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More on Subprime: Bernanke and Bankruptcy--Skeel

Fed Chairman Ben Bernanke has now called on banks to forgive portions of the principal owed by struggling subprime borrowers, which suggests that a major intervention may be coming. As between jawboning (the Republican inclination) and a bailout (the Democrats’ leaning), I’ll take jawboning any day. But the third option, amending the bankruptcy laws to allow borrowers to reduce their mortgages, is, in my view, much superior to either, as I argued in a post last week.

Rather than repeat those arguments, I’ll simply add two additional points.

First, if he’s looking for evidence that loan forgiveness sometimes makes everyone better off, Bernanke need look no further than his colleagues on the Federal Reserve. A decade ago, current Fed Governor (then a professor at the University of Chicago) Randy Kroszner examined a 1935 Supreme Court decision upholding Roosevelt administration legislation that abrogated the so-called gold clauses in corporate bonds. These clauses required corporate borrowers to repay their obligations in gold, a crippling obligation in a time of Depression. Roosevelt’s abrogation of the provisions effectively reduced the amount of the corporate debtor’s payment obligations. It’s no surprise that this helped corporate borrowers; but it also turned out to help the lenders (the investors who held the bonds). In a careful empirical study (“Is it Better to Forgive than Receive?”), Kroszner found that the value of the bonds actually went up, not down, when the gold clause abrocation was upheld, almost certainly because this made it less likely that the borrowers would default. Reducing the principal owed by subprime borrowers would quite likely have a similar win-win effect to day.

Second, while Senator Durbin’s proposed bankruptcy reform is the best way to achieve partial loan forgiveness, it is seriously incomplete. Under the proposal, a borrower would need to file for Chapter 13, the chapter that requires a debtor to repay a portion of what she owes during the three to five year period after bankruptcy. If a debtor owes $100 to its ordinary creditors, for instance, she may agree to pay them a total of $70 under her repayment plan. If a corporate debtor agrees to a similar plan (in Chapter 11), its obligations are reduced to the agreed upon amount, $70. In bankruptcy lingo, the other $30 is “discharged.” But, for reasons that have never been clear to me, a consumer debtor in Chapter 13 does not receive the reduction in payment (the “discharge”) until after she makes all of the payments required by the Chapter 13 plan. If she fails to complete the plan– as unfortunately is the case roughly two-thirds of the time– her original obligations spring back to life, vampire-like. She once again owes the entire $100, less whatever amounts she has actually paid.

This problem is easily fixed: in addition to passing the Durbin proposal, Congress could adjust Chapter 13 as a whole to make the debtor’s discharge effective as of the date the court approves a debtor’s repayment plan. Otherwise, many subprime debtors could end up losing the relief they thought they had.

Several commenters on my previous post have noted that permitting borrowers to reduce their mortgage obligations in bankruptcy could lead to a modest increase in the cost of credit for future borrowers. True, but the reform would also encourage lenders to be more careful, and it’s a small price to pay to address a crisis that seems to be getting uglier by the day.

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Comments ( 1 )

I'm afraid that simply reducing the loan amount will not be sufficient to "fix" the problem. What happens if the housing value drops some more, now I still owe more on my home than it is worth. I think consumers will do what they are doing now, walking away from the house - something lenders assumed would never happen.

From a strictly rational (if not moral) point of view it's pretty smart. Once can live "rent free" while the process of foreclosure unfolds (saving a bucket load of money in the process) then walk away and rent. This is much better than hanging around hoping the value will rebound - so what if they can't buy for another seven years - that's about the time home values will bottom anyway and they'll get a cheap deal.