Saturday, September 13, 2008

Anti-Consumer bankruptcy laws exacerbate subprime crisis

According to an article on Business Week Online, because of the revisions to bankruptcy laws that were passed in 2005, more people are fiscally bankrupt (if not legally so) are finding it makes more sense for their own finances to default and simply not repay their debts than to even claim bankruptcy, a move that is adding further damage to the broken housing market. The effect of the law was to force more people to repay their debts.

The new rules could force up anywhere from 4% to 15% of these debtors to repay their creditors under Chapter 13 rules rather than the more lenient Chapter 7 regulations, said Jeffrey Morris, a spokesman for the American Banking Institute.

It sounds rather counter-intuitive to think that because people must repay their debts, the housing market gets worse, but here's how BW explains it:

The latest lesson for lenders from the housing crisis: Be careful what you wish for. Banks and other financial outfits spent eight years and $40 million lobbying for sweeping new bankruptcy rules that would limit their losses from deadbeat debtors. But it turns out those changes, enacted in 2005, are forcing more troubled borrowers to walk away from their homes—even those who didn't take on risky mortgages in the first place. And that's bad news for lenders, which suffer financially every time they have to take a troubled property on their books.

Before the new rules kicked in, many consumers could find debt relief—and keep their homes—by filing for bankruptcy protection. Now the process is much more onerous and expensive and the benefits more limited, making foreclosure seem appealing by comparison. A July paper by David Bernstein, a researcher at the U.S. Treasury, found that 800,000 fewer homeowners have filed for bankruptcy since the rules kicked in. A quarter of those people, says the report, have likely had to give up their homes as a result—boosting foreclosures nationwide at least 4%. "[The rules] are directly responsible for the rising foreclosure rate," notes another report by investment bank Credit Suisse.

They got what they wanted. Previously, anybody could file for Chapter 7, the quick and cheap proceedings that liquidate financial assets but not the home to cover debts and dismiss unpaid bills. Now only low-income borrowers qualify, and Chapter 7 doesn't stave off foreclosure.

As a result, many struggling borrowers have no other option but Chapter 13, which requires that people follow a court-mandated repayment plan for all their debts, including medical, credit-card, and other bills typically discharged under Chapter 7. Going the Chapter 13 route can halt a foreclosure already in process. But that's often only a temporary salve, since other debts aren't eliminated, and banks can resume foreclosure proceedings as soon as the payments begin to slip anew. Says Chicago bankruptcy lawyer David P. Leibowitz: "In some cases, bankruptcy has become so onerous that it's not worth it to save the house."

Oops. Of course, the blame game can always go back and forth as to who began it all. As far as I'm concerned, there's no credible evidence that shows that any sizable number of people were ever abusing the bankruptcy laws. After all, it ruins your credit. It's not an option you take lightly, even when it was more beneficial. But of course, it's kind of obvious that if corporate lobbyists are spending money trying to get some law passed, it's beneficial to them monetarily and detrimental to the public. And of course it was another piece of partisan hackery passed when Republicans controlled Congress. But even if everything they said was true, the fact that people can't get out of at least some of their debt cleanly makes it much more rational to simply abandon their debts. Unfortunately, this only helps drop the bottom out of the housing market when what we really need is for people to stay in those homes. More important than punishing people for being stupid or punishing lenders for being greedy is the need to stabilize this market.

The bailout of Freddie Mac and Fannie Mae is an effort to keep the economy alive by keeping some liquidity in the market so lender can keep lending. But we also need to keep some liquidity in consumer's pockets, which is why I'm still waiting to hear about a rescue package for struggling homeowners. Well, maybe when we have a Democratic President...

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