Business June 2009

Sink and Swim

Bankruptcy helps the undeserving—and that’s the way it should be.
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Harry Campbell

America is the most bankrupt nation on Earth. Our government is for the nonce relatively solvent, its AAA rating intact. But our citizens declare bankruptcy at a rate that astonishes the rest of the world. In 2007, two years after we tweaked our bankruptcy law to make it tougher on debtors, the number of personal bankruptcies had dropped by more than half, but we were still well ahead of Great Britain, our nearest competitor in the Insolvency Olympics: roughly one in 500 Britons declared personal bankruptcy that year, against about one in 300 Americans. Since then, of course, the subprime crisis has increased our lead. We are the Michael Phelps of debt liquidation.

You’d think that title would be one we’d gladly relinquish. But in fact, America leads the developed world in bankruptcies because for more than a century, we’ve worked hard to build the best—and, not coincidentally, the most generous—bankruptcy code in existence. We didn’t do it by design, but in fits and starts; the hodgepodge of innovations that have helped systematically ensure that debtors get a fresh beginning were as much the brainchildren of grasping creditors as of beleaguered debtors. Nonetheless, our system works so well that other nations are trying to move away from their harshly punitive treatment of insolvent debtors, and closer to our free-and-easy, all-is-forgiven model.

Our leniency toward those with unsustainable debts helps not only profligate debtors, but the rest of us as well. Less onerous bankruptcy procedures boost rates of entrepreneurship: reduce the cost of failure, and people become more willing to take risks. America’s business environment is much more dynamic than that of Europe or Japan, for many reasons—and our generosity to capitalism’s losers is one of them.

Americans’ public attitude toward the bankrupt, however, is not nearly as generous as our law. Every move to make things easier for debtors meets with fierce resistance, not merely from creditors, but from ordinary people who are making payments on time. As this article went to press, the Senate was scrambling to find a compromise on a long-stalled House proposal that would allow bankruptcy judges to reduce the principal of home loans where the value of the property has fallen below the mortgage’s outstanding balance. Known as a “cramdown,” the idea was popular with most congressional Democrats, but apparently not with the voting public, which was telling pollsters in ever higher numbers that they thought the whole housing-bailout package was unfair.

And isn’t it? Most people didn’t take out giant loans with tiny down payments or do repeated cash-out refinancings. Yet the cramdown plan would make the sober, steady majority foot the bill for other people’s mistakes. First they would pay as taxpayers by helping to subsidize troubled loans. Then, the next time they needed a mortgage, they’d be charged a higher interest rate to compensate for the risk that they might declare bankruptcy and ask a judge to cram down their loan. And maybe they’d have to pay a third time, again as taxpayers, by bailing out banks that got too many of their loans crammed down. Meanwhile, the guy down the street who took out a second mortgage he couldn’t afford, to remodel, would be sitting pretty in his $60,000 kitchen.

It isn’t fair. But by the time someone is in bankruptcy, the time for fairness is already long past. Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations. Our system works so well precisely because it mostly sets aside our instinct for just deserts, and instead focuses on minimizing the costs to everyone. It lays out clear and predictable rules for lenders and borrowers, so that they can plan for disaster, and escape as quickly as possible if it arrives. Still, it’s plain as day that, in the current crisis, a whole lot of people are getting help they haven’t earned. As a result, commentators, academics, and legislators presiding over hearings have diverted much time and energy away from hashing out the ugly details of rescue efforts and toward making the one point on which we can all agree: these relief measures don’t seem fair.


Watch CNBC's Rick Santelli rant question whether Americans "really want to subsidize the losers' mortgages"

But imagine a system that would be “fair” in the eyes of Rick Santelli, the CNBC reporter ranting about “losers” with underwater mortgages, or of Senator Charles Grassley, who suggested that AIG executives should consider seppuku. Under such a system, a bankrupt company wouldn’t get to keep its management; it would be turned over to a receiver, so feckless executives wouldn’t get any further benefit from the company they’d ruined. Ideally, those executives would be personally liable for as much of the company’s debt as feasible, and they certainly wouldn’t be able to shed that liability with a well-timed personal bankruptcy.

But it’s not just executives who would suffer; in a really fair system, ordinary joes who ran merely their households into the ground wouldn’t get off easy, either. After all, most people who end up in bankruptcy made some decision that landed them there; a recent study indicates that the main difference between those who declare bankruptcy and others with the same income who do not is simply how much debt they took on. With more “fairness,” heavy borrowers couldn’t just walk into a court, turn over their spare cash, and walk away free, as those who declare bankruptcy under Chapter 7 do today. (Granted, they take a big hit on their credit report.) Those who are not actually destitute would be put on a very tight budget, and the excess would be turned over to their creditors to repay debts. And if they’d been really irresponsible, borrowing and wasting money they had no hope of repaying, perhaps they wouldn’t be allowed to discharge their debts at all. Creditors could seize any little bit of money the debtors ever got their hands on, until the ill-spent borrowings were paid off.

That feels, if not fair, at least fairer—people who have cost other people a lot of money ought to suffer a bit themselves. As it happens, this process describes bankruptcy in much of Europe. And it turns out that it’s not so great.

Let’s start with the corporate side. Receivership, even as practiced in a relatively forgiving country like Britain, often results in liquidation, not reorganization. Sudden changes of the entire management are hard enough in normal times, but when they take place in bankruptcy, the difficulties are multiplied. Very few people want to go to work for a company that may be terminal, particularly if a tightfisted receiver refuses to pay a premium for their efforts.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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