America is the most bankrupt nation on Earth. Our government is for the nonce relatively solvent, its AAA rating intact. But our citizens declare bankruptcy at a rate that astonishes the rest of the world. In 2007, two years after we tweaked our bankruptcy law to make it tougher on debtors, the number of personal bankruptcies had dropped by more than half, but we were still well ahead of Great Britain, our nearest competitor in the Insolvency Olympics: roughly one in 500 Britons declared personal bankruptcy that year, against about one in 300 Americans. Since then, of course, the subprime crisis has increased our lead. We are the Michael Phelps of debt liquidation.
You’d think that title would be one we’d gladly relinquish. But in fact, America leads the developed world in bankruptcies because for more than a century, we’ve worked hard to build the best—and, not coincidentally, the most generous—bankruptcy code in existence. We didn’t do it by design, but in fits and starts; the hodgepodge of innovations that have helped systematically ensure that debtors get a fresh beginning were as much the brainchildren of grasping creditors as of beleaguered debtors. Nonetheless, our system works so well that other nations are trying to move away from their harshly punitive treatment of insolvent debtors, and closer to our free-and-easy, all-is-forgiven model.
Our leniency toward those with unsustainable debts helps not only profligate debtors, but the rest of us as well. Less onerous bankruptcy procedures boost rates of entrepreneurship: reduce the cost of failure, and people become more willing to take risks. America’s business environment is much more dynamic than that of Europe or Japan, for many reasons—and our generosity to capitalism’s losers is one of them.
Americans’ public attitude toward the bankrupt, however, is not nearly as generous as our law. Every move to make things easier for debtors meets with fierce resistance, not merely from creditors, but from ordinary people who are making payments on time. As this article went to press, the Senate was scrambling to find a compromise on a long-stalled House proposal that would allow bankruptcy judges to reduce the principal of home loans where the value of the property has fallen below the mortgage’s outstanding balance. Known as a “cramdown,” the idea was popular with most congressional Democrats, but apparently not with the voting public, which was telling pollsters in ever higher numbers that they thought the whole housing-bailout package was unfair.
And isn’t it? Most people didn’t take out giant loans with tiny down payments or do repeated cash-out refinancings. Yet the cramdown plan would make the sober, steady majority foot the bill for other people’s mistakes. First they would pay as taxpayers by helping to subsidize troubled loans. Then, the next time they needed a mortgage, they’d be charged a higher interest rate to compensate for the risk that they might declare bankruptcy and ask a judge to cram down their loan. And maybe they’d have to pay a third time, again as taxpayers, by bailing out banks that got too many of their loans crammed down. Meanwhile, the guy down the street who took out a second mortgage he couldn’t afford, to remodel, would be sitting pretty in his $60,000 kitchen.
It isn’t fair. But by the time someone is in bankruptcy, the time for fairness is already long past. Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations. Our system works so well precisely because it mostly sets aside our instinct for just deserts, and instead focuses on minimizing the costs to everyone. It lays out clear and predictable rules for lenders and borrowers, so that they can plan for disaster, and escape as quickly as possible if it arrives. Still, it’s plain as day that, in the current crisis, a whole lot of people are getting help they haven’t earned. As a result, commentators, academics, and legislators presiding over hearings have diverted much time and energy away from hashing out the ugly details of rescue efforts and toward making the one point on which we can all agree: these relief measures don’t seem fair.
But imagine a system that would be “fair” in the eyes of Rick Santelli, the CNBC reporter ranting about “losers” with underwater mortgages, or of Senator Charles Grassley, who suggested that AIG executives should consider seppuku. Under such a system, a bankrupt company wouldn’t get to keep its management; it would be turned over to a receiver, so feckless executives wouldn’t get any further benefit from the company they’d ruined. Ideally, those executives would be personally liable for as much of the company’s debt as feasible, and they certainly wouldn’t be able to shed that liability with a well-timed personal bankruptcy.
But it’s not just executives who would suffer; in a really fair system, ordinary joes who ran merely their households into the ground wouldn’t get off easy, either. After all, most people who end up in bankruptcy made some decision that landed them there; a recent study indicates that the main difference between those who declare bankruptcy and others with the same income who do not is simply how much debt they took on. With more “fairness,” heavy borrowers couldn’t just walk into a court, turn over their spare cash, and walk away free, as those who declare bankruptcy under Chapter 7 do today. (Granted, they take a big hit on their credit report.) Those who are not actually destitute would be put on a very tight budget, and the excess would be turned over to their creditors to repay debts. And if they’d been really irresponsible, borrowing and wasting money they had no hope of repaying, perhaps they wouldn’t be allowed to discharge their debts at all. Creditors could seize any little bit of money the debtors ever got their hands on, until the ill-spent borrowings were paid off.
That feels, if not fair, at least fairer—people who have cost other people a lot of money ought to suffer a bit themselves. As it happens, this process describes bankruptcy in much of Europe. And it turns out that it’s not so great.
Let’s start with the corporate side. Receivership, even as practiced in a relatively forgiving country like Britain, often results in liquidation, not reorganization. Sudden changes of the entire management are hard enough in normal times, but when they take place in bankruptcy, the difficulties are multiplied. Very few people want to go to work for a company that may be terminal, particularly if a tightfisted receiver refuses to pay a premium for their efforts.
Liquidations are very costly. Workers get fired, of course; suppliers lose business; local governments lose tax revenue. But they’re costly even for creditors. Picture what would happen if a receiver shut down GM’s assembly lines until they could be sold. The workers would scatter, and with them, painstakingly accumulated human capital. The value of the inventory would plummet. Who wants to buy a car with no warranty and no pipeline for replacement parts? The residual value that GM has built up over decades in marques like Cadillac would vanish. Thus, creditors are often better off accepting partial debt payments from a going concern than selling off the assets piecemeal.
But if corporate liquidation, Euro-pean-style, is so punitive, why does America encourage individuals to liquidate—letting them trade the assets they have on hand for a full discharge—rather than making them work off as much of their debt as possible? In theory, making bankruptcy harder should make us all better off: by discouraging people from taking on too much debt, by paying creditors as much as possible, and by delivering a little just retribution to debtors for their profligacy.
That was the reasoning behind the 2005 bankruptcy reform. Although filings spiked before the law took effect, immediately thereafter they fell off a cliff. In 2006, just 598,000 people filed for bankruptcy, the fewest since Ronald Reagan was president. Filings have increased since but are still well below the rates that prevailed in the relatively sunny economic climate of 2004.
Harsher bankruptcy rules are seemingly doing what we wanted them to do: discouraging excessive risk taking. The question, though, is Which risks?
Look at entrepreneurs. All of the business literature indicates that starting a business is a phenomenally stupid thing to do. Most new businesses fail, and not simply because most would-be entrepreneurs are actually no-hopers. Even people who have founded successful companies in the past still have a 70 percent chance of failing. All those business failures are costly—but the successes are the difference between us and Tanzania. We want people to take these kinds of risks, even if that means we write off a lot of bad debt.
Tougher bankruptcy laws don’t necessarily curb the kind of behavior we want to discourage: borrowing money you have no way to repay, in order to buy unnecessary consumer goods. The amount that households put on their credit cards didn’t fall after the 2005 reform; over the next two years, it rose 12 percent. According to Michelle J. White, an economist at the University of California at San Diego, many bankrupts are what economists call hyperbolic discounters—people who pay a lot of attention to current pleasures, and very little to future costs. That’s why a person’s debt, not unemployment or divorce, may be the best predictor of bankruptcy.
If you’re the kind of person who buys now and worries later, the idea that government is making your inevitable bankruptcy filing slightly more annoying won’t discourage you. Actually, a higher hurdle to bankruptcy will make things worse, because banks will offer to lend you more money if getting the debt discharged is harder for you—money that you will happily, and irresponsibly, borrow and spend. The people who are most likely to be deterred from borrowing are the people who are taking the rationally contemplated risk of starting a company or buying their first home.
Of course, we’ll at least squeeze a little extra cash out of the real deadbeats. Maybe. Most repayment plans set up under Chapter 13 fail. People who weren’t previously good at living on a budget don’t magically get better at it with a court order. Moreover, job losses or other unexpected events can derail the highly structured payment plans. And the costs of administering an ongoing plan are much higher than for a simple discharge and write-off.
Meanwhile, those payment plans lash people to their old lives, even though those lives weren’t working all that well; it’s hard to move, or get training, for a better job if a court has to approve the expense—and why bother, if a trustee might seize the extra income? In the worst case, the failed Chapter 13 proceeding leaves the most-vulnerable people mired even deeper in debt they can’t repay. Such outcomes start to sound less like “fairness” and more like “throwing good money after bad.” Look around. Do the banks seem sounder because we made it harder for people to shed their debts?
These problems are simple compared with the questions raised by the current crisis. Existing bankruptcy law has no easy formula for dealing with a behemoth like Citi, or even GM, that has international subsidiaries, and where any punitive action we take could have massive unintended consequences. But we can look to the bankruptcy law we’ve evolved for some principles about what works. And what it seems to tell us is that, regarding insolvents, we too often ask the wrong question: Who should pay? rather than Who can?
Bankruptcy’s greatest boon is orderly liquidation of past failures so that banks and borrowers and insolvents can trust in their futures, invest in them. Yet listen to the public commentary on the bailouts, and you’d think that half of America would happily gut the rule of law if doing so would let them punish a single undeserving executive. Is penalizing the traders at AIG really more important than upholding a long-standing liberal democratic tradition?
In ordinary times, we maintain a sort of society-wide doublethink about the problem of insolvency. We all agree that it is a very terrible thing that should be avoided at all costs—but once it has actually happened, we try to forget about the past as quickly as possible, and we focus mostly on providing a predictable and relatively painless way for the insolvents to get back on their feet. That strategy, developed over time through trial and error, has served us well for most of our history. Why is it now a piece of the past that we’re only too willing to abandon?
A friend who also practices Bankruptcy law recently had the following situation arise: Chapter 7 client (filed 10/6/08, discharged 2/3/09), who recently called about HOA fees from post Bankruptcy filing. She filed Chapter 7 with intent to surrender and moved out on November 1, 2008. She hasn’t paid the HOA fee since then, and now they are coming after her (post Bankruptcy discharge) for the post filing HOA fees, plus interest. The house has not yet been sold by the bank despite the intent to surrender and abandonment of the house more than 6 months ago and the client is technically still the owner on record. She was current on the HOA fee until she moved out of the house. It’s not the client’s fault the bank hasn’t held the foreclosure sale yet… so is there any way to shift the fees on to the bank?
It may be that if she can hold off paying until the property is foreclosed and sold to someone, the bank will have to pay the HOA fees to get clear title. However, it may depend on how much the HOA fees are. If they are a lot, I have seen banks stall a long time in foreclosing so as to make the debtor pay those fees. If she does not pay, the HOA can get a judgment against her, garnish, etc., basically all the things she filed bankruptcy to get rid of.
It may be advisable to tell a client to live in the place and pay the post-petition HOA fees until the title changes and the lender finally kicks them out. The HOA fee is generally cheap rent. In this case, the Bankruptcy client will probably end up having to pay. Figuring out what to do about HOA fees is part of Bankruptcy planning. Another alternative is not to file for Bankruptcy until the foreclosure is done or almost done. Even when you file at the end of the foreclosure process, the lender may not transfer and/or record the deed so as to make debtor have to pay the HOAs. If the HOA fees are substantial, it can be a significant issue in the Bankruptcy case. There has been talk on the list of filing a quit claim deed transferring the title to the lender. Someone raised the issue that a gift has to be accepted. It may not be a gift when the lender has foreclosed but just not filed the deed. The lender obviously has the intent to take and own the property, and it already has the right to ownership and possession from the completed foreclosure process post Bankruptcy. The quit claim deed merely finalizes the transaction.