Commentary on the ongoing collapse of our financial house of cards seems mostly to be about the exact order in which particular cards were stacked against each other, and at precisely what angles.
But the foundation of any financial system, where the first cards begin to be stacked, is the bankruptcy system. Which makes it odd that discussion of whether the fairest and most rational solution to the current mess might involve some tinkering with what goes on in bankruptcy court, seems to be almost a taboo subject. This is especially surprising since there was a major reform to the bankruptcy system in 2005 — surely it is not crazy to think that the current mess might have something to do with that, since many of the loans that are mucking up the system were made in the wake of the 2005 reform.
It’s not that the subject of looking more closely at the bankruptcy process hasn’t been brought up at all; some of the bolder Democratic legislators have suggested that maybe some bankruptcy judges should be allowed to exercise some bankruptcy judgment about whether perhaps a few of the deals that went down in the last few years were really interpretable as rational contracts between fully informed consenting adults, or whether instead they were basically just scams of one kind or another.
But the vehemence with which this idea has been shouted down, and the heaping of scorn on anyone who suggests that it might even be worth thinking about, are striking. I am not an ignorant populist (though I confess to leaning toward the Democratic side of the aisle). I have spent quite a bit of time studying the bankruptcy system, in a year working at the Council of Economic Advisers from 1997-98, where I was involved in an effort to come up with a reform that would better balance the interests of households and banks. (My interpretation is that our bill failed in Congress because the banks thought they would eventually be able to get a better deal than the Clinton administration was proposing; they were right, they got their better deal in 2005). Since then I have kept up, because the academic literature on bankruptcy is close to my core area of academic expertise (household consumption and saving behavior).
Reflecting on the way the system works, it seems to me that the whole reason we have judges involved in this process, rather than just an automated computer program sitting in the judge’s chair, is that it is important to have a stage in the process at which an actual living breathing rational human being, educated in the law and with years of experience making financial judgments, can look at the particulars of each case and make a judgment about them. Or at least, there needs to be a credible threat that this might happen, to backstop the system and prevent the utter insanity that might break out if every last step were automated.
The outcry against such scrutiny has been so fierce and so deafening as to make me wonder more and more exactly what it is that the screamers don’t want anyone to see. What is in those cans of worms that is so terrible that even bankruptcy judges should not be allowed to look in them? The Gorgon’s head that will turn our entire financial system to stone?
Not that there isn’t a legitimate case for concern that such opening up could go much too far. If every single mortgage contract signed in the last few years were reopened to arbitrary reworking by bankruptcy judges run amok, there would be a complete and calamitous shutdown of the securitized market for mortgages, which would do a colossal amount of harm to the financial system as a whole, and might indeed turn a financial hiccup something much more serious. So we have to be careful here.
But what strikes me as the right balance is to (very quickly) come up with a set of criteria that define a set of “safe harbor” mortgage contracts which would be presumed to have been understandable and understood by all parties involved. Actually, the Fed has been working for some months on defining a set of rigorous “truth-in-lending” criteria on what will be allowable in the future, and what will not; surely the persons who have been working on that project could produce some sensible guidelines in a matter of days. Obviously, the traditional 30 year fixed rate mortgage with a 10 or 20 percent down payment would fall in the category of “eyes wide open”deals that can’t be rewritten. And probably 95 percent or more of even the subprime loans that were made in the last few years would also fall in the “off limits to bankruptcy court tinkering” category. In particular, it would be critically important to make sure that if somebody was charged a higher interest rate because that person had a bad credit score and so a higher risk of nonpayment, that is deemed a legitimate contract — risk-based pricing has been one of the great positive innovations in the last decade or so, because it has allowed previously-excluded people like minorities and self-employed people to get mortgages who in the past would have been turned down outright, with no recourse, in a New York minute. (If risk-based pricing were banned altogether, nobody without a perfect credit score would be able to get a mortgage in this country for 30 years. And many, many people have less-than-perfect credit scores.)
But the religious fervor that says that no judge should have the power to alter the terms of any contract, no matter how obvious it is to the judge that something very fishy was going on, seems hard to defend; if even a small percentage of the anecdotes on the internet about the shenanigans of some lenders (and some borrowers) are true, judges need the power to exercise their judgment. Then maybe we will have a better picture of what exactly was in this boggy rotten foundation corner of our house of cards, that is threatening to make the whole structure come tumbling down. And maybe we can better figure out how to shore up and rebuild that problem corner in a way that puts the whole structure on a solid footing.