Bankruptcy reform: screw the poor

Noticing that my recent post on the credit card industry has received the attention of a certain well known right wing blogger, I thought this would be a good time to comment about bankruptcy.

The goal of bankruptcy protection is to give people who have screwed up a “fresh start.” One of the few powers granted to Congress in Article I Section 8 of the Constitution is the power to create bankruptcy laws.

Our bankruptcy laws do have a major problem. The problem is that there are loopholes that allow rich people to shield assets from bankruptcy. One of these loopholes involves owning an expensive home in a state, like Florida, that grants an unlimited “homestead exemption.” And the other loophole involves trusts. A person should be allowed to file for bankruptcy, have all his debts absolved, and keep a small amount of money needed to restart his financial life. But getting to keep a multi-million dollar trust or house in Florida is basically a theft from creditors. Congress should do something to fix this problem.

But the Republicans, who seem to care only about the top ten percent and not the bottom ninety percent, are content to let their fellow fat cats take advantage of these outrageous loopholes and instead are going after the average person and trying to deny him his fresh start.

The problem for those opposed to this regressive reform is that too many people think that bankruptcy is somehow immoral and they relish the idea of punishing people who have gotten themselves into too much debt. But this is not true, bankruptcy is no more immoral than any other form of insurance.

When you buy your auto insurance policy, you can pay extra for a plan where the insurance company will reimburse you for damages to your car even if the accident was your own fault. Is it immoral to claim the insurance money if you crash your car because of your own bad driving? No, because you paid for it and the insurance company calculated a price such that on average it will make a profit on the policy. Insurance is a win-win commercial transaction.

What people don’t understand is that every contract to borrow money has an implied insurance policy built into it. Imagine if you walked into a bank to borrow money, and you were offered two loans. The first loan had a lower interest rate. The second loan had a higher interest rate, but it included a special type of insurance—if you somehow got into financial trouble after taking out the loan, so long as you intended to pay the loan back when you first took it out, you could be absolved from the debt. Is it immoral to take advantage of this loan provision if you need to? No, because it’s just like the car insurance. The lender prices the loan such that, on average, it makes a profit.

The second type of loan is the only type of loan that lenders are allowed to make. This is what the bankruptcy laws provide. The first type of loan is considered to be void as against public policy.

The credit card industry is the major sponsor of bankruptcy reform. They say they are losing money from too many bankruptcies being filed. Yet it’s their own fault for lending money to low risk lenders. Or one can more simply say this is the natural result of free market competition. When a product becomes a commodity, and a Visa credit card has become exactly that, then the profit margin associated with the commodity product sinks to near zero.

Anyone who understands economics can easily predict that changing the bankruptcy laws to prevent people from filing under Chapter 7 will only create a temporary profit spike for credit card issuers. Soon after, the internecine competition between credit card issuers will cause them to lower interest rates, increase marketing, and go after marginal borrowers who would not have been granted a credit card under the current bankruptcy laws. The end result is that profits for banks involved in the credit card scam go back down to where they are now, but in the process a lot of poor people will be totally screwed, trapped in debt that can no longer be relieved through bankruptcy. We will create a whole new underclass of indentured servants.

It's funny how the Republicans, who claim to be in favor of free market competition, are the ones trying to protect their rich donors from the hard reality of the free market.

Comments

[Simon]

Dear Abigail,

I thought your readers might find some historical context interesting. Many thousand, perhaps millions were sent to America under horiffic conditions to pay off their - or their parents - debts in a form of slavery as 'indentured servants'. We know know that most did not survive until they became free men or women.

Take a little time and read an account by a primary source.. One of the few who made the journey and was able to tell the tale (most indentured servants were illiterate)

Note that conditions such as these in Europe and Asia, particularly in the lands controlled by the British Empire - like India under the British East Asia Company were part of the complex reasons for the American Revolution.

Gottlieb Mittelberger, On the Misfortune of Indentured
Servants (1754)

http://odur.let.rug.nl/~usa/D/1601-1650/mittelberger/servan.htm

...

Our founders were rightfully afraid that corporations had the potential, if allowed free reign, to destroy America.

This is what is happening...

We must stop seeing corporations as people. This huge mistake is at the core of our problem. Pathological narcissistic greed is ruining this country.

[Phil]

Apparently I don't understand economics. Or our bankruptcy laws anyway. Could you further explain how the change in change in bankruptcy laws would only result in a "temporary profit spike for credit card insurers?" Would not the creation of "a whole new underclass of indentured servants" be quite profitable? How would the change in bankruptcy laws increase "the internecine competition between credit card issuers?" And are you saying that the change in bankruptcy laws would allow more people to qualify for credit cards?
-Confused

[Phil]

Kevin Drum's blog answered some of my questions:

In a normally functioning market there's at least a small incentive to limit loans to these high-risk customers, namely the possibility that they might go bankrupt, and the bankruptcy bill before Congress is a brazen attempt to remove even that small but annoying incentive to act responsibly.

Credit card companies want the ability to make risky loans, but they also want federal protection that protects them from bearing the risk that goes along with making those loans.

[Fargus]

Seems like the credit card corporations want protection from the same sort of risks that they're fighting so hard to deny everybody else.

Just think of this bankruptcy reform passing in the context of the eventual privatization of Social Security. Then people wouldn't have to worry about investing their retirement money badly, because it would all have been taken by the credit card companies.

[tom f]

RE: the generous homestead laws in Florida, I don't think it was a coincidence that WorldCom's CFO built himself a gigantic mansion in Florida despite the fact that his office was in Mississippi. Not that everyone in Florida's a crook, obviously, but if your looking to lend to or invest in a business you might take the CEO's primary residence into account---I once had to evaluate a potential purchase of a loan portfolio from a failed S&L that had all of its branches and operating units in the Northeast, but (otherwise inexplicably) had its "executive offices" in Florida.

[Paul Gowder]

Hear hear! Your comments on credit rates + bankruptcy as insurance for loss of the ability to pay are extremely insightful, and, I think, novel. It's a "meme" (oh, how I hate that term) that could bear spreading, as it usefully counteracts the propaganda that bankruptcy is costing everyone more money. "Yea, but it protects everyone, too." (Notwithstanding the complete lack of evidence that interest rates will go down after/if this bill gets rammed through.)

It's also good to see some economic analysis being wielded by a fellow liberal.