... But That's the Unsustainable Part

Steven Rattner calls for a bailout of Detroit,

Many call for scaling back the city to fit realistic population projections. While logical, the potential for downsizing Detroit is limited because the city’s population didn’t flee from just one neighborhood; the departures were scattered, requiring Detroit to deliver services across a geographic area the size of Philadelphia, with less than half the population. Further cuts will surely come, but in some key areas, like public safety and blight removal, Detroit needs to spend more, not less.

If Detroit does not find a way to scale itself back, to empty out those largely abandoned areas with one or fewer households per block, it's going to have to continue to provide police, fire and utility services to those areas - and the cost of doing so will not only vastly exceed the minimal tax revenue generated from those areas, it will impede efforts to ensure better emergency service response times to other parts of the city, response times that Rattner notes are unacceptable ("Average police response times have reached 58 minutes, compared with a national average of 11 minutes"). If the issue of providing public services to largely abandoned areas is not addressed this time around, I suspect that the City's future includes a second bankruptcy.

Why Shouldn't The Government Be The Senior Creditor

I'm sorry. Although I support the creation of a new bankruptcy chapter for companies deemed "too big to fail", and I support proposals to keep "too big to fail" from being an excuse in the future to bail out companies that should go through bankruptcy or otherwise be allowed to fail, I find myself completely unable to get worked up about the idea that certain Chrysler and GM creditors are getting a raw deal in bankruptcy.

The concept seems to be this: Even though the auto companies survive solely on government bailout funds, and can make their way through bankruptcy only with the government guaranteeing their debt and warranties and providing additional cash support, and even though the creditors objecting to the proposed distribution would be receiving far less but for the government bail-out, and even though to give them more increases the government's future exposure through the Pension Benefit Guarantee Corp., it's hideously unfair that the government is using its position to bring about a settlement that doesn't provide a greater transfer of taxpayer money to cover the private losses of GM and Chrysler investors.

Why are these people so willing, eager, to regard taxpayer dollars as meaningless. No, that's not quite right. As a justification for a wealth transfer from the taxpayers to investors who made a poor investment. What if we had a perfectly reasonable law that, when a major business falters and is deemed "too big to fail", but cannot obtain the private capital it needs to maintain its operations, in the event of bankruptcy any loans or other aid it receives from the government to get it through the crisis must be paid back to the penny before any other creditor may receive a distribution? How would that be unfair? Yet in the context of GM and Chrysler, the deal being offered to creditors is far more generous.

With all due respect to those who pretend that nobody can bid against Fiat for Chrysler because nobody has had time to figure out what Chrysler is really worth, how hard is it to beat a bid of $0? What reason is there to believe that Obama would be anything but pleased with a higher bid, a bidding war, or a bid from a domestic company? Seriously, Chrysler was privately held by Cerberus Capital Management, a company that deems itself a turnaround specialist, and I don't think they would have hesitated to provide a detailed prospectus to anyone who was willing to outbid Fiat. I also don't accept that Fiat is the only company that noticed Chrysler was for sale, and spent a bit of time kicking the tires and looking under the hood.

I expect that the legal challenges to the proposed resolution of Chrysler's bankruptcy will fail. I agree that what we're doing here (and, outside of the bankruptcy process, with major financial institutions) is far from ideal. I am anything but thrilled with the prepackaged bankruptcies we're looking at, and would very much have preferred to keep GM's ownership in private hands. But this notion that keeps rearing its head, that it's unfair not to give investors, financial industry employees, and others a windfall at taxpayer expense - where their investments would be worthless or they would be out on the street without government intervention - just doesn't move me.

The better argument is that we should have let Ford and GM enter bankruptcy last fall, without federal support, and let the market deal with it. It's highly questionable whether, three or five years down the road, this will look like the best use of the taxpayer money we're pouring in, with the short-term goal of saving jobs and perhaps allowing viable companies to emerge from the ashes of their former selves. Will it still look like it was a good idea to keep the companies going, in order to prevent huge numbers of their employees from becoming jobless in the middle of a difficult recession? It's hard to know - there is a serious price to worsening or perpetuating the recession. But while I hope I'm wrong, I don't think it is ever going to look good in terms of "dollars spent per job saved".

Chrysler in Bankruptcy

The American Enterprise Institute offers a drawn-out whine about how the Chrysler bankruptcy isn't sufficiently fair to creditors. As if you haven't guessed, I'm not impressed. The piece opens by comparing the Chrysler bankruptcy to "equity receivership", a contrived mechanism for the sale of distressed companies that predates Chapter 11 bankruptcy. The author, David Skeel, complains that the Obama Administration's desire for the bankruptcy court to quickly sell Chrysler to Fiat amounts to the same thing.

Except... Fiat's the only interested bidder. There may be other companies willing to buy small pieces of Chrysler, or who will buy some of its intellectual property, brands, equipment or real estate holdings at auction. But there's no other company even slightly interested in acquiring Chrysler as a going concern. The Obama Administration's pressure for a quick sale has to do with maintaining Chrysler's viability and not scaring off that single bidder. If the creditors who want to squeeze more money out of Chrysler manage to slow things down or increase the cost to Fiat, the odds are that Chrysler will fail. Skeel assumes that the creditors who are imeding the sale (who hold a minority share of Chrysler's debt) are acting in good faith; but it seems more like a continuing game of chicken. Can they coerce more money out of the other creditors, or out of Fiat, and will they really risk losing even more of their investment if they don't get the concessions they demand? Maybe; but it would not be responsible for the bankruptcy court to risk killing off Chrysler to find out.

As for Skeel's whinging about the union's share of the future Chrysler, coming out of bankruptcy:

It also seems to flout bankruptcy’s priority rules by giving Chrysler’s employees (who are general creditors) a big stake in New Chrysler while forcing senior lenders to take a major haircut. The usual rule is that senior creditors must be paid in full before lower priority creditors are entitled to anything.

Here's the deal: Chrysler only presently survives at all because it's benefiting from huge infusions of taxpayer money that, realistically speaking, won't be paid back. If Chrysler also backs out of its commitments to retirees, that's another burden that's places on the taxpayer, as the Pension Benefit Guaranty Corp. covers Chrysler's default on its pensions. While the AEI seems to be a huge fan of lemon socialism, some of us don't think it's unreasonable that at least some portion of the private losses involved remain in private hands. After all, but for the government bailout, the creditors who are whining about their losses would be suffering a far worse fate.

From there, it gets sillier. To "protect" creditors from the sale to Fiat, Skeel suggests,

First, [the bankruptcy judge] could insist on an independent valuation of the sale, rather than just taking the administration’s numbers for granted. Inviting competing bids, which Judge Gonzalez did this week, might serve as an adequate test of the government’s price in an ordinary case.

So we get an appraisal. But here's the thing about appraisals: They don't actually tell you market value. Do you know how you find out what something will sell for on the market? You sell it.

Oh, but "bidders who are willing to go head to head with the U.S. government are not likely to be thick on the ground"? Give me a break. Cerberus has been ready to dump Chrysler for at least a year, and the only company who made a viable offer was Fiat. It's childish to pretend that the dearth of bidders comes from Administration pressures, as opposed to the fact that Chrysler's a basket case that nobody wants. And while I'm sure the creditors who are trying to squeeze more money out of Chrysler's carcass are happy to have Skeel shill for them, the fact is that any attempt to "restructure" the deal could cause the only company willing to take on Chrysler to change its mind, or to line up with other companies to pick over the carcass of a dead company, returning far less to creditors than will be obtained through Chrysler's sale as a going concern.

Chrysler Is In Chapter 11 Bankruptcy

The news stories seem to be saying that Chrysler "will" file, but that's just because they're a bit slow with their updates. It's a done deal.

Let's hope this gets them past the hurdles set by creditors (whose expectations were, in my opinion, quite unreasonable given that Chrysler is bankrupt), and facilitates a quick deal with Fiat. Good luck to the employees and retirees, who may get hit pretty hard.

All Talk, No Action....

Fiddling while Rome burns.... [Insert cliché of your choice here.]

The point of calling on Congress to come up with the type of "Chapter 10" bankruptcy that its members know to be needed, or for Summers and Geithner to come up with a plan to wind down "too big or too entangled to fail" financial institutions, is not simply to goad them into taking action for the benefit of future generations. It's because things aren't exactly coming up roses right now, and those solutions could be useful, right now.

A group representing General Motors Corp. (GM) bondholders doubts whether the auto maker's survival plan will be enough to keep the company out of bankruptcy given the sharp decline in U.S. vehicle sales.

In a letter sent Sunday to U.S. Treasury Secretary Timothy Geithner and advisors to President Barack Obama's auto task force, advisors to the group say demands that bondholders swap two-thirds of their debt for equity in a restructured GM pose too much risk given the company's precarious state.

I'm not sure whether their concern is truly about GM's ability to survive; I suspect it's mostly about getting better security for their stake. But one way or another, if a "Chapter 10" existed, we wouldn't be having this discussion - either the parties would agree, or the company would enter into the new bankruptcy proceeding. There could be brinksmanship, but it would be qualitatively different - it would be between whether the negotiated outcome was likely to be better for everybody than a bankruptcy proceeding, not about which interest group gets the greatest benefit of an ad hoc taxpayer bailout.

If You Don't Like the AIG Bonuses.... You're Part of an Angry Mob!

I may have to stop reading the news for a day or two.

Ruth Marcus believes she has an insight here:

Could we put down the pitchforks for just a moment and have a reasonable discussion about the bonuses at American International Group?

I get the outrage. It's galling to pay $165 million to a bunch of wealthy traders to clean up a mess that they, or at least their company, made.

I get the political fix in which President Obama finds himself. The sums are staggering - if not to Wall Street, then to everyone else who's ever worked for a living. The public is worked up, increasingly convinced that its money is being flung around recklessly, to a gang of extortionists at AIG and at European banks, without any hint that the fundamental problem is being fixed.

Yes, obviously, these bonuses are inspiring rage disproportionate to their amount, which I've already observed is miniscule compared to the bailout. (CWD likes to remind me of the quip, "$10 million here, $10 million there, pretty soon we're talking about real money." If only we were talking in figures that "small".) But Marcus conveniently forgets how much the taxpayer has had to swallow. If this were the first scandal over outrageous bonuses, well, we can roll with it. If it were the second, well, we can't just let the system collapse, right? But at a certain point we, the taxpayers, have every right to say "enough". Contrary to Marcus's suggestion I think, if anything, U.S. taxpayers have been very patient and understanding.

But Marcus continues to chide anybody, even the President, who questions the wisdom of these bonuses. She thinks they're justified:

Well, because in the short run, hammering the AIG employees to give back their bonuses risks costing the government more than honoring the contracts would. The worst malefactors at AIG are gone. The new top management isn't taking bonuses. Those in the bonus pool are making sums that for most of us would be astronomical but that are significantly less than what they used to make. Driving away the very people who understand how to fix this complicated mess may make everyone else feel better, but it isn't particularly cost-effective.

This combines two contentions about the bonuses that I have previously seen presented in isolation, and to my surprise Marcus manages to somehow reconcile them - at least in her own mind:

• The people who put these deals together are the only ones who can undo them; so we have no choice but to pay them ridiculous amounts of money so that they'll stay and clean up their mess; and

• All the bad people are gone and have been replaced with good people, who shouldn't be punished for the fact that the people they replaced did bad things.

Obviously, if it was possible to replace all of the bad people in the space of a few months such that only good people remain, and those good people are competent to fix the problems created by the bad people, it can't be that difficult to find new, quality employees who can understand and fix the mess.

Beyond that, her justifications make no sense.

• These people used to earn more before their peers brought down the economy? Well, cry my a river. So did a lot of people who aren't getting six figure salaries and seven figure bonuses.

• New top management isn't taking bonuses? Then we're to assume that they're no good and are incompetent to fix the problems, because nobody qualified would take those jobs without huge bonuses?

• Taking back the bonuses will cost the government more than paying them? Care to explain how?

In the longer term, having the government void existing contracts, directly or indirectly, as with the suggestions of a punitive tax on such bonuses, will make enterprises less likely to enter into arrangements with the government - even when that is in the national interest. This is similarly counterproductive.

No wait, really. You're telling us that AIG wouldn't have agreed to be bailed out if it considered there to be a possibility that the government might try to reign in salaries? Even if we pretend they had a choice, didn't you just get through telling us that the new senior management voluntarily gave up bonuses? You think that was because they had no clue that the government would be concerned about excessive compensation? More to the point, where's your outrage about Ford and G.M. being instructed to shred their union contracts?

Marcus repeats some of the nonsense I've addressed in prior posts - for example, these bonuses were negotiated a year ago, before AIG received government money (but no question, let alone an answer, on whether these bonuses were negotiated, and enshrined in these extraordinarily bulletproof contracts, in anticipation of a government bailout. And that these bonuses have been common knowledge for over a year - she had best remind Geithner of that, because he begs to differ. And of course, this carries on into the "sanctity of contracts" nonsense argued even less persuasively by Sorkin.

Like Sorkin, Marcus also attempts to dance around her hypocrisy on the sanctity of contracts:

But, you ask, what about autoworkers who are being squeezed to renegotiate their contracts? Those renegotiations mostly involve the future terms of employment, though, it is true, they also could affect retiree health benefits. If an autoworker doesn't want to show up on the assembly line under the terms of a new deal, he or she doesn't have to. That's different from telling AIG employees they're not getting the amount on which they agreed for work they've already performed.

Horse puckey. If I negotiate a three year contract at a specific wage, and you tell me half-way through the contract that we're shredding it but "that's okay because it only affects my future wages," do I really need to explain to you that the wage structure of the entire contract was premised upon its three year term? Even if I ignore such things as earned retiree benefits, that Marcus dismisses as a footnote?

Further, this isn't compensation for work performed. That's called a "salary" This is a "bonus" - money paid in addition to salary. Typically, bonuses might be paid for this thing called "performance" - but no performance was required for these bonuses. These bonuses have been described as "retention bonuses" - payment to keep people in their jobs at AIG when they might otherwise quit. Except then, why are millions of dollars being paid to employees who have already left AIG? Marcus would tell us that the wage provisions of the UAW contracts can be renegotiated, but not the bonus provisions in those UAW contracts - aren't those "different", as well? What would it take to make Marcus cry "Shenanigans"?

Marcus continues by distinguishing this from bankruptcy - you know, where companies are in the same situation but taxpayers don't bail them out and pay their employees' salaries and bonuses, and the employees end up on the street:

This is more analogous, but bankruptcy is a legal mechanism designed precisely for the abrogation of contracts. It is intellectually consistent to support expanding the power of bankruptcy courts to rewrite mortgages on primary homes - as they can with vacation property - but balk at reneging on the AIG contracts.

Great. Now we're getting somewhere. Okay, Ms. Marcus, let's hear it - explain your intellectual consistency: Why it's okay for this very type of contract to go unpaid when a company goes bankrupt, but not when the only thing that keeps it out of bankruptcy is a taxpayer bailout, unprecedented in size?

Oh... You say you ran out of space before you could do that? How... unfortunate.

Once the pitchforks are out, it's awfully hard to convince the mob to put them down.

Don't worry, you're a Washington Post columnist and, at least so far, the angry mob hasn't turned on the village idiots.

Bring On "Chapter 10"

Recently, Barney Frank pointed out the obvious: If Chapter 11 bankruptcy isn't suitable for companies like GM or Chrysler, Congress can pass a new form of bankruptcy ("Chapter 10") that will allow them to continue payments to suppliers.

Meanwhile, the outlook for GM and Chrysler in their present forms continues to darken.

This leads "straight talkers" like John McCain to embarrass themselves,

McCain said the Obama administration didn't make the tough choice by letting GM fail, and instead has trapped itself in spending billions on a company barely on life support.

The problem, of course, is that the decision not to let GM and Chrysler fail was made by the Bush Administration.

Speaking from the White House at 9 a.m., Mr. Bush said the administration decided against forcing a bankruptcy to compel cost-cutting, fearing consumers might desert one or more of the car companies and touch off a broader collapse. Executives of the car makers have made similar arguments.

"Under ordinary economic circumstances, I would say this is the price that failed companies must pay, and I would not favor intervening to prevent the auto makers from going out of business," the president said. "But these are not ordinary circumstances. In the midst of a financial crisis and a recession, allowing the U.S. auto industry to collapse is not a responsible course of action."

In essence, Mr. Bush's plan lets the auto companies survive through March. He leaves it to the Obama administration to decide many tough questions after that.

But despite his dishonesty, McCain has a point. If we're going to pretend that we actually follow capitalism, or have a market economy, we need to consider how we can let companies like GM and Chrysler fail, or how we can give them the opportunity to reinvent themselves through bankruptcy despite the poor fit of Chapter 11. So I say, bring on Chapter 10.

Keep GM afloat while Chrysler enters "Chapter 10". If necessary, tweak the legislation to resolve any early problems. After a month or two, if the sky hasn't fallen, ease GM in to Chapter 10 proceedings. They'll emerge as smaller, leaner companies, ideally able to compete on their own merits. Or not. But they'll have a fair chance, and it will minimize the amount of taxpayer dollars we burn trying to sustain them in their current forms.

Cash Gifts Are Still Better

I know, you're still not convinced by the dead Circuit City gift card in your desk drawer, or that old email notice telling you that a friend gave you Flooz to spend at your favorite online stores. So let's add to the pile:

A company that sold gift certificates to businesses and individuals around the U.S. has shut down, leaving thousands to wonder if unredeemed certificates for restaurants and stores are worthless.

CertifiChecks Inc., which operated in 47 states, says it is filing for Chapter 7 bankruptcy and hasn't made clear whether it will honor the unredeemed gift certificates.

It's a Chapter 7 bankruptcy... I think that makes it pretty clear that most, and quite probably all, of the certificates won't be honored.

It was an amazing feat to convince people that cash gifts somehow lack class or thought, but that forcing somebody to spend money with a particular merchant or to hope that a third party lives up to its guarantee of payment.

Who Would Have Guessed....

Here's a real news flash....

General Motors Corp on Thursday said its auditors had raised "substantial doubt" about its ability to survive outside bankruptcy if it fails to stem its losses and stop burning cash.

Who would have guessed that having too many expenses, too few sales, and being out of money could result in bankruptcy.

How Much Is Too Much?

That GM Chapter 11 plan?

It's still sounding good.

The U.S. auto industry needs even more help from the government to survive than originally thought.

General Motors Corp. on Tuesday said it could need up to $30-billion (U.S.) from the Treasury Department to keep operating. Included in that amount is $13.4-billion the company has already received. Previously, GM had said it could need as much as $18-billion.

GM and Chrysler LLC said Tuesday they'll need billions more in government loans than they predicted just two months ago. The two auto makers also plan further job cuts and additional curtailment of auto production.

Both companies plan to reduce the number of models they offer to car buyers over the next few years.

Help Chrysler find a buyerCerberus find a buyer for Chrysler, or roll it into GM and let them go bankrupt together.

A GM Bankruptcy?

I say, go for it! If in fact it's a viable plan, it seems like a much better option than limping along, surviving only with infusions of taxpayer money.

The viability of a GM bankruptcy might also give Congress the backbone to give Cerberus the overdue instruction that it needs to live up to its claims of being a turnaround specialist, and require it to pay for its own mistakes.

Bankruptcy and Primary Residences

The housing bubble was blown up to its absurd proportion by the joint willingness of people to purchase homes that, in many cases, they could not reasonably afford, coupled with a mortgage industry that knew as much but was happy to lend them money anyway. I'm not personally happy that either side in that type of transaction is getting bailed out but, like it or not, they affected (and continue to affect) their neighbors. In a faltering economy, even some responsible borrowers are struggling with mortgage payments inflated by the housing bubble, while housing values may be further depressed by abandoned homes (perhaps half-built), empty lots from abandoned or unsuccessful development, and foreclosures in their neighborhoods.

With hundreds of billions, really trillions of dollars of taxpayer funds being used to prop up the lenders in that scenario, while speculators walk away from bankrupt corporations or get relief through bankruptcy court, it should be no surprise that people like Todd Zwicki are shocked that any relief might be directed at... ordinary homeowners. I'm not sure where I can find Zywicki's outrage at hundreds of billions of dollars being directed at financial institutions, and I don't see in his editorial any lament that debtors can "cram down" the value of their investment properties and vacation homes in bankruptcy. But how horrible, that bankruptcy judges may be able to "rewrite" mortgages for people who own only one home.

In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points.

There are three obvious responses to that.

• Why should mortgage lenders sit in a privileged position as compared to other lenders? I recognize that this is the "American way" - you hire lobbyists to get legislation to favor your industry over others - but what is it that makes home lenders so special? In bankruptcy, where some bills will go unpaid, at least in relation to the unsecured portion of their loans why should financial institutions be privileged over doctors and hospitals?

• Is there any reason to believe that the increased costs will be substantial, particularly in relation to borrowers who aren't marginal? Are second mortgages or mortgages for vacation properties significantly more expensive than primary home mortgages?

• So what? If the net effect of bankruptcy law is that lenders think twice about housing prices "always going up", or require a sufficient down payment and proof of income to be reasonably certain that the loan will be repaid even if the market is flat or values decline, isn't that a good thing?

Further, Zywicki ignores the fact that this legislation limits itself to mortgages in existence at the time it passes. That should ameliorate its assumed effect on future lending decisions. In terms of that change, Zywicki writes,

This is illustrated by a recent example: In 2005, Congress eliminated the power of bankruptcy judges to modify auto loans. A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform.

The car loan example is an interesting one, as it highlights how lobbyists for an industry can shift costs to other lenders. Bankruptcy reforms restrict judges from reducing car payments in a Chapter 13 plan so, instead, payments to other creditors go down. Zywicki doesn't explain why that's a superior outcome.

But more to the point, as you may have guessed from the fact that car loan rates haven't dropped by 2.65%, he seems to have his numbers wrong. The Federal Reserve Bank of New York observed that "auto loan interest rates were higher for households in states with high home equity exemptions" and performed an analysis to "see whether BAR [the 2005 Bankruptcy Reform Act] undoes that link":

Overall, auto loan delinquency rates tended downward after BAR in higher or unlimited exemption states, significantly so for direct loans. Consistent with that result, auto loan interest spreads also declined after BAR in states with high or unlimited exemptions. The link between spreads and exemptions was more significant using unscaled exemptions, but the magnitudes were comparable regardless. The decline in the average auto loan spread was 15 basis points lower after BAR for unlimited exemption states, a 5.7 percent decline relative to the mean over all states (265 basis points). The regression results show clearly in Chart 5.

Looking at chart five, you find that the chart tracks the "interest rate on new automobile loan (5 year) minus rate on government bond (5 year)." The mean over all states is 265 basis points. Prior to BAR the interest rates for auto loans in states with "unlimited home equity bankruptcy exemptions" tended to be higher than those in other states. Subsequent to BAR, on average, the difference diminished by 15 basis points, 0.15%. That's a significant number for lenders, and appears attributable to BAR, but it's hardly the massive reduction Zywicki claims.

Zywicki's next argument is a red herring:

But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principle amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.

We should not fashion bankruptcy laws to prevent bankrupt people from declaring bankruptcy, merely because of the potential that it might be difficult for bankruptcy courts to do their job. We should instead provide bankruptcy courts with the necessary manpower and resources to do their job.

Beyond that, Zywicki pretends that this legislation will help people who aren't bankrupt. Sure, millions of people "owe more than their house is worth" - and the vast majority of them aren't bankrupt and are making their house payments. The problem faced by the majority of people who aren't making their payments isn't the value of their home - it's the fact that they can't afford their payments. Given that bankruptcy is not cost-free, many of those people will struggle, try to work things out with their lenders, and find ways other than bankruptcy to work their way through their financial difficulties. Others will weigh their options and walk away from their homes - either by allowing foreclosure or by surrendering their homes in bankruptcy.

Continuing his supposition that this legislation will cause people who aren't bankrupt to declare bankruptcy, Zywicki writes,

Finally, a bankruptcy proceeding sweeps in all of the filer's other debts, including credit cards, car loans, unpaid medical bills, etc. This means that a surge in new bankruptcy filings, brought about by a judge's power to modify mortgages, could destabilize the market for all other types of consumer credit.

I guess Zywicki has forgotten his earlier comments on the non-modifiability of car loans. But even overlooking that, I'm not sure how this follows. If you force people in bankruptcy to either give up their homes or to pay the full amount of their mortgages, you already create a significant distortion. In the former case, the home lender gets a foreclosure, and it may be that the other creditors recover a bit more money by removing mortgage payments from a Chapter 13 repayment plan. In the latter case, a Chapter 13 plan incorporates the higher-than-market mortgage payment, and other creditors get less. I guess the "horrible" outcome for Zywicki is the homeowner who otherwise would have allowed foreclosure but who can now stay in their home, resulting in smaller payments to other creditors. I somehow suspect, though, that the nightmare prospect for lenders is instead that borrowers who would have stayed in their homes anyway will have their mortgages revised, resulting in greater payments to other creditors and lesser payments to housing lenders.

Zywicki makes a reasonable point in relation to the interest rate that should be paid post-modification.

Consider that the pending legislation requires the judge to set the interest rate at the prime rate plus "a reasonable premium for risk." Question: What is a reasonable risk premium for an already risky subprime borrower who has filed for bankruptcy and is getting the equivalent of a new loan with nothing down?

Of course, he then extrapolates to suggest that if a borrower is bankrupt, they should be paying double-digit interest, and that anything affordable would be a "submarket rate, apparently violating the premise of the statute and piling further harm on the lender". If this were a medical study, at this point I would be asking "which pharmaceutical company is bankrolling Zywicki's research"? It may well be that the legislation should provide additional guidance to judges when it comes to setting interest rates. But Zywicki's comments betray his contempt for the goals, and perhaps even the concept, of bankruptcy.

Zywicki offers a single example that he pretends illustrates how the proposed legislation could be abused:

Imagine the following situation: A few years ago a borrower took out a $300,000 loan with nothing down to buy a new house. The house rises in value to $400,000, at which time he refinances or takes out a home-equity loan to buy a big-screen TV and expensive vacations. He still has no equity in the house.

The house subsequently falls in value to $250,000, at which point the borrower files for bankruptcy, the mortgage principal is written down, and the homeowner keeps all the goodies purchased with the home-equity loan. Several years from now, however, the house appreciates in value back to $300,000 or more -- at which point the homeowner sells the house for a tidy profit.

I do find some humor in the way Zywicki depicts the borrower in his example as the modern equivalent of Ronald Reagan's Cadillac-driving welfare queen. Never mind what's typical - he's trying to evoke an emotional reaction.

Okay... so I have a marginal borrower who comes into my bank and says, "Give me a $300,000 loan for my $300,000 house." I wouldn't ordinarily give him the loan, and would historically have required 10-20% down to protect my investment, but I've decided that housing prices will invariably go up at 10-20% per year so I authorize the loan.

Within three or four years I'm proved "right" - the home now appraises for $400,000. So I'm very secure in the event of default. Now the borrower comes back to me and says, "I want to take out every penny of equity." I again note that he was a marginal borrower at $300,000, and that's even more the case at $400,000. But I'm more convinced than every that housing hyperinflation appreciation at a rate of 10-20% per year is inevitable, and that housing values never go down, so again I authorize the loan.

Then the bubble bursts, and the economy crashes. The borrower loses his job and falls behind on his payments. His house appraises for only $250,000. Traditionally I would foreclose, try to sell the house as quickly as possible, and hope to recover about $220,000 to $230,000 after the costs of foreclosure and sale. If I were in a state that allows deficiency judgments, I might seek one from the borrower - although it would be dischargeable in bankruptcy. Not a good outcome for me....

Under the new law, the borrower declares bankruptcy. A court revises his mortgage to reflect the market value of his home, and sets an interest rate a few points above prime. He makes his payments. But sixty months later, at the end of his repayment plan, he is able to sell the house for $300,000. All I get back is the $250,000, plus of course the interest I've obtained over the course of the repayment plan (not a bad rate of return, but well below what I would have charged this borrower in the post-bubble market). (Sure, I gave this guy a 0% teaser rate to get him to sign up, but let's not change the subject.)

I'm well ahead of where I would have been had I foreclosed at the bottom of the bubble, but so is the borrower. I'm in the same position as any other creditor at the end of bankruptcy, seeing a debtor who has recovered from a crisis and is now able to pay off some of the debts that were discharged, but for reasons I can't fathom he's protected by the law. It's almost as if bankruptcy is supposed to help people get back on their feet and get a fresh start - how absurd is that!

Meanwhile, the only thing I could have done to protect myself would have been to apply reasonable lending standards, and not let a marginal borrower repeatedly max out the equity in his home. Or voluntarily worked with the borrower to restructure the loan or payments in a manner that would have kept him out of bankruptcy. How unfair is that!

What if I'm in state where first mortgages are non-recourse loans, and where I lent $400,000 for a first mortgage to a home buyer whose house is now worth $250,000? If the borrower allows foreclosure, I can't get a deficiency judgment. If the borrower goes into bankruptcy under the proposed law, I get a $150,000 unsecured claim that should be partially repaid over the course of the repayment plan. That would appear to improve my position at the expense of other unsecured creditors. If the debtor is ordered to repay 1/3 of his unsecured debt over the course of the repayment plan, my recovery is $250,000 + $50,000 = $300,000, the assumed market value of the house at the end of the plan.

Credit Suisse took a look at this proposed reform, weighing the good and bad. Its report reflects that the impact of this reform is likely to be substantially less than Zywicki suggests, for reasons that seem obvious:

The impact of the law reform at this stage is unclear as we’re not sure what percentage of borrowers can and will take advantage of this option. For borrowers who can’t even pay the secured amount of the mortgage, bankruptcy isn’t an option. For borrowers who have lots of excess income, bankruptcy will provide little benefit. So only borrowers who want to stay in their homes, can afford the secured amount but not the entire mortgage, and are willing and able to go through the invasive procedure of Chapter 13 bankruptcy seem likely to apply.

Bottom line is that the new plan adds an important new tool in the foreclosure avoidance arsenal and will likely result in a marginal reduction of foreclosures.

A benefit I see in resolving these issues in bankruptcy is that the burden is primarily borne by the two responsible parties - the borrower and lender. There's a further benefit, in that if foreclosures are prevented, housing values in the rest of the neighborhood are less likely to be negatively affected by foreclosure sales or abandoned properties. But the biggest benefit, as I see it, is that lenders might think twice before repeating the reckless lending policies that inflated the bubble and led to the current financial crisis.

Coordinated Bankruptcy for the Auto Industry

The Times offers an interesting editorial proposing that the federal government facilitate the simultaneous bankruptcy of the "Big Three" auto makers, accompanied by extension of sufficient credit to sustain their operations through that process. This beats the current congressional proposal of, "Come to us with a business plan we like and maybe we'll lend you money," as it would allow the auto companies to address problems they cannot discuss as part of such a business plan - for example, how to eliminate failing brands and close hundreds of auto dealerships. If Ford announces, "We're going to close down Mercury," or even more modestly, "We're going to close it down as an independent line, while making select Mercury models available through Lincoln dealerships", they would create immediate consumer concern about Mercury vehicles, and would be immediately sued by Mercury dealers. If they say, "To control expenses, we need to cut the number of dealerships by a third," again they would be facing lawsuits by car dealers afraid of being among that third.

Meanwhile, the fact is that the manner in which cars are sold and distributed in this country is out-of-date, excessively costly, and anything but consumer friendly. At this point if you want to buy an iPod and only an iPod, you can go online to the Apple Store and buy one. But if you want to price shop or compare the iPod to other brands, you can choose from thousands of online and retail vendors who carry multiple brands of MP3 players. While iPhone sales are more constrained, once again you can find stores that offer contracts through multiple services, so you can go in and choose between an iPhone and a variety of service plans, and similar products from other vendors and service providers.

Try that with a car.

What if you're interested in offering a new type of dealership - a concierge type service that caters to professionals at their offices, allows them to arrange to drive a car model of their choice on their schedule, and offers the full range of makes and models they are apt to want to buy? Good luck with that.

What if an auto maker wishes to take the Saturn model to its next logical level, and build a Dell-style website where customers can pick a model - any model they offer - customize it, and have it delivered in days to a dealership with them with no haggling, no surprises, no post-sale pressure for "paint protection" or similar add-ons, no concern about financing (you've already been approved online) or confusing over rates. Get a good price, don't worry that you're paying more than the next guy or being otherwise hoodwinked, and show up at the dealership to inspect your vehicle, go over any special features, and drive away. The manufacturers are already about 90% of the way there with their "design your own vehicle" features on their websites. But do you think there's any chance that the crucial remaining 10% will get past NADA?

Bankruptcy only touches on these issues - facilitating the dropping of brands and closure of dealerships - but it doesn't do anything to overcome anachronistic, protectionist state laws that prevent innovation in vehicle distribution and sales, reduce manufacturer and customer cost, and increase customer convenience. But really, you're unlikely to hear anything about this from the CEO's of the Big Three.

I continue to favor something similar to bankruptcy but legislated by Congress, as opposed to Chapter 11, as being a possible path to reforming the auto industry with a much lower risk of failure. For those who complain, "Foreign auto makers will think it's unfair," I say, "They're not complaining about protectionism in their own nations, and you know what else - they're welcome to join in." If Congress is unwilling to act, cannot act with sufficient speed (as the authors of the editorial surmise), or forces bankruptcy upon the domestic auto industry, I think it's fair to say that it will be the result of a failure of leadership - in Congress, the auto industry, the UAW, and the nation's auto dealers and their "union", NADA (who are strangely omitted from most discussions of the industry's problems).

Bush On The Mortgage Mess

Bush plans to veto the proposed "housing-relief bill", expressing,

The president on Wednesday repeated his opposition to a bill “that will reward speculators and lenders” who have suffered because of their own foolishness.

If that's truly the way he feels, he should be advocating for changes in bankruptcy law that would permit lenders and borrowers to share the cost of their folly through first mortgage cramdowns in bankruptcy court. But of course, he doesn't actually favor that - he seems to instead favor "solutions" which direct taxpayer money to lenders but not to borrowers.

Who Should Get The Taxpayers' Money

In flattering McCain (who Will still appears to detest), George Will presents a false dichotomy, pretending McCain supports a solution to the "economy's housing-related credit woes" that doesn't involve any bail-outs whatsoever. Quoting McCain, Will writes:

He says "it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers." For now, he is with Senate Republicans in opposing the Democrats' proposal to empower judges to rewrite the terms of some mortgages, an idea that strikes at the sanctity of contracts and hence at the ethic of promise-keeping that is fundamental to social life. He opposes an additional dose of the toxin that has made the credit system sick -- he favors strengthening rather than weakening down-payment requirements for loans backed by the Federal Housing Administration. And he has admirably avoided the rhetoric of victimology, such as that used when The Post editorialized that "lenders pushed tens of billions of dollars in potentially high-interest mortgage debt on people ill-equipped to handle it."

So the honest translation would be that McCain opposes only aid directed at borrowers. While he wants stronger guarantees that federal loans will be repaid, something that to me is a perfectly reasonable demand, he has not actually opposed bail-outs of financial institutions. He just wants to add a few more strings to the bail-out packages they receive.

The honest question this might raise is, why support bail-outs of those who were in the best position to prevent this from happening in the first place, while providing no benefit at all to those (whatever you think of their culpability) on the other side of the loan? If Will were to think about it, he would recognize that offering bankruptcy relief to those borrowers wouldn't let them avoid their loans - it would allow them to discount their loans to the present market value of their homes. The borrowers would have their creditworthiness severely downgraded for a decade. But the owners of the loans, not the taxpayers, would have to absorb the difference. That, it seems, is unacceptable to either George Will or John McCain.

I'm not going to benefit from the bailouts - If I even own stock in any of the financial institutions involved, it's part of a mutual fund. And I'm the opposite of the sort who purchases "more home than I can afford" than maxes out my HELOC. As a conservative borrower and spender, who believes in paying my bills in full, I am hardly brimming with sympathy for those who chose to believe promises that were plainly too good to be true. Yet if my choice is between having my tax money used for a bailout, or having irresponsible lenders take a loss due to the bankruptcies of their irresponsible borrowers? I'll support the bankruptcy reform, thank you very much.

Wouldn't This Be Fair?

As United is excused from paying its pensions, and taxpayers are asked to effectively provide that company with a $5 billion subsidy, perhaps there should be a corporate bankruptcy reform analogous to that imposed on individuals.

Nothing too arduous - simply examine whether the corporation's executives make more than 25% of the state's median income, and whether the company can reasonably repay more than 25% of its otherwise dischargeable debts. And, if the answer to both questions is yes, forbid discharge. Oh yes - and the corporation's executives should be required to attend credit management classes at their own expense.

Individual Responsibility

A few weeks ago, a friend who is wrestling with his allegiance to the Republican Party expressed to me that he did not believe that the growing number of Republican initiatives which place new burdens on the working classes were driven by an actual "conservative" ideology. He expressed that he believed the initiatives came out of a form of selfishness which did not involve much thought of other people - instead, their focus is on "what's good for me". Whether or not "what's good for me" is good for anyone or anything else is considered irrelevant. Don't get me wrong - my friend isn't against selfishness. He just prefers to be honest with others - and with himself - as to his motives.

By way of contrast, others attempt to find a pureness of ideology in the Bush Administration's policies. Efforts to privatize Social Security, and destroy its foundations, are about creating an "owernship society" and demonstrating to workers the value of saving. Never mind that workers won't have any meaningful control over "their money" in the savings accounts, and that benefits as a whole will be significantly reduced. Tax cuts which fall disproportionately on the rich are about rewarding hard work and productivity. Never mind that most of our society's hardest workers see no significant benefit, even as they experience a decline in the real dollar value of their wages, while enormous benefit falls upon the profligate heir who has never worked a day in his life.

This conservative charity to the Bush Administration, of course, continues in analysis of the new bankruptcy bill:

Behind the Bankruptcy Reform Act, as behind the President’s proposal for social security reform, is an ideology of giving nonwealthy people greater responsibility for their own economic welfare, which entails subjecting them to additional financial risk. Under the present system, the prudent and the imprudent consumer pay the same high interest rates, assuming creditors can’t readily determine which consumers are prudent and which are imprudent. By lowering interest rates on credit-card and other consumer debt while at the same time discouraging default, the Bankruptcy Reform Act will encourage consumers to exercise greater care in borrowing—yet at the same time, because interest rates will be lower, the Act will enable prudent consumers (who do not face a high risk of bankruptcy) to borrow more and by doing so will increase their consumption options. The Act will not redistribute wealth from the poor to the rich, but from the imprudent borrower to the prudent borrower.

Where to begin....

• The notion of "giving nonwealthy people greater responsibility for their own economic welfare"... Geez, while it is awfully nice of the rich to share the non-wealth, why don't the rich themselves get a share of this "greater responsibility"? Surely we're not going to pretend that all wealth is earned. Are heirs and trust fund babies so responsible in the manner in which they accept their fortunes that no further lessons or burdens should be imposed?


• And this.... "Under the present system, the prudent and the imprudent consumer pay the same high interest rates, assuming creditors can’t readily determine which consumers are prudent and which are imprudent." - has he never heard of a "credit report"? Now, while I can't speak for those who don't pay their bills on time, I can't go to the mailbox without finding offers for low interest loans and credit cards. So unless the argument is that banks and credit cards companies are erring on the side of offering everybody cheap credit....


• And this.... "the Act will enable prudent consumers (who do not face a high risk of bankruptcy) to borrow more and by doing so will increase their consumption options" How do I say... beyond the fact that prudent consumers already have available credit, one of the key distinctions between being a "prudent consumer" and an "imprudent consumer" is not taking on more debt than you can handle. I somehow doubt that, even if credit card companies started to offer lower interest rates, prudent consumers would suddenly decide to increase their debt loads - particularly given that prudent consumers understand that their "cheap credit" will only last until they are late on a couple of credit card payments, at which point their rates will be increased to a level just shy of usury.


• And this.... "The Act will not redistribute wealth from the poor to the rich, but from the imprudent borrower to the prudent borrower." So I can expect Citibank to be issuing me a check sometime soon?


• And this.... "Bankruptcy legislation being debated by the U.S. Senate is designed to make it harder for people to walk away from their credit card and other debts. But legal experts say the proposed law leaves open an increasingly popular loophole that lets wealthy people protect substantial assets from creditors even after filing for bankruptcy.". No mention? Well, I guess it isn't a problem for Posner that the imprudent wealthy get massive loopholes when they declare bankruptcy, as long as the working poor are taught a lesson in "responsibility".

Several years ago, following his own bankruptcy, M.C. Hammer was asked what it was like to be bankrupt. He smiled patiently at the reporter, and explained that there is a huge difference between bankruptcy for the poor and for the rich, that he continued to be extremely comfortable, and had no right to complain about anything. Bush is happy to keep it that way, and it seems that ivory tower conservatives are happy to give him cover.

There He Goes Again, II

Followers of this blog know I'm not a fan of Joe Lieberman. Paul Krugman, today, reminds me of some of the reasons:

[I]n his latest radio address, Mr. Bush - correctly, this time - attributed the $600 billion figure [falsely advanced as the cost of delaying Social Security Reform by one year] to a "Democrat leader." He was referring to Senator Joseph Lieberman, who, for some reason, repeated the party line - the Republican party line - the previous Sunday.

My guess is that Mr. Lieberman thought he was being centrist and bipartisan, reaching out to Republicans by showing that he shares their concerns. At a time when the Democrats can say, without exaggeration, that their opponents are making a dishonest case for policies that will increase the risks facing families, Mr. Lieberman gave the administration cover by endorsing its fake numbers.

* * *

As it happens, Mr. Lieberman stated clearly what was wrong with the bankruptcy bill: "It failed to close troubling loopholes that protect wealthy debtors, and yet it deals harshly with average Americans facing unforeseen medical expenses or a sudden military deployment," making it unfair to "working Americans who find themselves in dire financial straits through no fault of their own." A stand against the bill would have merged populism with patriotism, highlighting Democrats' differences with Republicans' vision of America.

But many Democrats chose not to take that stand. And Mr. Lieberman was among them: his vote against the bill was an empty gesture. On the only vote that opponents of the bill had a chance of winning - a motion to cut off further discussion - he sided with the credit card companies. To be fair, so did 13 other Democrats. But none of the others tried to have it both ways.