Editorial
The Permanent Liability Bankruptcy Option
One of the costs of lending money is the risk that the borrower will not repay the loan. In the United States, bankruptcy laws make it rather easy for people to declare bankruptcy and have their debts wiped clean. Banks and other lenders add a risk premium to the interest they charge on loans in order to make up for the bad debts. This raises the cost of borrowing to everyone, including those who do pay back their loans.
by Fred E. Foldvary, Senior EditorHousehold bankruptcy has risen steadily since 1990. Attempts to reform the bankruptcy laws were halted by the September terrorist attack. The economy is now in steep decline, with many more bankruptcies. This is not a good time to stop people from clearing their debts, even though banks and other lenders have to bear the cost and pass some of the cost to other borrowers.
Senate bill S. 420 and House bill H.R. 333, that would have made it more difficult to eliminate debts, are now stalled. The bills were passed, but were not reconciled into a common bill. Congress now does not want to look like it is hurting consumers at a time when we are being urged to spend and invest to get the economy back on track.
Businesses bankruptcies have also soared. Over 200 internet companies shut down in 2000, and the bankruptcies have risen in 2001. In the second quarter of 2001 (April to June), there were over 10,000 business bankruptcy filings and over 390,000 household filings.
Household debt is now at a record level relative to income. Bankruptcies by other people hurt you by making loans more costly, which inhibits production and growth. The 1.4 million household bankruptcies costs the economy $44 billion per year, or $400 per year per average American household (see bankruptcy abuse).
While overall bankruptcy reform may need to wait, we can do something to help households reduce the cost of other folk's bankruptcy. Why should you have to pay the risk premium on loans if you personally are not a high risk? One simple reform could reduce costs for those who do pay back loans: enable a borrower to waive bankruptcy debt clearing. If the borrower wants to, he would be able to sign a statement saying that in the event of bankruptcy, this loan would not be wiped clean, but remain a debt as long as the borrowers are living.
This permanent-liability option would make the borrower a lower risk. The lender would be able to reduce the risk premium and the nominal "interest" paid on the loan. Lenders such as credit-card issuers would be allowed to specialize in loans having permanent liability. Those not opting for permanent liability would see some increase in their loan rates, but they should bear that cost if they seek the option of not paying back the loan upon bankruptcy.
Businesses organized as single proprietors and partnerships would come under the same legislation. Their business debts are also personal obligations of the owners of the enterprise. In the case of partnerships, limited partners would not be assuming the partnership debt, but only the general partners who run the business. Likewise, shareholders of corporate stock would continue to have only equity ownership with no personal liability. Lenders to corporations would bear the risk as they do now, and if you fear nonpayment, then ask for the cash up front!
If corporate debt is canceled when the corporation vanishes, why must individuals have liability for their debts? That's because a corporation can lose all its assets, but we don't want to bring a natural person down to zero. Bankruptcy laws let a person keep his house, car, and other necessities. We can let a corporation as a legal person die, but not a natural person. But in return, we should not allow people to simply eliminate debt by fiat. More precisely, we should enable people to have the freedom of choice to enter into permanent obligations. Bankruptcy law now prevents this choice. So we force folks to share the risks of the more risky borrowers.
That's not fair. We should let people choose to make themselves less risky by assuring a lender that the borrowers will have the debt even if they fall into hard times. The lender can then work with borrowers to plan a payback program that will not be too punitive to the borrowers.
It would help the American economy to recover more quickly if the government passed a "Permanent Liability Bankruptcy Option." That is something that Congress could pass immediately if there is more public awareness of the social cost of making loans too risky.
Copyright 2001 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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