based-trustees have recovered and distributed some $60 million into the economy this year. The completion rate of bankruptcy filings under Chapter 13 is 36% in Puerto Rico, compared with 30% on the U.S. mainland. Given the success of Chapter 13, there are initiatives tied into the proposed bankruptcy reform to make it available to a wider audience.

"In our experience, collections on mortgage and personal loans have been extremely stable over the past four years," said Citibank’s Gaviria. "Current collection figures for personal revolving lines of credit are running significantly below the similar periods in 2002 and 2003."

For bankruptcy filers, Chapter 13 is attractive because it now has a higher debt limit, could allow them to keep their home equity and cars, and protects their co-debtors, typically relatives, friends, and co-workers. Creditors are prevented from collecting on either the debtor or the co-debtor once the former makes the bankruptcy petition and agrees to pay the related debt in full. Also, Chapter 13 cases are relatively inexpensive to process.

People who must resort to filing for bankruptcy may feel guilt and inadequacy. They also may fear others will think they are out for a free ride. That doesn’t seem to be the case in Puerto Rico, however. Most locals who petition under Chapter 13 fulfill their financial obligations.

"There is a tendency among locals to settle debts and be on good terms," said Judge Carlo. "It could be a cultural issue where the individual’s reputation is central to the his or her life."

Know your bankruptcy chapters

As of June 30, there were 32,539 open cases in the U.S. Bankruptcy Court in Puerto Rico being handled by three sitting and two visiting judges, plus a variable number of trustees.

Bankruptcy judges have the duty to resolve controversies between debtors and trustees, creditors, and other interested parties. Their tool, the Bankruptcy Code, includes five chapters: 7, 9, 11, 12, and 13.

Chapter 7 is the liquidation alternative, commonly known as straight bankruptcy. This chapter has no debt limit and is available to individuals as well as corporations.

Chapter 9 is for municipalities but isn’t applicable to Puerto Rico.

Chapter 11 is a reorganization chapter available to individuals and corporations.

Chapter 12 is available to individuals and corporations in the farming business, as defined by the Bankruptcy Code, and has a debt limit of $1.5 million.

Chapter 13, also known as the wage-earner chapter, is available only to individuals with unsecured debts of less than $307,675 and secured debts of less than $922,975.

The goal of the bankruptcy system is to obtain the discharge of all unsecured debts incurred before and owed at the time that the bankruptcy petition is filed. The discharge is a privilege conceded by law to each debtor who complies with the duties and obligations under the bankruptcy law.

Credit counselors lend a hand

Consumer Credit Counseling Service of P.R. (CCCS), one of several credit-fixing firms on the island, has been helping locals climb out of debt for 14 years, helping them manage their finances and perhaps avoid having to file for bankruptcy.

Generally, local consumers have continued spending briskly despite the weak economy of the past few years. Published reports in May 2004 pegged total annual consumer income at $43.6 billion, compared with consumer spending of $40.2 billion.

While consumers don’t seem to be spending beyond their means, there isn’t much breathing room. This small gap between income and spending combines with the low savings rate in Puerto Rico to create one of the reasons for locals’ increasing demand for credit services.

According to the CCCS, its typical client is 41 years old and has annual income of approximately $18,000 and total debt of $24,000.

"Most of the people who visit us don’t have to enter into a bankruptcy process," said CCCS President Roberto Baerga. "Our orientations in the office and via telephone tend to provide the information people need to handle the situation. If there are still debt problems after adjusting their budget, however, consumers can join an optional debt-management program."

"We believe a good reason for the credit crisis is the lack of consumer orientation," said Baerga. "Adequate orientation could lead to good budgeting and saving habits."

The CCCS is a nonprofit organization affiliated with the National Foundation for Credit Counseling. It provides services in the areas of budget analysis, management of personal finances, and use of credit.

According to the CCCS, it has interviewed nearly 76,000 people, arranged payment plans for 23,888 clients, and recovered $122.4 million in debts since its establishment.

Personal Bankruptcies in Puerto Rico by Working Population

2001 / 2003

Professionals 524 / 674

Teachers 238 / 279

Clerical workers 772 / 887

Police officers & other security workers 816 / 830

Technical workers 301 / 340

Construction workers & related others 374 / 418

Hotel, restaurant & cafeteria workers 705 / 598

Health services workers 249 / 209

Sales workers, managers & related others 931 / 1,145

Other craftspeople 5,454 / 4,420

Total bankruptcies by working professionals 10,364 / 9,800

Bankruptcies by retirees & unemployed people 3,267 / 3,6598

Total personal bankruptcies 13,631 / 13,459

Source: Puerto Rico Commerce & Export Co.

This Caribbean Business article appears courtesy of Casiano Communications.
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