Joseph Stiglitz offers an insightful column on the mortgage mess and the evolution of bankruptcy law over the last decade — in particular, explaining how our laws make good loan underwriting beside the point:
When it became clear that people could not pay back what was owed, the rules of the game changed. Bankruptcy laws were amended to introduce a system of “partial indentured servitude.” An individual with, say, debts equal to 100% of his income could be forced to hand over to the bank 25% of his gross, pre-tax income for the rest of his life, because, the bank could add on, say, 30% interest each year to what a person owed. In the end, a mortgage holder would owe far more than the bank ever received, even though the debtor had worked, in effect, one-quarter time for the bank.
When this new bankruptcy law was passed, no one complained that it interfered with the sanctity of contracts: at the time borrowers incurred their debt, a more humane – and economically rational – bankruptcy law gave them a chance for a fresh start if the burden of debt repayment became too onerous. … That knowledge should have given lenders incentives to make loans only to those who could repay.
Thinking of bankruptcy rules that allow a judge to wipe out debts or modify loans — famously denied to mortgage borrowers in the spring of 2009 — as an incentive to do better underwriting helps explain why the financial sector opposes changes and why we face so many problems with consumer debt. A system where an un-repayable loan is wiped out or modified is very different from one that ends with the borrower wiped out — and the former is healthier for the economy at large.
— Tim Fernholz
