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
