Debt madness - Is the tide beginning to turn?

Warning! This briefing is not for the faint hearted. It contains tales of explicit financial recklessness that some readers may find offensive.

A chap, let’s call him Dave, rang up the other day for advice. He was about to nip down to his local county court to make himself bankrupt and explained that:-

• He was 23 years old
• He lived at home with his parents
• He worked as a window cleaner
• His personal debts amounted to £70,000
• Apart from his personal possessions he had no assets whatsoever.

Dave wanted to know if, in bankruptcy, he would be able to keep his bucket, his ladder and his squeegee.

Since Medieval times, the tools of a person’s trade have been protected in bankruptcy so it was possible to reassure him that his squeegee was not at risk. That, however, is not what is interesting about this case and many many like it.

Dave would not have been issued with a credit card until he reached the age of 18. He therefore incurred £70k of debt in five years. Should he be applauded or vilified?

For most people this story will instil a feeling of moral outrage but let us consider for a moment who has lost out.

Arguably, Dave himself has done rather well.

He has enjoyed £70k of someone else’s money which he will not have to repay. That’s the equivalent to earnings of more than £100k before tax.

Admittedly Dave is now a bankrupt but will that be much of a hardship? He has no assets that will be confiscated and, on average, bankrupts are being discharged after eight months.

Once discharged he will be free to borrow again and, indeed, will inevitably be targeted by credit card companies, competing to lend to him.

But what about the financial institutions that are left with Dave’s bad debts? They are profit-driven organisations that make rational decisions in the interests of their shareholders. The surprising fact is that, up to now, despite their recent complaints about the “Aggressive marketing” of personal insolvency by unregulated advisors, many banks calculate that it is better to lend recklessly than to undertake expensive credit checks. Not only do they save the cost of the credit checks but they avoid the possibility of refusing credit to individuals from whom they might make a profit.

It is often said that the cost of credit card default is borne by other customers. But is that really true? Those who pay off the balance on their cards each month enjoy free credit and the rest pay interest at average rates of about 12%.

Bank base rates are, as of July 2006, 4.5% and fewer than 1% of customers default. It is difficult to believe that, even if the banks could eradicate default entirely, interest rates on credit cards would fall to one or two percentage points above base rate.

Finally it is no secret that Dave and people like him have been largely responsible for keeping the UK economy afloat recently. One respected, but politically incorrect, economist said recently that “What Germany needs right now is 20,000 British housewives to be parachuted in with their credit cards”. On that basis one could argue that Dave and the “WAGs” (Wives and Girlfriends of the English football team) for that matter should be awarded medals for doing their bit for Britain.

And if Dave deserves a medal, the couple we advised last month deserve a knighthood. Admittedly they had a few more years of experience than Dave, each being in their late sixties, but that should not detract from their “achievement” in clocking up £½million of unsecured debt over 46 credit cards.

What many would find shocking is that their credit rating was absolutely impeccable despite having a monthly pension income of £2,000 compared with minimum credit card repayments of £12,000 a month.

The purpose of this briefing, however, is not to scandalise but to warn that the tide is starting to turn. Over the last few weeks we have started to see a dramatic increase in the number of “Bankruptcy Restriction Orders”.

Recent bankrupts have benefited from the relaxation of the rules brought in by the Enterprise Act 2002. Indeed the new rules have led to record numbers of new personal insolvencies, now running at about 300 a day. The legislation was based on a belief that there are two types of bankrupt:

• Firstly, those unfortunate but responsible risk-takers for whom bankruptcy should not create a stigma or restrict them from re-engaging in entrepreneurial activity; and
• Secondly, those irresponsible individuals whose ability to obtain credit should be curtailed for an extended period

The Bankruptcy Restriction Order (“BRO”) was introduced as the means by which the Insolvency Service could hold the culpable to account. Until recently, BROs have been used very rarely but they are becoming increasingly common. It is therefore important to try to understand in what circumstances they apply.

Often they are implemented by agreement rather than by court order so there is a paucity of case law and little consistency.

For example, we recently dealt with a bankrupt who owed in excess of £1million. Despite having a business with a turnover of less than £100,000 and being unable to explain where the money had gone, no restriction was sought.

By contrast, an eighty year old man received a three year BRO for incurring gambling debts of £8k as did a woman in her thirties who attributed her debts of £30k to “living a life of luxury when she knew she couldn’t afford it” by paying for socialising, hair and beauty treatments and clothing.

In summary, the era of impunity for the reckless consumer may be coming to an end but, during the next few months, it may be almost impossible to predict who will get away with murder and who will be made an example of for relatively minor misdemeanours. Meanwhile, as the banks post dramatically increased consumer bad debt provisions, they may start to be a little more reticent about their lending. For those that have been juggling their debts between credit cards, it could well be that the end is nigh.