Almost the only tool the government hasn’t seriously tried in its battle against the economic crisis is bankruptcy. Rather than bailout out Bear Stearns, AIG or GM, it would have made more sense to address their financial distress in bankruptcy. The most sensible strategy for addressing the foreclosure crisis is a proposed amendment to the bankruptcy laws that would let a homeowner write down her mortgage to the value of the house if the house is worth less than she owes.
Both strategies have met fierce resistance, on precisely the opposite grounds. The argument against letting AIG or GM file for bankruptcy is that it would be disastrous to leave these companies to market forces, rather than intervening to prop the companies up. Lehman’s bankruptcy, which roiled the markets, is widely cited as proof that bankruptcy doesn’t work. But the problems with Lehman had very little to do with bankruptcy. They stemmed from a bait and switch by the government—the government had strongly suggested it would bail out every large troubled investment bank (see Bear Stearns), then refused at the last minute to do so with Lehman. And it’s hard to argue that the AIG bailout, which occurred at the same time, has been more successful than Lehman’s bankruptcy.
With the mortgage write down provision, the concern is too much interference with the market, rather than too little. The same banks that are taking billions of dollars of government handouts complain that the provision would undermine the enforceability of mortgage contracts.
In each case, an irrational fear of bankruptcy seems to be coloring people’s perceptions.
Even experts assume that bankruptcy would mean death for General Motors, despite the fact that General Motors would be better able to deal with many of its problems in bankruptcy. Many people think that allowing consumers to write down their loans in bankruptcy would terrify lenders and make the mortgage lending crisis even worse. But the bankruptcy provision is more likely to provide a way out—a way to deal with troubled mortgages that still aren’t being refinanced in serious numbers.
It isn’t too late to try the bankruptcy strategy-- bankruptcy is still an option for AIG and GM, and a watered down version of the mortgage writedown provision is making its way through Congress this week. But the government has wasted a lot of time, at what looks like great cost.