Saturday, April 16, 2005

"Bankruptcy reform" is a lot like tax rates--it's an opportunity for plenty of partisan ranting on behalf of bedrock principles, but it's really about marginal adjustments and practical outcomes, not hard-and-fast absolutes.

On the right, Todd Zywicki argues (and argues and argues and argues....) that the new bankruptcy reform bill will help reduce bankruptcy fraud and abuse, thus lowering interest rates for honest borrowers and protecting individual, small-scale and non-profit creditors from bankruptcy-abusers. On the left, Paul Krugman and Mark Kleiman essentially follow the "cui bono?" path, and conclude that the bankruptcy reform bill is all a plot by consumer creditors to increase their profits by winning the right to squeeze their helpless, impoverished debtors even harder than before. What's missing from both of these arguments is a clear picture of what bankruptcy is for, and why one might want to tighten or loosen its rules.

Bankruptcy is simply a standardization of the act of defaulting on debts. When a debtor defaults on a debt, then the creditor can go to court to recover as much as possible of the debt from the debtor's remaining assets. When there are multiple creditors, though, deciding whose repayment gets which priority up to what amount becomes quite complicated. Bankruptcy is a way of resolving this complexity--in effect, the debtor's current assets are divided up among the creditors according to certain rules, and the debtor's debts are thereby ruled discharged.

Of course, the devil's in the details. When can a debtor declare bankruptcy? Which of the debtor's assets are the creditors then allowed to divvy up? Which debts and obligations are thereby discharged? The answers to these questions can be more debtor-friendly--say, giving the debtor maximum flexibility in choosing when and how often to declare bankruptcy, requiring that only certain specific assets be seized, and specifying that all obligations are thereby fully discharged. Or they can be more creditor-friendly--say, severely limiting the debtor's option to declare bankruptcy, requiring that all present and future assets be prospectively seized, and only allowing a few debts to be thereby discharged. Where the laws stand on these questions thus determines a balance between debtors' and creditors' interests, which can be shifted in either direction at any time, for political or economic reasons. The latest "bankruptcy reform" bill, for instance, would shift the balance slightly further towards the creditors' interests in certain ways.

The bill is a response to a recent significant rise in the rate of bankruptcies. The bill's supporters argue that "abuse" of the law is increasing, as bankruptcy becomes less of a cultural stigma, and that the resulting hesitancy on the part of lenders may reduce the availability of credit to "honest" borrowers. The bill's opponents respond that the rise in bankruptcy is a result of increased "sub-prime" lending--that is, lending to borrowers who were higher bankruptcy risks in the first place--and that creditors are simply trying to avoid having to pay the price for their reckless lending practices.

Rather than attempt to assign blame for the rise in bankruptcies, it would be worthwhile to ask whether they're a problem in the first place. In fact, the rise in bankruptcies is a result of increased lending to risky borrowers--but the lenders weren't simply being foolish or reckless. Rather, their behavior is a perfectly sensible response to the financial revolution of the '80s and '90s--the same one that helped trigger today's housing and mortgage boom.

In the last couple of decades, it has become legally and technically possible to "repackage" debt more flexibly than ever before. For example, mortgages were once issued by individual institutions, who stood to lose substantial amounts of money if more of their mortgages defaulted than they had expected--say, as a result of a local economic downturn. Today, however, mortgages can be "bundled" into "mortgage-backed securities"--bonds whose value is based on the combined future mortgage payments of many different borrowers. These bonds can then be sold off to multiple investors, spreading the risk of any one institution's mortgage portfolio over perhaps hundreds or thousands of institutions. As a result, any individual institution's risk is greatly reduced.

Of course, since financial institutions are in the business of fielding controlled amounts of risk in exchange for the chance of a profit, their response has been not to reduce the risk of their portfolios, but rather to seek higher profits by jacking their risk back up to its previous level. The obvious way to do this is to lend to higher-risk borrowers, at higher interest rates, and then reduce their exposure to its previous level using the repackaging trick.

Something very similar has happened in the consumer lending business. Those "sub-prime" lenders--credit card companies that sign up hordes of questionable credit risks--are engaged in exactly the same game as the mortgage issuers: they repackage their cusomers' future credit card payments as bonds, then sell them off to multiple buyers, spreading out the risk to the point where any one buyer's exposure is bearable even at high default rates--that is, at high bankruptcy rates. And since these higher-risk loans also carry higher returns--poor credit risks are always charged higher interest rates--these bearable-risk, high-return bonds are good business for everyone. That's why those millions of "pre-approved" credit card applications keep flowing through the mail, even as the bankruptcy rate increases.

Under these circumstances, the argument for bankruptcy reform--that it's necessary to stem the rising tide of bankruptcies to keep credit within reach of higher-risk customers--is clearly nonsense. The increased availability of credit to less credit-worthy customers is driving the increase in bankruptcies, not being threatened by it. It's true that making bankruptcy more difficult and onerous for debtors would make credit even easier for high-risk borrowers to obtain. (So would the return of debtors' prison, for that matter: lenders would be confident of the willingness of even high-risk debtors to do everything possible in order to repay their debts and stay out of jail.) But the increase in the bankruptcy rate, far from being a harbinger of decreased credit availability, is actually a symptom of increased credit availability. Credit availability may or may not be at the "ideal" level today, but if you think we need more of it, then you should already be happy with the direction it's been going.

The day bankruptcy rates drop, on the other hand--because creditors are too afraid to lend to all but the least risky borrowers--we might want to consider tightening bankruptcy laws, in order to boost lenders' confidence that they'll be repaid. That day may yet come--say, after some future economic downturn triggers a sharp rise in bankruptcies, panicking creditors into tightening their credit standards. (Indeed, I suspect a greater-than-expected jump in interest rates could well create such an outcome very soon.)

However, that day is certainly not today. Creditors are hardly spooked by the current rising tide of bankruptcies--on the contrary, they fully expected it, have factored it carefully into their calculations, and are loving every minute of it.

1 comment:

Anonymous said...

This is the reasoned view of the bankruptcy bill. The political viewpoint is that the credit card companies are expending political capital to get the ability to increase fees on the class of debtors that generates the most profit for them.