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Subprime Lending, Default Risk, and Personal Bankruptcy Reform

posted by Jason Kilborn

Katie’s post reminds me of an interesting discussion of financial risk and bankruptcy reform in another recent post by Alex Tabarrok over at Marginal Revolution.  Tabarrok takes issue with the neo-Victorian reaction of “credit snobs” to the subprime mortgage default crisis (“credit is something that only the rich can handle”) and defends the democratization of credit.  One of Tabarrok’s remarks runs smack into a stark difference between U.S. and European reactions to widespread default crises and bankruptcy reform.  He notes that, in the new world of financial innovation, “defaults are to be expected,” explaining that “the whole point of recent financial innovation (and reformed bankruptcy law [emphasis added]) has been to reallocate risk [a]way from borrowers and toward those lenders in the world wide market for capital who are in the best position to handle the risk.”  The parenthetical comment glosses over major differences between recent U.S. and European reforms.  These differences illustrate even more vividly the lopsided (misguided?) U.S. reaction to the subprime lending crisis.

To a U.S. reader, the parenthetical statement about bankruptcy reform seems patently false—the BAPCPA did quite the opposite as of October 17, 2005. It heaped more of the already substantial risk onto the shoulders of those unsophisticated consumer borrowers least able to bear the burden, and it provided a (potential) windfall to companies that engage in riskier and riskier lending (like subprime mortgage and credit card lenders, car title lenders, payday lenders, etc.). As Katie observes in her post, even if the victims of the subprime mortgage debacle have a chance at redress for the harm they’ve suffered, the redress will be quite limited by corporate bankruptcy rules, and any small redress will be cold comfort to those who have lost their homes.  The mortgage lenders, in contrast, are free to restructure and play another day.

Tabarrok’s comment makes more sense if one looks at European personal bankruptcy reform.  In Belgium, part of the personal bankruptcy system adopted in 1998 imposes a kind of tax on lenders (including subprime mortgage lenders) based on total loans in default at the end of each year.  The tax is directed at supporting the personal bankruptcy system and educating consumers about credit and relief from debt!  Elsewhere, the trend of reform has been toward marked expansion of relief for overburdened consumers.  This is most visible in France, which in February 2004 implemented the first real Chapter 7-style “immediate fresh start” procedure on the continent.  Similarly in Germany, the demands on individual debtors in exchange for relief have fallen dramatically in recent years, especially following a significant 2001 reform.  Just as historically restrictive systems like that in Sweden are being simplified and liberalized (the Swedish reform went into effect on January 1, 2007), the U.S. system is headed in the opposite direction.

When discussions of “financial innovation” go global, U.S. and European commentators will inevitably talk past each other if the topic of personal bankruptcy comes up.  The sides have now switched their historical places, with Europe now offering more and easier relief to individual debtors and the United States offering less and more restricted (or at least expensive) relief--just when the subprime market debacle shows that the judgmental “personal responsibility” finger is pointed in the wrong direction in the the United States.

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