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Source link: http://archive.mises.org/9918/the-problem-with-bankruptcy-laws/

The Problem with Bankruptcy Laws

May 8, 2009 by

In the United States, defaulting homeowners can walk away from their problem after declaring bankruptcy under Chapter 7. There are significant advantages to this option. It allows these people to make a new start, and return to the labor market free from debt. The risk of such defaults is built into banking models, and the costs are distributed among other borrowers. However, this system has never been tested under the extremely stressful conditions of a bursting asset-price bubble. FULL ARTICLE

{ 28 comments }

Gil May 8, 2009 at 10:06 am

Meh. The good ol’ fashioned view used to be that if you incur a debt then you must repay it, period. You cannot shirk the debt just because it has become too much of a discomfort. The obvious outcome for someone who has a debt to repay yet has no means to repay is to become a ‘debt slave’ to the lender and is the property of the lender until the debt has been repaid. However, a modern way to avoid bad lending practices is the way lenders wanted the aspiring borrowers to put up some sort of ‘collateral’ – if the borrowers can’t pay then they lose their collateral instead of becoming a ‘debt slave’. Simple.

matt May 8, 2009 at 10:45 am

………or banks could lend prudently so as to limit their dowside risk should property values erode. You can make marginal loans to good people and good loans to marginal people but when you start making marginal loans to marginal people, you get what you deserve.

Jeffrey G May 8, 2009 at 10:55 am

With a mortgage, the borrower isn’t walking away leaving the bank with nothing. The borrower is walking away leaving the bank with… the house. This is what the bank signed up for. It was baked into the theory behind CDOs. “We can make risky mortgages knowing that a certain percentage will most certainly default, but we will have the house, which is valuable and we will sell it for money, so it isn’t a big deal.”

Is the house now upside-down? So what? I’m not crying for the bank. They are the bank. They are supposed to know the market. They got the market wrong, that’s all. I hear radio commercials for Comerica Bank claiming they have no sub-prime debt. Perhaps they knew the market better than other banks.

Jonathan Wyse May 8, 2009 at 11:11 am

Gil: Collateral works fine, unless the collateral falls in value. That’s fine, unless negative equity causes moral hazard, that creates an incentive for borrowers to exploit government bankruptcy law. That’s the problem I’m pointing to.

Matt: The point is that moral hazard, by giving individuals freedom over declaration of bankruptcy, causes problem in this market.

Jeffrey G: I outlined the traditional reasoning behind lending and collateral, and you are also correct in your depiction above.

There wouldn’t be a problem with bank prices bursting, in general. Banks can build this into their estimations too, and of course are liable to take risks (and maybe lose out, as you are suggesting).

The problem (again) that I’m pointing to in the article: is that bankruptcy laws allow borrowers to free themselves from their burden when they hit negative equity. It would be market to let market forces determine the optimal ‘liability’ that borrowers have if they default debt, rather than allow declaration of bankruptcy. It is similar in effect to undermining enforceability of contracts, by choice of one party to that contract.

matt May 8, 2009 at 11:27 am

by giving banks a free pass on making collateralized loans with no downsize risk aren’t you essentially creating a no lose situation for banks? a system that utilized too much risk and leverage will now have another safety net. Does that not encourage more risky lending? just trying to understand your plan and thanks for the reply.

Joe Stoutenburg May 8, 2009 at 11:39 am

I like the idea of writing the terms of default into the contract in advance. People who opted for soft escape clauses would undoubtedly pay a higher rate to reimburse the bank for unrecovered losses. Making use of a soft escape clause would still have the kind of negative consequence in credit rating as we currently see. People who opted for rock-solid guarantees for the bank (perhaps including indentured servitude) would enjoy a lower rate.

Bankruptcy laws are a case, as you say, of the state overriding contracts. These matters could be solved through the private agreement of parties to a contract. Instead, we get one-size-fits-all “solutions” that cause intended consequences.

Jonathan Wyse May 8, 2009 at 11:46 am

If implemented, I think the bank’s claim on your income would have to be limited in temporal and proportional terms (i.e. maximum 10% of your income for 15 years if you default). There’s no guarantee that they would get ALL their money back – so there’s still substantial risk.

Also, real sub-prime lenders (those least likely to have assets) can be at risk of losing their jobs, especially in times like these. If the defaulter was on welfare, I don’t think the bank would be allowed to make any substantial claim for compensation.

Thus, sub-prime lending might be less risky (obviously so, if you’re eliminating the risk that they’re default by choice if their house goes into negative equity) but still pretty risky.

Also, banks would be making a loss if they got the money later than originally agreed because they couldn’t possibly receive full compensation.

The income-liability suggestion is only one way in which the moral hazard could be eliminated, though. The problem is basically that bankruptcy allows you to renege on your debt. When the borrower can choose to let that happen, mortgage contracts are undermined.

Allow free market to determine the nature and conditions under which ‘bankruptcy’ happen, and allow borrowers to contact into a certain type when they’re negotiating their loan?

Jonathan Wyse May 8, 2009 at 11:48 am

Joe,

That’s exactly it! Thanks for expressing it so well..

Jeffrey G May 8, 2009 at 11:56 am

The problem (again) that I’m pointing to in the article: is that bankruptcy laws allow borrowers to free themselves from their burden when they hit negative equity.

That is only a problem for the bank. If they knew from the beginning that they would be on the hook if home prices went down, that would not be a moral hazard for the banks. They would be careful in making the loan. Risky loans would be hard to get for customers, so the moral hazard impact for them would be minimal. There will always be people who will be willing to borrow as much as they can without thinking of the consequences. The knowledge of when to say “no” should be in a bank’s business model. That is part of their job, to know the market.

If banks know they will get bailed out, well that’s another story.

Peterp May 8, 2009 at 12:02 pm

The bankruptcy laws have been the rule of the game for a long time. They apply to both companies and individuals. If an entity takes on too much risk and fails it can discharge its debts. This is not the cause or even a contributor of the current situation. The correct cause and contributor to this crisis is the manipulation of the money supply by the central planner (FED) and the misalocation of capital. Changing the rules for bankruptcy on individuals only without removing the central planner would create a nation of servants.

Jonathan Wyse May 8, 2009 at 12:46 pm

Jeffrey:

If you observed moral hazard in the medical insurance market, is it just a problem for medical insurers? No, it can lead to sub-optimal outcomes from the perspective of consumers and society. Same principle applies here. That’s why it’s not just as simple as saying “It’s the banks’ problem”.

Peterp:

Care to elaborate on why you don’t think this was “even a contributor of the current situation”? I’d be interested to hear.

Peterp May 8, 2009 at 1:27 pm

Bankruptcies and defaults are the results of the current situtation. The contributors are what created the asset class bubble. Monetary policy manipulation and misalocation of resources are the contributors.

matt May 8, 2009 at 1:35 pm

would you translate this protection to the corporate world?

Walt D. May 8, 2009 at 3:00 pm

This has been discussed before on this site. As I see it, the controversy arises from a conflict between the Libertarian’s right to property doctrine and the right to contract.
The Libertarian draws no distinction between my borrowing money from my brother, interest free, and a credit card where I borrow from the bank at a high rate of interest. In Ireland, using traditional Catholic values, it is probably a sin to borrow money and not repay, under any circumstances.
A mortgage is a contract, by definition, and both parties agree at the outset to abide by the terms of the contract, which include, among other things, what happens in the case of a default. The cost associated with credit risk is built into the interest rate. Since this is determined by the bank, if the bank gets the risk premium wrong then that is their problem.
What is egregious is the Federal Government coming in, after the fact, and abrogating the contract, as it did in the case of Crysler’s secured bond holders. As Warren Buffett put it, this is like selling a bankrupt person’s house and then shorting the mortgage holder to pay off credit cards.

Jonathan Wyse May 8, 2009 at 9:50 pm

Matt:

I’m not sure what you mean by protection? I think it makes sense in the case of firms as well, but it’s less clear. I guess there could be flexibility over reorganisation when firms declare bankruptcy. Also, entrepreneurs that are willing to make themselves more personally liable in the event of failure will find it easier to get loans perhaps?

Essentially, those who are gonna duck out of their loan by declaring bankruptcy are not differentiable from the rest under the status quo. But by allowing individual negotiation of terms of default, you allow people to signal how serious they are about repayment.

Walt D:

Again, it’s not just the bank’s problem if they get the wrong end of the stick. If government intervention causes market distortion and prevents enforceability of contracts, surely it’s everyone’s problem?

The whole “they knew the possibility of bankruptcy declaration” argument would be akin to my responding to your complaint as regards treatment of Crysler’s secured bond holders by saying: “they did know there was a chance that the government would interfere and abrogate the contract though, and they should have built that into their estimation of risk”. That’s true, but it ignores the root of the problem.

Bennet Cecil May 8, 2009 at 10:38 pm

Insolvent companies and individuals need to be able to liquidate their debts and start over. This is best for our nation and for the debtors. The debtor can start over and produce for himself and for society. The lender can reduce the impact of loss by having collateral and also by diversifying his loan portfolio.

The US federal government is the largest and most dangerous debtor in the world. When it defaults, the bankruptcy will have huge effects on China, Japan, and the Middle East. Investors should diversify away from dollars. Hard assets are superior to the fiat currency of a nation that consistently overspends its income. Bankruptcy of the US government will be the rupture of the largest financial bubble in history.

Bennet Cecil May 8, 2009 at 10:38 pm

Insolvent companies and individuals need to be able to liquidate their debts and start over. This is best for our nation and for the debtors. The debtor can start over and produce for himself and for society. The lender can reduce the impact of loss by having collateral and also by diversifying his loan portfolio.

The US federal government is the largest and most dangerous debtor in the world. When it defaults, the bankruptcy will have huge effects on China, Japan, and the Middle East. Investors should diversify away from dollars. Hard assets are superior to the fiat currency of a nation that consistently overspends its income. Bankruptcy of the US government will be the rupture of the largest financial bubble in history.

gene May 9, 2009 at 12:03 pm

There is ONE HUGE PROBLEM with the logic or actually lack of it, in this article.

Banks are all “corporations” which have been vested by the State with the privlege and advantage of “LIMITED LIABILITY”.

How can we possibly be finding fault with an individual exercising limited liability by defaulting on their mortgage to institutions that have been “blessed” by the state with “limited liability”? There is ZERO logic there, ZERO!!!!

Limited liability in any instance is dead wrong, individual or corporation, there is no difference.

gene May 9, 2009 at 12:39 pm

I shouldn’t say “dead wrong”, that is a subjective judgement.

Any type of “forced” acceptance of other’s liability, such as the chartering of corporations under “limited liability” status by the State, of the forgiveness and transfer of debt of individuals or corporations by the State is Socialism. A market cannot be considered free with forced transfer of liability. You can determine the wrongness or rightness.

Contracts, of course, can determine liability any way both parties agree to. Limited liability granted by the State is simply a contract forced upon whoever it affects by unjust law.

Jonathan Wyse May 9, 2009 at 12:45 pm

gene:

You’re just playing word association. I can play that game too.

“How can we find fault with individuals who commit ‘crimes’ when the people that they’re committing ‘crimes’ against have also committed crimes! There is ZERO logic there, ZERO!!!!”

That’s not an argument, except by distraction. If you want to argue against limited liability of shareholders, that’s another debate.

Also, your post (while short) is inconsistent. You claim to be against limited liability anywhere (which is illogical – clearly in absence of moral hazard, people should be able to contract into deals with PLCs), but refuse to engage constructively with arguments against its abolition in an individual case. Do you prefer ‘consistency’, which means limited liability for everyone? That’s very illogical.

gene May 9, 2009 at 12:56 pm

Jonathan,

I am completely in agreement with the article.

Problem being, it makes no sense to enforce liability on individuals and not on corporations or shareholders as you mention.

Any forced transfer of liability is socialism.

How can there be a free market when advantage is granted [incorporation] before any transactions take place?

Adam May 9, 2009 at 2:22 pm

Good point, Gene.

You shouldn’t be able to have it both ways: Deny bankruptcy protection for individuals in the name of preventing their moral hazard, but keep full bankruptcy protection in place for corporations so they can continue to exploit moral hazards on their part.

Intellectually you can say these are separate topics or debates, but in reality, you cannot separate them politically.

If you take this whole debate to its logical conclusion, we will end up arguing as Gene is for the elimination of all bankruptcy laws and the ability to form corporations. We’ll be back to the days of Adam Smith. Wouldn’t that be great?

Basically, there would be a lot less incentive for banks to lend money to anyone, and a lot less incentive for anyone to borrow. So there would be a lot less lending and credit flowing around. Banking and finance would be much simpler. Wouldn’t that be great?

The only downside is that our standard of living would be a lot lower than they are today. We’d all be a lot poorer.

gene May 9, 2009 at 3:34 pm

Hi jonathan,
First I must say that I wasn’t being “complete” commenting that the article had “zero” logic. that isn’t true, the article was very logical and it was a good article.
But, it was a serious omission and unlogical to leave out the fact that banks have the exact liability protection that the article was criticizing about in regards to individuals.

Hi Adam,
You may be right about the standard of living but can we be sure? everything you mention that would happen, less credit etc., would also lead to much lower prices, wouldn’t it? And since corporations wouldn’t exist as they do today, it would seem the great quantities of wealth they possess would have to go somewhere?

Unless we believe that the wealth created IS the result of incorporation, then it makes sense that “we” actually created it and things might not be all that different in terms of wealth level. But, it is hard to say one way or the other, really.

Jonathan Wyse May 9, 2009 at 9:49 pm

Gene:

Actually, I’m not suggesting “enforced liability”. In fact, that would be philosophically just as bad really. It seems like allowing individuals to freely contract into their defaulting arrangement would be best. The market will determine optimal liability arrangements. All the government is doing under those circumstances is enforcing contracts – which is key.

As regards the hypocrisy of firm treatment, I can see the political link. The circumstances seem vert different. However, I’m sure there have been cases where creditors have lost out due to declaration of bankruptcy but the firm was then reorganised? I can see this as moral hazard from the perspective of the employees – but not shareholders if they were to lose their shares under these circumstances. This would only be moral hazard if that wasn’t the case, in which case the limited liability needs to be revised.

Meanwhile, shareholders that were free to enter contracts with “extended liability” might be more trust-worthy. But isn’t that qualitatively the same as them just buying more shares? Except that they’re keeping the money in their own pockets as opposed to letting the firm use it productively. Perhaps shareholders should be free to offer to make that extended liability, and not constrained by the state’s imposed ‘get out of jail free’ card of bankruptcy.

Adam:

Again, I’m not advocating forced liability of ANY level. I’m advocating freedom to contract, with state enforcement as usual. You’ve just stated (without backing it up using any reasoning) that if people were FORCED to accept total liability, the banking system would shut down. Would that banking system shut down if people were granted the FREEDOM to choose their own level of liability when they borrow money (firms or individuals)? You also just said words like ‘incentive’, without placing them in any formal logical structure. Feel free to elaborate..

Jonathan Wyse May 9, 2009 at 10:19 pm

Gene:

Another thought as regards the vastly different incentives at play. It’s just entirely disanalagous.

Shareholders are going to lose their limited liability either way, and aren’t exposing themselves or putting any effort in by continuing the company. Meanwhile, workers will work for the company as long as they are being paid. Thus, there’s no moral hazard surely?

Firms enter contract with each other, in full knowledge of the limited liability. But there’s no problem with that due to the absence of moral hazard. There’s no imaginable situation in which it would be better for anyone to default on their debts rather than continue plodding along. The shareholders lose EVERYTHING either way. But the fact that another firm lent them the money in knowledge of this, means there’s no big problem. Mind you, allowing determination of bankruptcy conditions through private arrangement would improve the market outcome.

The only imaginable circumstances might be workers preferring the firm to declare bankruptcy and be reorganised, rather than reform by laying off workers.. Interesting..

gene May 10, 2009 at 12:11 pm

Hi Jonathan,

I agree, a free market needs the freedom to “choose” liability under contract law.

My point would be that the “chartering” of “limited liability” by the State is an enfringement upon that freedom. The freedom must exist in [and be present before] the transaction, not be enforced before by the State.

Yes, I agree the State’s job is enforcement of the contract. Can we trust them!!!!!!!

I think the point you have brought up in your comments, is the “nature” of liability. Is liability inherent in the contract or does it only exist when its limits are exceeded? That’s a good one!

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