Upside Down? Bankrupt? No Bailout for You, Bub!

For those who would make the unwise decision to roll the old car’s debt into the new car, yet another reason not to. Policy wonks may recall how during the Bush administration the banking industry got its fondest (pre-bailout) wishes granted. The bankruptcy rules were re-written to make it substantially more difficult for a normal person to discharge debt. (Interestingly, mansion owners in Texas and Florida somehow survived unscathed while the vast majority of bankrupts are still done in by medical bills.) The upshot is that fewer qualify for a full Chapter 7 discharge and more must file a Chapter 13 repayment plan. Here’s what that means for the “typical” car buyer.

Let’s say a woman buys a new 2004 Grand Am. Rolled into her “deal”: $5,980.00 of debt from her trade in. The total contract comes to $23,850.00 before interest and fees. It is a standard GMAC car loan contract. Two years later, the woman files for bankruptcy, which is no surprise if she makes deals like this one.

When she files for bankruptcy, as a creditor with a lien on property of any sort, she bears a risk of “cram down.” The loan amount will be adjusted (downward) to the actual value of the item with the lien. The exception (and there always is one): there’s no “cram down” in a chapter 13 if the debtor “reaffirms” the loan, for a house or a car. It is “secured” debt and given priority. (Debtor has to live somewhere and get to work so this is routine).

This becomes a crucial question to the GMACs of the world. The loan is worth, to the bank, either a) the cram down value, meaning that any overage is lost, or b) the whole loan amount, even if not directly attributed to the value of the car. In this case, the value of the Grand Am was $10,950.00. The lien amount was $17,904.00.

Reproduce this case by one hundred thousand and you see why this is not just a minor point of bankruptcy law. The finance company would have to eat all the bad decisions of debtors and unwise car finance contracts, as that debt would be “unsecured” and in most cases that means “unpaid.” This would also mean that depreciation of product would also come out of the creditor’s side, a not inconsiderable issue in today’s world.

The Second Circuit of the United States Court of Appeals reasoned that the loan, even if more than the car’s value, was part of the transaction between the parties, and as such, GMAC was entitled to full security for the full note, not just the value of the car. The dissent, which we can only hope prevails if the US Supreme Court ever hears this, reasons that the purpose of the security is to secure the product, not side deals or other loans.

The short answer here is that even if you file bankruptcy, an upside down car remains “upside down” and none of that debt can be discharged. This is a huge win for the banking industry. Even if you go bankrupt, there is no bailout for you!