The Bankrupt Rich

By Daniel Indiviglio

A few weeks ago, I wrote a post about how the rich aren't getting richer. This recession is taking a toll on the wealthy as well as the low and middle classes. That fact spurs little sympathy from most, so I doubt another article about the rich's troubles from Bloomberg today will either. Apparently, the real estate crash is causing even the rich to go bankrupt.

Bloomberg reports:

Wealthy individuals' Chapter 11 bankruptcy filings jumped 73 percent in the second quarter from a year earlier, according to the National Bankruptcy Research Center, a research firm in Burlingame, California.


More individuals or families with at least $1,010,650 in secured debt and $336,900 unsecured are using Chapter 11 of the U.S. bankruptcy code typically associated with business reorganizations. Falling U.S. home prices leave them unable to refinance or sell properties when they drop below the value of the mortgage, said Joseph Baldi, a Chicago bankruptcy attorney.


Listings of homes for sale worth $1 million or more increased 27.3 percent in July from October, according to Zillow.com, a Web site that tracks real estate transactions. The number of homes sold with a value between $1 million to $2 million fell 23 percent in July from a year earlier, according to the Chicago-based National Association of Realtors. There was a 21-month supply, up from 16 months last year.



Clearly 73% is a huge jump. But it's hard to know just how significant this statistic really is, since it's just a percentage increase and not an actual number For example, if in Q2 last year only 11 wealthy individuals declared bankruptcy, I'm not sure 19 (a 73% increase!) declaring for the same quarter this year deserves too much concern. If you multiply those numbers by 100, however, they start to matter. (I attempted to contact the NBRC, but they did not respond.) But let's take this percentage increase in good faith and assume the numbers do matter.

So why did these individuals file Chapter 11 and not Chapter 7 like everybody else? Bloomberg explains:

The debt levels in the 2005 law prevent many higher-income people from filing Chapter 7, Green said.


"They're locked out of Chapter 7, because they make a lot of money, and it's a disaster," Green said. "They're in a netherworld, just hanging out there."



I have a few observations about this trend. First, in case you didn't know, the rich do have debt. In fact, the rich often have debt levels that far exceed that of the middle class and poor. Why? For one, because they can. It's a lot easier to get credit if you've got lots of income or a high net worth. That's especially relevant if you can get financing for cheaper than you are earning for the return on your investments.

Second, the rich generally care at least as much about "keeping up with the Joneses" as the other classes. In high society circles, status is very important. Having a bigger house, nicer car, better designer clothes, etc. matters a lot. Having grown up in Boca Raton, Florida, I accumulated enough anecdotal evidence of this to fill a book.

So what does this bankruptcy trend mean for the economy? Mostly bad things. First, it's bad for investment. If more rich are going bankrupt, their investments will be liquidated, and obviously they won't be making new ones anytime soon. It's also bad for consumption. During a recession the rich are generally more comfortable spending money on discretionary items than everybody else. If they just filed bankruptcy or are on the verge of doing so, then that rule fails to hold.

Finally, it could have some interesting implications for banks' lending standards. If they did give too much credit to wealthy individuals, they might be rethinking that strategy. This recession is making clear that no one is immune to a catastrophic market shock. Banks should probably rely more on measures of total indebtedness than debt-to-income ratios. If that income disappears, all bets are off. They may also require even greater amounts of equity for more expensive real estate. Even the standard 10% to 20% down may not be enough to cover losses when a high-priced property becomes illiquid -- and those losses can be far more substantial in nominal terms when the property values exceed $1 million.

This article available online at:

http://www.theatlantic.com/business/archive/2009/09/the-bankrupt-rich/24738/