Wednesday, April 27, 2016

Was Bankruptcy Reform a Bad Idea? Maybe Not.

Was Bankruptcy reform a good idea?  Generally, yes.

In a recent posting, I noted offhand:

Since we live in a Capitalist society, there are lenders who will lend money to people with less-than-perfect credit scores.   As in any mathematical model, you can adjust the cost of the loan based on the factors above - the credit score, the collateral, and so forth.    Since a group of such "sub-prime" loans will have a higher default rate, the interest rate (and fees) will be correspondingly higher.   The borrowers are, in effect, paying for the malfeasance of their fellow sub-prime borrowers who do default.
Re-read that paragraph again and maybe you'll understand how lending works.  Most folks don't.   When you borrow money or use a credit card or whatever, part of the money the bank makes in the deal goes to paying the cost of bad debt and fraud.    Credit card companies write off a lot to fraud (stolen cards, etc.) which is why they charge retailers 2-4% on each transaction.  If fraud could be reduced, the cost to retailers could be reduced, which means prices could be lower.  When someone commits credit card fraud, we all pay for it.

Similarly, the interest rates you pay on a loan (including credit cards) are not all pure profit for the banks.  A lot of that money goes to pay for the bad debts that are generated by your fellow borrowers.   The guy down the street who stops making his car payments effectively increased yours as a result.   Defaulting borrowers are not funny, nor should they be sympathized with.  They cost us all money, and no the banks are not "making money" by foreclosing on properties - they lose their shirts (and as shareholders, we take a hit here as well!).

The next time you hear some deadbeat blather on about how "unfair the banks are" and how he's defaulting on his loan, reconsider your sympathy.   You are paying, almost directly, for his irresponsible behavior.   The bank doesn't pay, you do.  And no, the bank isn't being "unfair" to him, either.

Since we no longer have debtor's prisons (and no, going to jail for not paying a court fine or failing to appear for as summons is not the same thing as a debtor's prison - not even close!) people can - or could - largely escape from debts in the past by declaring bankruptcy and just walking away from debt.

And in the past, it was a pretty lucrative racket.  Since many States had laws sympathetic to consumers, some people willfully incurred debts they had no intention of paying back and then intentionally went bankrupt to avoid paying off these loans.   In some States, you might have been allowed to keep your home (working out a deal with the bank), your car (as you need it to get around) and the "principal tools of trade" which could be just about anything.   Before reform, bankruptcy could be a license to steal.

When you create economic rules, be they taxes or bankruptcy laws, you often create unintended consequences and as a result, some folks will try to game the system rather than live by the intentions of the rules.  In the years before I went to law school, some wily law students figured this out and ran up a lot of law school debt while living high on the hog.  New clothes, new cars, new computers - whatever - all paid for by law school loans.  A day after graduation, they declared bankruptcy and started over, right before they accepted their six-figure salary job with the big law firm.

Nice work if you can get it.

Similarly, the "humanitarian" impulses of legislators and courts tended to backfire when people started to realize that bankruptcy could be a way of life rather than a last resort.   Run up debt, never pay it back, go to court and get out scott-free.  Repeat every seven years.

Some lenders even realized the unintended consequences of these laws.  Since you can only declare bankruptcy every seven years (in most jurisdictions) the best borrower, ironically, is the guy who just emerged from bankruptcy.  Since he can't go chapter 7 on you, you can safely tow away his car or reclaim your collateral.  As a result of this, I've seen friends of mine go from bankruptcy to back in debt, nearly overnight.  The "relief" of bankruptcy was very brief.

Now, in the old days, the system was kind of based on trust and the honor system.   People didn't walk away from debt obligations because it simply wasn't done and moreover was a sign of shame.   However as our society has gotten larger, people are less and less concerned about social standing with regard to such issues.   Or more precisely, a lot of people today would rather be known as a deadbeat crook driving a Mercedes than an honest thrifty person in a Toyota.   We are more concerned about projecting an image than our actual reputations.

So the idea of screening debtors using credit reports - and later credit scores - has limited utility.   The system will only alert you to the chronic defaulter.   And for the person who makes even one mistake in their lives with debt, it punishes them forever, or nearly so.  Judging people's creditworthiness is no easy task - the idea of a firm handshake and good moral character are no longer useful in today's world.   And of course, it goes without saying you can't select your debtors based on their race or religion.

So what did banks do?  Well, they adjust interest rates to compensate for default rates.   If you are a "high risk" borrower, as determined by your credit history, your interest rate is higher.   So you pay a little more (or a lot more) every month to help cover the cost of the defaults by your fellow high-risk borrowers.   It is like health insurance before Obamacare.  Once you got sick, you were screwed, and your rates skyrocketed and stayed there.

One thought to alleviate this problem was the idea of reforming bankruptcy.   Since many "bankrupt" people still had assets and even jobs, they could in fact pay back a portion of their debts over time.  Just because you are technically insolvent (your debts exceed your assets) is no reason to wipe the slate clean.  And in 2005, bankruptcy laws were reformed in the USA so that a debtor entering bankruptcy has to try to "work out" their debt rather than just write it off.  This means the debtor has to pay back at least a portion of the debts, over a stated period of time.  (Note: there have been a lot of other incremental reforms as well, before and since).

What this means, of course, is that the party is over when it comes to bankruptcy.  If you declare bankruptcy, you will still be faced with debts and even onerous payments for a number of years.  The amount of "breathing room" you will get will be far less.   Granted, the lenders might get more of their money back, over time.  But on the other hand, the cost of appearing in court and arranging these payment plans might exceed the actual value of the payback received.  It is hard to say.  The net effect may be more to punish debtors by making bankruptcy less attractive than to reward lenders by allowing them to recover more of the debts.

And sub-prime lending rates would seem to reflect this, as it doesn't appear that rates have in fact declined over time, even if risk to the lender has been reduced.

But the punishment aspect of it should - at least in theory - discourage people from taking on frivolous or high-interest debts, or taking on debts they have no intention of repaying.   That was the theory anyway - carrot and stick, with a lot of stick to shake around.   Whether this theory has worked out is debatable.

Similarly, to close the loophole on Student Loan bankruptcy, these Federal loans were made to survive bankruptcy - as a figurative lien on the life of the student.   For Federal loans, which are offered at attractive interest rates, this sort of made sense.   If everyone defaulted on Student loans, then the rates would have to go up - or the government would be on the hook for a lot of debt.

But the GOP got into the act and decided that Private Student Loans should have similar protection from bankruptcy.  And it wasn't long before odious lenders and "for profit" colleges started offering such loans to people they knew could never pay it back.   Eighteen-year-olds would sign these loan documents, fully believing they were going to be rich once they graduated from college, and that is how we ended up with Bernie Sanders running for President.

Of course, you as the consumer still have a lot of choices in this area - and you do have these choices.   Looking back on my own life, I can tell you that most, if not all, of the debt I incurred in life (other than commercial debt) was not for things I needed but rather for things I wanted.    Moreover, my spending money on wants often meant that I ended up borrowing money for needs.

I could have been more frugal and thus avoided an awful lot of borrowing.   But I decided at the time that I needed to spend money to be happy or some such rot - that I deserved to "treat myself" now based on money I would earn later.   The later me decided this was a shitty idea, of course, and those two people never seem to agree on just about anything.  (Indeed, later me thinks that early retirement is probably a bad idea, while earlier me thinks it is just swell).

And the problem with borrowing money is that the worse you are at it, the most it will cost you, over time.  There quickly reaches a "tipping point" where the cost of borrowing is so high, you end up a perpetual debtor.   And this tipping point can be reached in a number of ways:
1.  Credit card debt sneaking up over time.

2.  Student loan debt with no way to pay it off.

3.  Previous bankruptcy or bad credit rating.
In each case, you are forced into the high-risk or "sub-prime" lending pool, and interest rates of 15-30% or more become your new norm.  Each additional dollar you borrow at this point becomes almost toxic.  But since folks in this situation are always broke, they keep seeking out new sources of borrowing, as they feel there is no other way to obtain money to purchase things.

Bankruptcy can at least give a person a chance to start over, that is, if they are willing to really change their way of life.   The relief can be very brief, however, if the debtor decides to take on a slew of new debt, at even more onerous rates.   Even with bankruptcy reform, it is still possible to obtain relief through bankruptcy, and the terms are still relatively generous, if you are smart about it.   Things like retirement plans are protected in bankruptcy, so that you can emerge without losing one of your major assets - that is, if you have a retirement plan.

The problem for some folks, particularly students who over-borrowed, is that they took on a debt that they might not realistically ever pay back.   Now, I am talking over $100,000 in debt, at high interest rates and with default penalties added in.    These are far above the national average debt about about $35,000 which can be paid back, over time, if a person chose to make sacrifices in their lives which of course, few are willing to do.

Sadly, after having made these poor choices, many are compounding this by making more poor choices.   One fellow opines that he can walk away from a $15,000 student loan debt (now $25,000 with interest) if he just waits until 25 years have elapsed, at which point the unpaid part is forgiven.   However at that point, he will owe income tax on a $100,000 windfall.    Perhaps it is a perverse strategy that might work.  The problem is, he is spending the best earning years of his life with a shitty credit score - which makes it hard to get a job, rent an apartment, or buy a house.   He will spend the part of his life that most do buying their first home, getting married, getting a job, and raising kids - living with friends or roommates and owning little or nothing.   All to escape a debt that could be paid off even on a minimum-wage job delivering pizzas.  I suspect drugs are involved.

Was bankruptcy reform a good thing?   In the end analysis it really doesn't matter.   As we talk about a lot here, your personal choices outweigh the effects of national trends.   You can protest student loans all you want, that still won't get them paid off.   Whatever student loan relief Hillary pushes through likely won't forgive all your debts - or maybe any of it.

A better plan is to pick a degree that is worthwhile at a school that is affordable.   Majoring in "whatever" and paying "whatever they charge" and then arguing it is "unfair" no one hires you is not really a good battle plan.