The Liberty Papers

Business Week has an interesting article up making the case that the Bankruptcy reforms that went into effect in 2005 turned what might have otherwise been a bad downturn into a full-scale collapse:

The old bankruptcy law, in effect since 1978, was considered extremely housing-friendly. Most distressed borrowers favored filing under Chapter 7, essentially cheap, quick debt liquidation. In practice, most got to keep their homes, while the rest of their property and assets were sold off to pay a portion of unsecured debts such as credit-card and medical bills. When the assets ran out, the remaining loans were cancelled—although some debts were off limits, like student loans and child support. Future paychecks could go to mortgage payments.

By contrast, the new law was designed to protect creditors. For one thing, only low-income borrowers can file for Chapter 7, which wipes out debts. The amended law pushes more people into Chapter 13, which forces households to accept 3-5 year repayment plans on all debts—secured and unsecured. In other words, they’re still trying to make payments on car, credit card, medical, and other bills that used to be discharged in Chapter 7. That makes meeting the mortgage more onerous. Filing for Chapter 13 temporarily halts foreclosure proceedings, but the protection only lasts as long as the borrower is making mortgage payments.

But even low-income subprime borrowers aren’t escaping the new law. In theory, Chapter 7 is still available, but the new law hiked the cost of going bankrupt in order to discourage the practice. Under the old law, the average cost of filing for Chapter 7 was about $800 to $1,400 in attorney and other fees, according to Henry J. Sommer, president of the National Association of Consumer Bankruptcy Attorneys. He estimates that the cost is now up to roughly $1,400 to $2,400. That’s a hefty price tag.

As the author notes, score one for the law of unintended consequences.

But is he right ? And, even if he is, should the bankruptcy laws be reformed yet again to allow the Courts to rewrite the terms of mortgages ? Its not an easy question to answer.

One thing out of the way first, though; the bankruptcy reform that passed in 2005 was bought and paid for by the credit card industry, most notably MBNA, which had donated hundreds of thousands of dollars to Democrats and Republicans over almost ten years in its effort to pass a law that it claimed was necessary due to widespread abuse of the bankruptcy system. However, as I noted shortly after the law went into effect, here and here, it’s fairly clear that the so-called abuse didn’t exist and that the reforms that passed were more about rewriting the law to make it more creditor-friendly than fixing any alleged abuses.

Moreover, it seems clear that, by making it harder for people who are truly in financial hardship to start over again and still keep their homes, the reforms have contributed to the crisis that we’ve seen unfolding before us.

As a cure, the author recommends that Bankruptcy Judges be given the authority to rewrite the terms of a debtor’s loan to alleviate hardship. As I’ve noted before, that is a cure that is worse than the disease we’re now suffering through. However, it’s fairly obvious that 2005’s bankruptcy reforms have served to make a bad situation worse than it needed to be.