Saturday, July 18, 2015

Debtors Unfairly Excluded From Protection – says the New York Times

Here is a July 16, 2015 New York Times editorial claiming that the bankruptcy laws are unfair because mortgages, student loans, and some bonds cannot be restructured in bankruptcy.  The Times misses important tradeoffs that hurt the people the Times is trying to help.

My comments are in italics.

The large debt loads that weigh heavily on Americans and the American economy — in mortgages, student loans, and most recently, the bonds of Puerto Rico — have one thing in common: They cannot be restructured in bankruptcy. Creditors cannot be compelled by the court to reduce such debts, leaving insolvent borrowers at the mercy of lenders. The situation is unfair, because creditors often bear at least partial responsibility for loans that fail and so should share the pain of bankruptcy with borrowers. It is also harmful, socially and economically, when the potential of individuals is impaired because they are not allowed a fresh start under bankruptcy law.

Borrowers can get a fresh start by defaulting.

Presumably, the lenders and borrowers signed the loan contract because they both benefited.  The “at the mercy of lenders” phrase gives away the Times’s bias against lenders.

There is no issue of unfairness.  Lenders are not responsible for “loans that fail”, which is a euphemism for borrowers that fail to comply with the terms of their loan contract.  Lenders’ allowable actions when borrowers’ fail to comply are specified in the loan contract – which both parties agreed to.

But reform of the bankruptcy law, while urgently needed, is very difficult. All too often, Congress and the public reflexively put all the blame for default on borrowers. That misguided belief then serves as justification for keeping the courthouse door closed to many debtors. The consequences are perverse. When debtors cannot use bankruptcy to modify or discharge debt, lenders are more likely to push loans to excessive levels and create bubbles that can burst with disastrous results.

The Times reflexively puts the blame on lenders – having conveniently overlooked what is a contract.

The Times is correct that lenders are more likely to lend if they have more recourse in default.  But the Times seems unaware that an implication is that lenders are less likely to lend if they have less recourse.  Recourse for lenders is most valuable when borrowers are less well off.  The poor will be hurt most by less recourse.

Lending sensibly based on loan contract terms is what the Times is really complaining about, and that is not equivalent to “pushing loans to excessive levels and create bubbles . . .”.  The disasters the Times is concerned about are mostly due to Government forcing lenders to make economically unwise loans – for political reasons.

Consider a loan the Times would consider unfair.  There is a housing bubble.  A lender loans a borrower the full purchase price of a house (no down payment), with no collateral other than the house.  After a while, the housing bubble bursts, the economy goes into recession, the borrower loses his job.  The lender forecloses, takes the house, and sells it for less than the loan amount.

In this case, the lender was foolish, because only under the best of circumstances was he likely to get his money back.  In contrast, the borrower benefited from the lender’s foolishness.  First, while the borrower ended up losing the house, he didn’t put anything up for it to begin with.  He also avoided paying more in rent than he did maintaining the house.  Moreover, if the housing market had continued to rise, the borrower would have had a profit.  The borrower came out ahead and could have come out a lot more ahead.  The loan contract favored the borrower, not the lender.  In investment parlance, the borrower received a free put, which entitled him to deliver the house against a fixed dollar loan – which he did, to his advantage.

A loan the Times would consider less egregious would be the above loan, but with a sensible down payment and a corresponding lower principal.  Relative to before, the borrower would be worse off by the amount of his lost down payment.  But the times might argue that the borrower would not have taken out the loan if a down payment had been required – because he could not afford it.  On the other hand, the real estate market might have risen and stayed up, in which case the borrow would have foregone a substantial profit.  The Times is naïve – things are not as simple or one-sided as it thinks.

The Times is rightfully concerned about the borrower being out on the street.  But that is not because the lender was unfair.  The Times does not appreciate that a society that fails to honor contracts is a disaster.  Any help given to the borrower should come from sources other than the lender – unless the lender desires to provide the help.

The solution is for Congress to liberalize the bankruptcy law with targeted amendments. The place to start is to allow homeowners who cannot repay the mortgage on a primary home to seek bankruptcy protection Some 7.7 million homeowners still owe a total of $260 billion more on their mortgages than their homes are worth; nearly half of these are deeply underwater, putting them at risk of default. A bankruptcy option could help many of them hold on to their homes. In the past decade, 1.3 million foreclosures could have been avoided if borrowers had been able to rework their loans in bankruptcy, according to estimates by Moody’s Analytics.

Liberalizing the bankruptcy laws as the Times wants will increase the chance that the borrower will be able to hold on to his home.  However, that is tantamount to rewriting the original loan contract for existing loans, without the lender’s consent.  Actions like this will make future lending more risky, hence less attractive – Contract terms will be less favorable to lenders and they may not be enforceable.  This will lead to less lending and more costly lending terms– particularly to the poor.

Private student loan debt, which does not provide the flexible repayment options available on federal student loans, should also be dischargeable in bankruptcy. In 2005, in a sop to for-profit colleges, Congress made it virtually impossible to reduce private student loan debt in bankruptcy. Since then, excessive lending has proliferated, with students urged to take on debt in exchange for degrees and certificates that all too often do not lead to jobs.

More flexible repayment options for student loans and making them dischargeable in bankruptcy will lead lenders to make it harder and more costly for students to borrow – thereby reducing education.  This is opposite to what the Times wants.  Moreover, a populace with less education is less likely to make good economic and political decisions, leading to poorer outcomes for everyone.

The Times provides no reason why the proportion of “excessive student loans” that are devoted to obtaining “useless” degrees is any different from other student loans.  Perhaps students from poor families that benefit the most from obtaining “excessive student loans” are more likely to get useful degrees than other students.

In Puerto Rico, a disorderly default seems likely unless Congress provides bankruptcy protections for utilities and other public corporations that have accumulated some $25 billion in debt. It is unclear from the history of the bankruptcy law why Puerto Rican corporations were excluded from protection; the exclusion may have been unintentional. Investors who bought Puerto Rican bonds argue it is unfair to change the rules in the middle of the game. But that possibility was factored into the price they paid for their bonds. It is also unfair to deprive Puerto Ricans of basic services, like electricity, that would be imperiled in a messy default.

The Times blithely asserts that investors who bought Puerto Rican bonds factored rewriting their loan contracts into the bonds’ price.  Whether or not that is true – which the Times has no way of knowing – it will become true if the contracts are rewritten without their consent.  Future borrowing cost will be higher, reflecting this risk, and the utilities’ customers will pay more – another missed trade off.

Bankruptcy should always be the last option. But it should be an option. Otherwise, debt that could be reduced and restructured becomes an enduring obstacle to stable lives and a problem for the broader economy.

Why stop there, why not simply forgive all debt that defaults?

No comments: