Schumpeter Was (Unsurprisingly) Right

Commenter Thorley Winston waxes wroth below at my criticism of the new consumer bankruptcy bill:

What rubbish. There is nothing “anti-consumer” about requiring that people who voluntarily decide to enter into a contract should have to uphold their end of the bargain.

Without going into deep detail on this bill (I’ll suggest a reasonably neutral link), let me respond to Thorley and actually get to spend some time kicking at the well-polished loafers of the corporate shills who have pushed this legislation.

I’m always amused when, as a Democrat, conservative Republicans bust me for believing in Big Government Intervention – usually, on behalf of the poor, the less powerful, and people who have been typically excluded from ‘the game’ we play in our economy and polity.

I’m amused because they are the same ones who trip over the tassels on their loafers rushing to the Capitol to get laws changed that might materially improve their lot in life.Let’s look at bankruptcy as an example, and without deeply analyzing the bill, suggest that as far as consumers are concerned, this substantially shifts the burden in bankruptcy to them and from creditors (who stood to lose).

Now portfolio management is simple; I underwrite the risks in my portfolio and set a return necessary to cover the risk. The pattern on increasing consumer willingness to use bankruptcy as a tool for financial management – much like Worldcom, K-Mart, Johns-Mansville, and other corporate borrowers, who follow the pattern set out in ‘Strategic Bankruptcy‘.

But to me, the issue really isn’t a ‘goose’ and ‘gander’ one; the issue is simple.

When the companies that are in the business of loaning money to consumers don’t like the returns or risk they are taking to get those returns, their response isn’t to improve underwriting, better manage their loan portfolios, offer better credit education to their customers – it’s to use their financial and political clout to change the rules under which those loans were made.

Because the laws in place were are much a part of the structure of those loans as the actual agreements executed by the people ol’ Thorley is so contemptuous of.

And that, my friends, is why I can’t get at all distraught about the fact that government regulation imposes burdens (in general – obviously there are lame and counterproductive regulations) on business. Live by the fine print, die by the fine print, I always say.

15 thoughts on “Schumpeter Was (Unsurprisingly) Right”

  1. But this would seem to suggest that we can never change rules that have unintended consequences or whose application is later deemed unfair. I haven’t studied this issue very much but my impression is that people are filing for bankruptcy at unusually high rates. Most of the social stigma of bankruptcy is gone, too. So, why not change the rules going forward?

  2. As noted, I have no problem changing the rules; I just think the changes should be somewhat balanced between the two sides (i.e. make it harder for consumers to shed debt, and make it harder for lenders to pack debt on consumers).

    A.L.

  3. “Because the laws in place were are much a part of the structure of those loans as the actual agreements executed by the people ol’ Thorley is so contemptuous of.”

    How about we apply new bankruptcy law to new loans?

    I dislike the idea that lenders have the responsibiliy to determine whether the loan would be an undue burden on the borrower, and that they have no legal recourse for getting stiffed unless they denied loans to marginal borrowers. The borrower, not the lender, is in posession of the information needed to determine whether a loan and its legally-enforced payback provisions are in his best interests or not, and it is the borrower who should evaluate his own situation and decide whether he will be able to pay back the loan and, if not, decline to complete the transaction.

    “(i.e. make it harder for consumers to shed debt, and make it harder for lenders to pack debt on consumers).”

    Lenders do not pack debt onto consumers. Consumers borrow money on their own initiative.

  4. “Live by the fine print, die by the fine print”

    Most consumer contracts also has some fine print, usually stating that it’s the consumer’s responsibility to pay their bills.

    Obviously businesses have to take into account that a certain amount of people won’t pay. But being ‘poor’ does not grant immunity for entering into a stupid transaction and then not having to pay for it.

    When you sign the contract you indicate that you read the terms. If you can’t understand the terms than perhaps you should not enter the agreement.

    The credit card companies may be predatory, but in the end you still need to USE that credit card to get into trouble. Kind of like gun control. It’s not the card that is dangerous, it’s the people using it incorrectly. And quite frankly, when you use it incorrectly, you must pay (literally!).

  5. Donovan Janus:

    When you sign the contract you indicate that you read the terms. If you can’t understand the terms than perhaps you should not enter the agreement.

    Yes, just so. But.

    But I’m a college-educated guy, with some math training, and if you challenged me to explain the details of all the agreements I’ve entered into…I couldn’t. More honestly, I couldn’t explain the specifics of any of them without a the text, a magnifying glass, and a half-hour.

    In point of practice, (almost) all of us make the assumption that the fine-print clauses we are agreeing to are “reasonable,” and that if they are unreasonable, then they will be unenforceable. To the extent this presumption is justified, it’s because of the history of regulation of these matters, and because most businesspeople are honest.

    I’d rather see legislatures set up ‘level’ playing fields than leave it at caveat emptor.

  6. “I dislike the idea that lenders have the responsibiliy to determine whether the loan would be an undue burden on the borrower, and that they have no legal recourse for getting stiffed unless they denied loans to marginal borrowers.”

    But this is the essense of lending! It is why it is even profitable in the first place.

    Lenders have capital that can be used for different investments – certain investments are higher risks than others. You lend to those who you think will be a safe investment and will pay off decently enough, or you lend to others who are slightly higher risk, but will pay off more. Marginal borrowers are more likely to have lower credit limits and higher interests rates, but in the end, they’re marginal borrowers because their credit history shows them to be marginal borrowers.

    Part of the reason the system works is that lenders measure the risk that they will get a payoff on their investment – i.e., that a borrower will pay back the loan. If a lender is insufficiently smart at estimating the risk, then he’ll loan out too much money, not get it paid back, and go out of the lending business. If a lender is smart about who he lends to, he makes a profit on his investment.

    The way these bankruptsy bills are set up, a lender who does not estimate risk isn’t penalized for not estimating risk – they’ll get paid back regardless of whether or not it was smart for them to loan the money in the first place. And who will pay the cost for that? Disproportionately, those who are poor or in the lower middle class (because they are more likely to be marginal borrowers and are more likely to declare for bankruptsy and are likely to be hit hardest by not being able to get rid of debt).

    Borrowers need to be smart, yes, but so do lenders. I think that borrowing a million dollars to finance the creation of a great literary work of fiction would be in my best interests, but I don’t believe any bank would be stupid enough to believe that the risk of it actually paying off would be worth the money they’d be out of when it doesn’t pay off. The bankruptsy bills reward being stupid. And in business, that’s wrong.

  7. Remember that bankruptcy has to balance two competing concerns.

    On the one hand, obviously rules which are too lax lead to “strategic bankruptcy”, where people will intentionally spend beyond their means and then declare themselves bankrupt because they can secure a significant financial advantage by doing so. This is why bankruptcy should be relatively difficult (and yes, at least somewhat painful.)

    On the other hand, if you’ve spent beyond your means, and the law insists that you pay back debts that you have no legitimate way to pay back, then you’re going to have to turn to criminal methods, or just give up – and not in the “withdraw into quiet despair” way, but in the “walking into a Bank of America office with a shotgun, a rifle, and 500 rounds of ammo” way. By offering the “reset option” of bankruptcy, people who have gotten in wayyyyyy over their head still have an option to take that allows them to continue living an honest life, something that is very much in society’s interest.

    Anything that makes bankruptcy more accessible is going to lead to an increase in people taking advantage of the system in order to shirk bills they could pay (or encourages them to rack up bills they never meant to pay.) Anything that makes bankruptcy less accessible is going to cause people who get hit by huge, unexpected, life-wrecking expenses to turn to crime, to change their identities completely, or to snap and go postal.

    One should also mention that lenders continue to bombard people with offers of credit, credit, and yet more credit; saying that this has nothing to do with an increase of people who default on their credit is silly. I’d be very interested in seeing an analysis of the change in the rates of defaults (per 100k people? Per $1m lended?) as that might do a better job of indicating whether increasing bankruptcies are dependent on the increased use of credit, or conversely, independent of those factors.

  8. Armed Liberal,

    I agree with your post.

    I just think the changes should be somewhat balanced between the two sides (i.e. make it harder for consumers to shed debt, and make it harder for lenders to pack debt on consumers).

    While I agree with the latter statement (or at least believe that consumers should not pile debt on themselves as much – it is their choice after all), it would have to be a very gradual process. Otherwise, a reduction in consumer spending – about 2/3 of American spending, IIRC – would bring our economy grinding to a halt. Then either the government or business would have to increase its spending – and voila, socialism or less pay for workers, respectively. There really isn’t an easy solution for this problem; at best, the Japanese solution of saving instead of spending results in an economy that can have long downturns (because of increasingly dpressed savings). The peculiarities of the American economy allowed the recent recession to be fairly minor thanks to an increase in consumer spending – but it’s hard to see how this could happen again in a subsequent recession, without increasing consumer indebtedness.

  9. As someone who creates models to predict credit risk for a Major Credit Card Company ™, I will say that lenders do an extensive amount of work to analyze the risk of lending someone money. When you see someone and say “geez! how can anyone offer him credit! they’re just asking to get screwed!”, what you don’t realize is that the lenders DO make money, even if 1 in 5 of the people like him don’t pay back their loan. This is due to the fees and finance charges collected before the person “charges off” (doesn’t pay the remaining portion of the loan.

    Most Major Credit Card Companies have a good understanding of the riskiness of the peopel they are offering credit too. Granted, there are some (*cough* Metris *cough* Providian *cough*) that have thought they understood their risk but didn’t. But chargeoffs are watched EXTREMELY closely by investors for credit card companies. It’s often given much more relevance than it should in equity valuation models used by Wall Street analysts, actually. There are such strong incentives to keep down chargeoff numbers that a number of companies have been moving away from the much more profitable subprime market — and the result has been that their profits INCLUDING LOSSES have gone down… but they’re still doing it anyway, because of the stigma the market places on chargeoffs.

    My point is, credit card companies aren’t being reckless, losing money hand over fist from unprofitable risky loans. Just take a look at the performance over the past year of the major credit card issuers (and that was during a RECESSION).

    The other important thing to remember is that the vast majority of chargeoffs are not as a result of bankruptcies. If companies were losing money on risky loans, it wouldn’t be because of bankruptcy laws.

    Why do they want to change bankruptcy laws then? It’s pretty simple… the same reason every other industry lobbies Congress to get bills passed that benefit them — they’re profit-maximizing corporations, and get a very positive return on investment from lobbying. It’s not because they’re getting taken to the cleaners and need it to survive (though they may portray it as that as a way to try to win more lawmakers to their side). And yes, I agree that this type of lobbying, while nearly universal in the American economy, is generally a bad thing.

    That doesn’t mean that the bankruptcy reform law is a bad thing though. The fact that the companies lobbying for it are doing it for self-serving reasons doesn’t change the normative status of the reform.

    The fact of the matter is that bankruptcies among people who don’t “really need it” have been going up significantly. For the same level of indebtedness and income, the proportion of people who are choosing to declare bankruptcy rather than enter into a repayment plan with reduced interest, partial debt forgiveness, etc has been increasing at a very steep rate. It’s this shift in attitudes towards debt that is scaring lenders. People who in the past would have repaid their loans are now choosing not to. And that is what lenders want to stop.

    If people are fundamentally unable to pay, they will still declare bankruptcy under the reform. It’s the people who are on the margins, who in the past would have declared bankruptcy but will now enter debt repayment programs that are really impacted.

    At the end of the day, people are responsible for their own actions. If they took on debt they couldn’t afford to repay, they should not be playing victim and crying that they shouldn’t have to pay because the evil corporations should have protected them from themselves. If that mindset wins over, we’ll end up going back to the 80s, when only the moderately wealthy had access to revolving credit, and if someone had poor credit they were simply assumed too risky to deal with. The societal benefits of allowing people with spotty pasts to try to rebuild their credit and have access to things like homeownership far outway the societal costs from not protecting people from themselves.

  10. Ariel raises an interesting point and most probably an unintended consequence of our “buy it now and (maybe) pay for it later” culture. Have loose credit rules created a “bubble” economy in which growth is artificially inflated by expenses that have outpaced incomes? This, to my non-economist eyes, seem to eerily mirror the dot-com stock issue in the late ’90s, where prices of stocks could not match performance and earnings, creating a situation where much value was merely “on paper”. As consumer debt snowballs it does create actual economic growth, but is it sustainable growth or are we poised for a credit collapse?

    I see two main reasons for how we got here, and no good solution. First, lenders have less disincentive to make marginal or risky credit available. In some cases this is through guarantees or through passing the cost to other customers, but much credit used today would have never been made available to the consumer in the past. The second is a radical cultural shift in the consumer. Class envy and a sense of entitlement, often fueled by the lenders, has created an impression of almost a right to credit. I vividly remember an infuriating commercial where Merle Haggard looked into the camera and told the millions watching “you deserve a credit card.” Add to this the elimination of shame or embarassment that once universally accompanied debt and you have a society that acts as if the right to spend twice your income was enshrined in the Constitution.

  11. “The way these bankruptsy bills are set up, a lender who does not estimate risk isn’t penalized for not estimating risk – they’ll get paid back regardless of whether or not it was smart for them to loan the money in the first place.”

    They should get paid back if it’s at all possible. There is a contract, you know.

    “And who will pay the cost for that? ”

    The people that borrowed the money, that’s who! Which is as it should be.

    The fact that lenders have to devote any thought to the possibility of the other party in a signed contract stiffing them out of money that they agreed to pay is a bug, not a feature. In an ideal world, people won’t do that. In our world, sometimes people will do that. Now we can’t eliminate it entirely, but surely we shouldn’t let borrowers get away with it on the theory that the lender should have acted in loco parentis and stopped the other guy from borrowing money he wasn’t going to be able to pay back, and that his failure in his presumed parental duties voids his entitlement to legal recourse to enforce the terms of the contract.

    Yeah, I know shit happens, and sometimes people who had every reason in the world to think they’d be able to live up to their agreements find they no longer can when something unpredictable deprives them of their income. That’s what bankruptcy is for.

  12. I think it should take quite a bit to get out from paying back a loan. There’s a big difference between paying back a loan and paying back a lot more than the loan is worth.

    I have a friend whose financial distress is due to exactly ONE loan. This person was laid off from their job, and has had significant difficulty finding a new one in the current economic environment (with any luck that’ll improve soon). There are no credit cards in the picture or any other kind of debt. This person cut their living costs down to nothing, because the cash flow wasn’t there. Temping has been the only option, while searching for something new. There’s a single car loan, at 16.5%, on a loan value (say, 35k) that exceeded the value of the car when it was bought (predatory salesperson, earning commission from credit company). Over two years payments on that loan have exceeded half of the value of the loan. The loan balance? Somewhere around 32k.

    Just about every penny this person earns goes to paying that car loan, in a desperate attempt to avoid destruction of a credit rating.

    The kicker is that the car is worth around 18k, at this point, if sold privately. If this person was left with the remaining 14k loan, the situation would be dramatically better, even at the same interest rate. But…the credit company holds the lien. They’ll repossess, sell the car for half its market value to an insider who’ll flip it for a profit, put that against the 32k, then come for the rest.

    It’s this kind of thing that strikes me as unfair.

    Experts can take advantage of non-experts in a big hurry. Consumer laws help a lot; they lay down guidelines on things like loan-sharking. Good consumer law makes it safe for the lesser-skilled consumer. It also makes life a lot easier for honest businesses.

  13. A.L., it’s extremely naive and ridiculous to paint almost any action on bankruptcy as “on behalf of the poor,” at least as regards the future.

    In the long run, lenders will make their profit. Changes like this just affect rates and such. Lax bankruptcy laws lend to more people spending beyond their means, which means that lenders eat losses– which means in turn, that lenders are much less likely to lend money to the poor, and charge higher interest rates as a result, to earn the money back.

    Result: The poor who would be able to successfully borrow money, improve their lot, and pay it back, are now stuck not being able to get a lone, or having to pay loan shark-type interest rates if they do. (Ban the high interest rates, and they just won’t get money loaned to them.) So by your “pro-poor” actions, which certainly help some people with bad luck, you’re going to exclude even more poor people from “the game,” as you put it.

    It’s just plain stupid to pretend that any economic action like this is just “pro-poor.” An action that benefits those poor who, because of bad luck or any reason, aren’t able to pay back their loans, will directly hurt those poor who would be able to pay it back. Some win, and some lose. Is there a proper balance somewhere? Probably, but there are always winners and losers, even among the poor, with actions like this.

  14. John T – sorry, you’re misreading a bit; I haven’t suggested that the new laws will fall disproportionately on the poor; I said that as a liberal, I was in favor of government action to favor the interests of the poor, the relatively powerless, and those who were excluded.

    In this case, we have the more powerful – the lenders – using their financial clout (like the $450K loan to Rep. Moran) to sway the laws more in their favor.

    That’s what I have the biggest problem with.

    I’m in favor of bankruptcy reform; I think it’s overused. Bujt I think it doesn’t have to be – as the present proposals are – a windfall to the lenders.

    A.L.

  15. I was in favor of government action to favor the interests of the poor, the relatively powerless, and those who were excluded.

    But that’s the problem. It’s essentially impossible for any bankruptcy reform bill to favor the interests of the poor, powerless, and excluded as a block. Some will get helped, and some get hurt.

    Now, it’s true that any proposals that affect contracts already signed are almost surely a giveaway to one side or the other, that’s granted. Outside of that, though, there’s not going to be a real long-term effect on profitability of the lenders, though certain changes could affect the size of the companies. (Which therefore affects the number of employees and the CEO pay and other things that the companies care about.)

    Looking at the link you provided, the only thing that could fairly be characterized as a giveaway to these companies would be if these new rules would apply to people who got loans under the old system– the article’s a bit unclear on that.

    Yes, it makes it harder to declare bankruptcy. That increases the expected profit on a loan. The response of the lending agencies (due to competition and a desire to make a buck), therefore, is to both offer loans to people who wouldn’t otherwise be able to get them, and to decrease the interest rates charged. Again, this helps those of the poor that would be able to repay their loans, while harming people who run into trouble.

    I’m in favor of bankruptcy reform; I think it’s overused. Bujt I think it doesn’t have to be – as the present proposals are – a windfall to the lenders.

    Please point me to what is actually a giveaway to the lenders there. There is absolutely nothing in the article to even hint at such a thing, other than the changes possibly applying to older loans. That, if true, is a giveaway. Nothing else is– except that it’s a giveaway from people who would fail to pay back their loans to people who would be able to. (Regardless of wealth, and both categories include the poor and rich in great numbers.) It will hurt some of the poor, and help others.

    The profit rate of the lenders will not grow, outside of any short term effects from loans already signed. The lenders apparently believe that the changes will result in more loans being signed… obviously there’s a tradeoff point, because if you make bankruptcy too dangerous, people won’t want loans.

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