Asymmetrical Information

From the desk of Jane Galt:

How much bankruptcy fraud is there?

The true answer seems to be that no one knows. The best number out there is from the FBI, which sets it at around 10%, but government bureaucrats have been known in the past to pull numbers out of thin air in order to comply with the regulatory mania for quantitative precision in the face of uncertainty. The American Bankruptcy Institute, which is roughly neutral, estimates it's more like 3.5%. And these folks have done a study which I won't vouch for, but which is certainly entertaining reading:

We gathered a random sample of Chapter 7 petitions in 24 states, all filed the same day: June 5, 2002. It was the day in the middle of the worst year for filings. Our sample size was about 7.9% of all the Chapter 7 filings of that day.

All the cases we studied were successfully discharged.

We created a database of asset, debt, income, and living expense numbers and looked at the statistical results. We also did something judges don’t always do: We read some of the petitions carefully.

The FBI estimates that 10% of bankruptcy filings involve fraud of some kind. But fewer than 0.1% of filers are convicted. And our statistical analysis suggests that even the 10% fraud estimate is probably low.

For instance, in what amounts to a wild supposed coincidence, nearly one-third of filers say they spent their very last cash on their legal and filing fees.

Among individual petitions, one after another stretched credibility to its limits. We illustrate with 30 case studies, all pretty clear stuff. Check James, who had $800,000 of unsecured debt but claimed the assets he acquired were gone after being struck by lightning. Russ in California had no job, no income, and no cash but somehow maintained his monthly gym membership. Brian owed money on a hot tub he claimed was stolen (by a gang of patient thieves, apparently; it takes hours to drain one and at least six large men to lift the shell.)

Bob and Susan had $120,000 of annual income but couldn’t pay their debts for one big reason: $826 per month they spent on a SeaRay boat. Still, they reaffirmed the boat loan. Alexis filed, owing only $2,088 in total debt, even though she had a good job and could have paid half the debt with what she spent on lawyer and filing fees.

That last case, by the way, is malpractice by her bankruptcy lawyer; you should never, ever consider filing bankruptcy for a sum that you could pay back in a couple of years by working one shift a week at McDonalds. Those sorts of bankruptcies are far more costly to the "abuser" than the credit card companies.

But that brings up the question: what is fraud? Most of us would agree, I think, that there is a difference between, say, not listing your grandmother's engagement ring among your assets, and "forgetting" to mention a boat, some rolexes, a rembrant sketch and a numbered bank account in Switzerland. When the FBI says that 10% of cases involve fraud, how many of those cases are the former, and how many the latter?

That matters, because as with all social policy, there is a tradeoff between catching the guilty and persecuting the innocent. Living, as we do, in an imperfect world, having to make do with bankruptcy courts staffed with human beings rather than angels, we must deal with the fact that eliminating more fraud also means denying just relief to more innocents. If 10% of bankruptcy filings involve gross abuse of the process, then perhaps it's worth it. On the other hand, if 1% of filings involve gross abuse, and 9% involve people trying to hang onto a couple hundred bucks of extra stuff, then is it worth punishing the innocent in order to root this out?

Posted by Jane Galt at April 15, 2005 6:26 AM | TrackBack | Technorati inbound links