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The Problem with Bankruptcy Laws

Mises Daily: Friday, May 08, 2009 by

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When faced with a collapsing housing market and mounting real burden of debt, it's entirely rational for households suffering negative equity to simply walk away. This is a major problem in the United States, and has exacerbated the banking crisis caused by defaulting borrowers. Many of these consumers might suffer a terrible credit rating as a result, but it still makes sense for them. It seems odd that the market would allow such an insidious example of moral hazard to wreak havoc with the banking system. The guilt of the real culprit is less surprising.

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.

The source of the "limited liability" of borrowers, once they have declared bankruptcy, is difficult to determine. It is at least partially politically motivated. The result is that citizens, if they default, can only lose their home. Their future earnings are not at risk, and there are some kinds of exempted property, although some other assets (if they have any) tend to be at risk, depending on the state. This poses a substantial problem in the current climate, where it can be beneficial for otherwise-sound households to default on debt due to negative equity.

It would be expected that, were it not for the arbitrary regulations governing bankruptcy laws, the market would probably draw another line in the sand that would make borrowers more liable for their debt — especially given the variable nature of housing prices (although, perhaps banks could have taken the risk they would not fall).

For example, defaulters could be obliged to pay back the bank from their salary for any agreed amount of time, up to a maximum proportion of their total annual earnings — as when individuals choose to file for Chapter 13 under the status quo. However, they could actually contract into this at the initial stage of their mortgage.

This would prevent the kind of moral hazard that has sprung up, while preventing the borrowers from sliding into indentured slavery. There would be no incentivization of risk on the part of banks either, as they would still be taking on partial risk (although the risk associated with subprime mortgages would be somewhat reduced, these would be the people least likely to have an income afterwards that could be claimed). Arbitrage would also ensure that the return from defaulting borrowers wouldn't be higher.

Meanwhile, such a system of "extended liability" for homeowners would have prevented the extra stress on banks caused by negative-equity defaulters. Because these people would know they are paying back the full sum either way, they would instead keep the house and pay back the (albeit, exorbitant when considering the plummeting value of their home) debt over time — perhaps while keeping their home, if they had proof of income. This would prevent the plethora of defaults further dragging down asset prices by increasing supply, which makes negative equity defaulting a self-replicating process.

The problem is that individuals under the status quo can simply choose the type of bankruptcy under which to file. All in all, leaving the market to determine the optimum liability of householders with more flexible government bankruptcy regulation would have prevented the extra glut of houses coming onto the market and allowed banks to keep loan assets on their sheets that were guaranteed some return.

It might even create incentives for banks to help struggling borrowers to find employment, or sponsor them while they find employment. Meanwhile, the "limited liability" of negative equity borrowers today only serves to deter lending and create moral hazard. The financial system paid the price, but they will nevertheless be blamed.