Arnold Kling  

Motives and Consequences

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Hedge Fund Guy writes,


Costs of lending are always passed on to the consumer. No one is forced to lend (well, there is the Community Reinvestment Act, but that's a quid pro quo, and an exception), so lenders will either pass increased costs along, or withdraw from the highest risk market segments. Making it harder for borrowers to not pay decreases the expected charge-off rate. As a result, the interest rate will decrease and more significantly the availability of credit will increases.

On the other hand, Paul Krugman writes,

The bankruptcy bill was written by and for credit card companies...any senator who votes for the bill should be ashamed.

This is a classic illustration of Type C and Type M arguments. Krugman is focused on the motives of the credit card companies, and he implicitly assumes that bankruptcy legislation is win-lose, where if the credit card companies win, then creditors lose.

'Hedge Fund Guy' is looking at the consequences of bankruptcy reform. By making it more difficult to abuse the system, it would allow lenders to offer better terms to high-risk borrowers. Therefore, bankruptcy reform could be win-win for most high-risk borrowers and for lenders.

For Discussion. Suppose that Congress wanted to protect homeowners by allowing a family to keep its house if it cannot pay the mortgage. How would this affect the mortgage market?


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COMMENTS (43 to date)
Tim Harford writes:

Within reason, of course. Bankruptcy has always encouraged risk-taking behaviour, because it shifts some of the downside risk away from the individual.
This is sensible if the individual doesn't enjoy all the upside risk - surely true for most entrepreneurs.
The United States has long offered relatively quick, easy bankruptcy - in India, by contrast, bankruptcy is nearly impossible. The Indians are trying to shift to a more American system - is it really wise to meet them half way?

Bernard Yomtov writes:

This is just silly.

First of all, I'm not holding my breath waiting for lower credit card rates, even though I do understand the theory. Let's see how it does empirically, shall we?

Second, assume it holds, and the tradeoff for stricter bankruptcy rules is lower rates. Who says that's an improvement? Bankruptcy is a useful legal arrangement that protects debtors in certain situations. Per the theory it does this at the cost of rates being slightly higher than they would otherwise be. How does "hedge fund guy" or anyone else pretend to know the optimum tradeoff here? Krugman is arguing that the tradeoff has been tilted towards the credit card companies. Surely that's true, unless you think they exerted massive pressure to pass a bill that wasn't going to help them.

Finally, if stricter bankruptcy rules are such a wonderful thing, why didn't the new law tighten up on loopholes available to the wealthy, and why don't the law's defenders, like you, ever mention that?

Bob Knaus writes:

The answer to Arnold's question depends on the details of the legislation that Congress would pass to "protect" the homeowner.

If "protection" meant that you could keep the equity built up in your home even if you defaulted on your mortgage, then the mortgage market would collapse as a huge number of people would engineer their tax returns to show poverty, and stop making mortgage payments.

If "protection" meant that you could live in your house as long as you liked without paying your mortgage, but that the mortgage balance would come out of your equity when you sold the house, then low-down-payment mortgages would disappear. PMI rates would skyrocket. Rates on 80% mortgages would go somewhat higher, to compensate lenders for the risk that they might have to wait years without a payment stream, until the defaulting homeowner sold his property.

Then there is the Pretty Boy Floyd solution, as immortalized by Woody Guthrie. Instead of robbing trains to help farmers make their mortgage payments, the government would rob taxpayers to help homeowners make theirs. This would drive mortgage interest rates down and home prices up. Of course, the snowballing moral hazard thus created would eat more and more tax revenues every year.

Take your pick!

Boonton writes:
'Hedge Fund Guy' is looking at the consequences of bankruptcy reform. By making it more difficult to abuse the system, it would allow lenders to offer better terms to high-risk borrowers. Therefore, bankruptcy reform could be win-win for most high-risk borrowers and for lenders.

The lenders loaned the money knowing the borrowers could declare bankruptcy. Therefore the terms and rates they charged should have reflected that risk. Now the rules are changed after the fact in favor of the lender. Therefore this bill has created a windfall for the lender who now enjoys lower risk but has contracted rates based on a higher risk profile.

It's a little bit like buying a new car for $25K with a 50K warrenty and then having Congress pass a law automatically extending all warranties to 150K. The auto buyer gets a windfall and the auto maker/dealer gets the loss.

If Bush and the GOP were really fair they would have grandfathered in all debts incurred before this bill and only applied this to the 'new playing field'. As for lower costs to consumers, this is nonsense too. Lenders, being rational and in a competitive environment, will base their prices on risk. For those with good credit and a low bankruptcy risk profile it already makes sense to charge them a rate to reflect that. That fact that a credit card company may incurr losses due to bankruptcies by high-risk borrowers is irrelevant. If the company tried to pass those costs onto low risk consumers a competitor that specializes in only low risk lending will take those customers away by offering them low rates to transfer their balances.

Needless to say this bill does nothing but exclude some of the middle class from bankruptcy protection. The 'preventing abuse' is simply yet another lie by the Bush administration. The rich are still able to game the system by putting their assets in state trusts or holding property in states that allow homeowner exclusion (This is the trick that OJ used to buy a multimillion dollar home in Fl even though he owes the goldman family millions).

Lancelot Finn writes:

I'd like to bring up a related issue, while at the same giving a bit of negative publicity to a dastardly gang of pirates who just robbed me for all I was worth, causing me involuntarily to entertain the thought of consumer terrorism for the better part of the last three weeks.

I got a cell phone plan from Cingular Wireless (cursed be its name through all the ages) a few months ago. I was under the impression that the plan was a national plan. It turns out it was a regional plan. This may have been negligence on my part, but, as later events proved, Cingular (cursed be its name) certainly had no incentive to make it clear to me that they'd be extracting a fortune of roaming charges from my sorry carcass if I used the phone outside the DC area.

My wife and I used the cell phone a lot over the Christmas vacation in California and on our honeymoon in Hawaii, in the belief that we were using our usual minutes. Our friends and relatives kindly sent us many wedding presents, and Cingular (cursed be its name) sent us one too: a bill for $1600.

That's right: $1600.

Now, suppose that a bill were introduced in Congress to prohibit mobile-phone companies from extending more than, say, $300 worth of credit without their explicit consent. If people so requested, they could sign up for special "high-credit-limit" phone plans, by which they could run up charges on their phones over the $300 limit, though in that case they would still have to specify exactly how high they wanted their credit limit to be.

Well, my problem would have been solved. I never wanted to have the right to run up more than a couple of hundred dollars on my phone at most. I'd have preferred that they cut off service. And in my naive way I just never imagined that a company could do that to you. It seemed natural that if there were really absurd, extraordinary charges, they would let you know.

I am quite confident that the public interest would be served by such a bill. At present, mobile-phone companies pursue a screw-the-suckers business model, by which they give you plans that seem reasonable but have all sorts of loopholes by which you can run up huge charges. That's where they make their profit. Since most people would prefer not to sign the extra contract that allowed them to run up debts over $300, the whole industry would have to abandon the screw-the-suckers business model and make their profits from providing services instead.

I don't see any reason a libertarian should object to the change. People are still free to make any contract they like. Because of changes in how contracts would be interpreted, certain contracts would simply have to be made more explicitly than they are now. And I have little doubt that, like me, most of the screwed suckers didn't understand that they were opening up an unlimited liability to the cell-phone compnaies. In this sense, the contract was illegitimate trickery from the beginning. To demand explicit consent for large-liability loans would simply advance the rule of law.

What do you think? Should I sue Cingular the Cursed and try to change the mobile-phone industry?

Meanwhile, as to the bankruptcy bill, my personal experience of corporate shenanigans has made me sensitive to corporate theft when I see it elsewhere. The bankruptcy bill stinks.

Yours truly,

Lancelot Finn

DEATH TO CINGULAR!

hedgefundguy writes:

If one accepts the premise that costs are all eventually passed on to the consumer, the current proposal merely makes it more difficult for those able but unwilling to pay to reneg. Basically, those with poor credit scores, who include those who would game the system and those who would pay back their loans before all else, have to subsidize those able but unwilling to pay in that same credit score grouping. This creates greater adverse selection, which transfers costs disproportionally to those honest people with few assets (as oppose to affecting anyone with good credit scores). I think the move is both good business and good hearted.

Of course, many people think it unlikely that companies will pass on savings. In that case, put you money were your mouth is and invest in credit card companies, since the barriers to entry necessary to maintain collusive pricing imply super-normal profits: tickers of good pure plays include KRB, EQTX, CCRT, PVN, AXP, COF, MXT, and ADVNA.

Tony Vila writes:

I definitely should invest in said credit card companies. Otherwise though, I don't think Congress should be making their life better if it doesn't improve consumer surplus (or at least, I wouldn't argue so to my Senator).

Impressed by the level of debate, both right and left, in the comments.

This is contrasted to the actual post. Anyone who reads the Krugman article saw that he says plenty of bad things about the consequences of the bill, along the lines of what we see in the comments here. And implicit in the Motive argument is that if congress is writing bills for the credit card companies and not for the consumer, then the consumer is losing out.

The right seems far too eager to dismiss Krugman as a hack, quote him out of context, and mislead their readers about his views and explanations. This attitude is entirely against the desire for rigorous academic debate this blog thinks needs to go on. Your cynical quote is part of that.

Bob writes:

Lancelot,

I am sympathetic to your experience and agree that an externally-imposed, simple, clear default contract does not constitute excessive gov intrusion into private contracting. The problem is, of course, that gov-imposed contracting is rarely simple or clear, creating additional costs. Try buying real estate in California.

But I'm also sympathetic to Cingular's situation. Number portability destroyed the existing wireless model, although hopefully the industry can find something better than burning a few customers for $thousands in unexpected charges. But many industries get all their profits from a fraction of their customers, and those customers are often unhappy.

Boonton,

You are, of course, right about the windfall on existing balances. But changing rules mid-stream is a systemic problem that cuts both ways (e.g., number portability changed, for the worse, the economics on existing wireless investments, transfering value from providers to customers). I would be more concerned about reducing the Fed Gov's ability to meddle than about the "fairness" of this particular legislation. Sure, it's flawed, but is anyone surprised?

Bob writes:

HFG,

I suspect that the critics are not ready to put their money where their mouth is. Probably a wise decision considering COF is so eager to diversify out of CCs that they're willing to buy HIB for a big premium at a very iffy time in the interest rate cycle.

Lawrance George Lux writes:

Alteration of Interest rates, even lower, does not necessarily make a good thing(I need to write an essay on Interest rates and money creation). The greater stringency of Bankruptcy law may be a good thing, but deception in debt creation must also be stopped--i.e., one Post above.

Suppose that Congress wanted to protect homeowners by allowing a family to keep its house if it cannot pay the mortgage. How would this affect the mortgage market?

Little, if the Law insisted on repayment of the Principal, with Interest allocated towards the Principal, and Mortgage lenders covered by forfeiture insurance. This would be basically a payment schedule alteration, and real cost increase to Interest charges would be 0.3%. Complete absolvement is another matter, and forestalled by about seven legal opinion Cases as Precident. lgl

...assume it holds, and the tradeoff for stricter bankruptcy rules is lower rates. Who says that's an improvement? Bankruptcy is a useful legal arrangement that protects debtors in certain situations.

Well, if no one knows, then Krugman doesn't either, so, by your logic, you ought to be chastizing him.

Bernard Yomtov writes:

hedgefundguy,

Gee, if this bill won't increase CC profits why do the CC companies care so much about it?

And am I supposed to think that I'm the only person who understands this, so that I can easily make abnormal returns by investing in these companies?

I'm not one of you clever multi-billionaire hedge-fund operators, just someone who tends to believe the market is reasonably efficient, at least when it comes to widely publicized events.

Bernard Yomtov writes:

Well, if no one knows, then Krugman doesn't either, so, by your logic, you ought to be chastizing him.

HFG is making two claims, I think:

1. That tightening the rules (for non-wealthy debtors only) will improve economic efficiency

2. This is the only standard worth using.

Krugman suggests that perhaps there are broader issues than just economic efficency (I know-that's inconceivable on this blog, but there it is), and that this bill tilts the field toward the CC companies - undoubtedly true. I agree with both of those points.

Arnold Kling writes:

Tony Vila wrote, "The right seems far too eager to dismiss Krugman as a hack, quote him out of context, and mislead their readers about his views and explanations."

I actually think I tend to be too nice to Krugman. I could have quoted where he praised the so-called "medical bankruptcy study," which would have been laughed out of any college econometrics seminar.

Readers are welcome to read Krugman's whole article and draw their own conclusions. That's why I link.

Boonton writes:
I actually think I tend to be too nice to Krugman. I could have quoted where he praised the so-called "medical bankruptcy study," which would have been laughed out of any college econometrics seminar

Indeed, Krugman being wrong about medical costs causing bankruptcy actually helps the argument against this bill. If Krugman was right what would that mean? That medical costs were basically being paid for by washing them away thru bankruptcy? "Get the doctor and hospital to treat everyone then stiff them in bankruptcy court" isn't a very efficient way to allocate medical care in an economy.

Guess what, Marginal Revolution cited the best take down of Krugman's 'Medical costs causes bankruptcy' idea:
http://mahalanobis.twoday.net/stories/560448

Finally, good research should always ask, what empirical findings would this not explain? For example, the most conspicuous datapoint in consumer bankruptcy over the past 25 years was the big increase in the mid 1990's. Clearly something major happened that caused bankruptcies to increase about 60% in a non-recession period. Medical expenses were not rising sharply, but credit card solicitations did rise dramatically. It seems as if credit card availability, and thus overextension, is a major, if not the major main bankruptcy culprit.


In other words, friends, the credit card companies made a strategic decision. They started soliciting and granting credit to people with poor credit. They knew bankruptcies would increase but they estimated that the increased cost would be washed out by the increased revenue they could earn by charging people with poor credit higher rates and increased fees (plus the additional revenue they earn from merchants when more and more transactions happen by credit card rather than cash or check).

Who exactly are the people being treated unfairly here? The middle class who this bill targets or the credit card companies who had the choice not to lend under the current bankruptcy regime (or to secure their debt as Sears does with their card)?

This bill targets middle class people who get in over their head. Bush and the GOP couldn't go after the poor directly (though I'm sure they would like to) so they sold this bill as addressing those who 'abuse' the system. Yet they left the loopholes open for those who want to abuse the system (those are the people that will study how to set up their assets *before* they get into debt trouble).

Bernard Yomtov writes:

I suppose figuring out how many bankruptcies are caused by medical bills is an interesting problem. Though I will say that the one "debunking" of the relevant study that I read, by Todd Zywicki at Volokh, was unconvincing, to be polite.

But what is the issue here? If I ask you whether we ought to offer relief to people bankrupted by medical problems, does your answer depend on whether that accounts for 50% of bankruptcies or 25% or 1%?

If so, why? And if so, explain whether a high percentage or a low one would incline you to favor such relief.

David Thomson writes:

“First of all, I'm not holding my breath waiting for lower credit card rates, even though I do understand the theory. Let's see how it does empirically, shall we?”

Your response is most peculiar. This is actually something that can be taken for granted. We can indeed expect lower credit card rates. These companies must compete for our business. Are you perhaps hinting that they might be violating our antitrust laws? If so, please provide some evidence.

“Meanwhile, as to the bankruptcy bill, my personal experience of corporate shenanigans has made me sensitive to corporate theft when I see it elsewhere. The bankruptcy bill stinks.”

The transparency issue greatly concerns me. It does seem like the credit card companies often play a “gotcha” game with their customers. I do want our elected representative to demand clearer information. Your concern is the only one that I believe is valid. Paul Krugman’s complaints are essentially idiotic.

Jon writes:

Arnold Kling, in making his type "P" argument, choses to pull Krugman's type "M" argument out of the many type "C" arguments in the piece. As I have maintained before, type "M" arguments are useful for pushing people to make their type "C" arguments heard.

If bankruptcy reform truly were not increasing profits, the Bankers association would not be fighting for it.

Arnold Kling and the Hedge Fund guide conveniently leave out the high costs this bill imposes on people in proving they don't abuse the system.

Let's face it. Whether it is bankruptcy, welfare, or tax collection, there is a substantial cost in sorting out who is abusing the system, who is someone who goofed, and who is someone who is a victim of pure bad luck.

To catch the few abusers, the bankruptcy bill will pose steep legal costs on those who can least afford it.

One must ask also, if the government and courts can separate the abusers from the innocent victims, why can't the credit card industry do the same and stop lending to the alleged "abusers".

Jon writes:
Guess what, Marginal Revolution cited the best take down of Krugman's 'Medical costs causes bankruptcy' idea: http://mahalanobis.twoday.net/stories/560448

Finally, good research should always ask, what empirical findings would this not explain? For example, the most conspicuous datapoint in consumer bankruptcy over the past 25 years was the big increase in the mid 1990's. Clearly something major happened that caused bankruptcies to increase about 60% in a non-recession period. Medical expenses were not rising sharply, but credit card solicitations did rise dramatically. It seems as if credit card availability, and thus overextension, is a major, if not the major main bankruptcy culprit.

I went to one of the sources cited by these authors (Domowitz and Sartain) and they conclude from their statistical analysis both that the impact of medical debt is large and that it makes the likelihood of bankruptcy much more sensitive to other variables.

One also must remember, most medical providers accept credit cards and frequently demand payment at the time the service is provided. Thus the two debts are harder to distinguish.

Also if people have no income and have exhausted their assets one of two things often happen -- the doctors refuse to treat the person or the medical providers forgive the debt.

David Thomson writes:

This bothers me greatly:

“And the GOP rebuffed an effort by Sen. Daniel K. Akaka (D-Hawaii) to force credit card companies to disclose to their clients how long it would take to pay off their balances if they made only the minimum payments.”

http://www.redstate.org/story/2005/3/10/105835/413

I have no problem whatsoever with these companies providing credit to riskier prospects. But it is very disquieting when apparently they wish to be less than candid regarding their offerings.

Tony Vila writes:

Arnold Kling writes:

I actually think I tend to be too nice to Krugman. I could have quoted where he praised the so-called "medical bankruptcy study," which would have been laughed out of any college econometrics seminar.

Sure, but saying "he is using bad studies for his evidence" seems a much more respectable way of treating his arguments than "he thinks we shouldn't enact this bill only because credit card companies want us to". (And has convinced me he is less obviously right than I was before.)

It's nice that you link to him. I followed the link because I was skeptical that the quote really described his views. But any one who comes in here believing Krugman (and any Democrat) is already a hack, will just see that line, think "Ha, Krugman doesn't even accept the basic tenets of cosnequentialism". I really don't think there's no responsiblity to mis-characterize his wording because people can look it up themselves.

John Thacker writes:

Booton:

If Bush and the GOP were really fair they would have grandfathered in all debts incurred before this bill and only applied this to the 'new playing field'.

This I agree with. Changing the terms after the loan is made is a pure windfall. It could even be considered a form of takings, and I might agree with that-- then again, the Supreme Court hasn't agreed when regulation "in the public interest" costs companies and landowners value for property and things that they planned before the regulation came down. Would you agree that all regulation changes should be grandfathered in, or at least takings paid for? I'm amenable to that.

As for lower costs to consumers, this is nonsense too. Lenders, being rational and in a competitive environment, will base their prices on risk.

Well, yes, certainly. I couldn't agree more. But doesn't a smaller chance of someone declaring bankruptcy, and thus a greater chance that the company will continue to recover some of the debt, decrease risk? It seems axiomatic to me that it does decrease risk, which by your own arguments should decrease price.

Bernard Yomtov writes:

Your response is most peculiar. This is actually something that can be taken for granted. We can indeed expect lower credit card rates. These companies must compete for our business. Are you perhaps hinting that they might be violating our antitrust laws? If so, please provide some evidence.

And I find your comment most peculiar. I am hinting at nothing. I am merely suggesting that we wait for evidence before concluding that rates will drop.

I understand full well the theory that says they will. But the people who taught me the theory also taught me that theories need to be tested empirically, and that sometimes very reasonable sounding ideas fail these tests.

They also taught me that the world is a complicated place, so systems sometimes do not perform as our theories predict, because there are factors operating that the theories ignore, and that prove to be important in specific contexts.

Or perhaps our grasp of the theory and its application is imperfect. Look, HFG argues that the cost of lending is passed on to the consumer. Well, then, any reduction in that cost due to stricter bankruptcy laws will also be passed on to the consumer in the form of lower rates.

But then why do the CC companies care? They are not going to capture the gain, according to this logic, so why the massive effort to tighten the rules? Are you suggesting this is pure altruism on their part?

Bob writes:

Boonton,

My understanding is that the new provisions are being phased in, a simplier (if less effective) alternative to grandfathering that limits the windfall. But I have not studied the bill and who knows what the final law will actually look like?

As the discussion has moved to slamming the bill, can we discuss what a good bankruptcy law would look like? I'd like to see a small number of (simple) regimes with the default being fairly generous to borrowers and the alternatives giving borrowers the opportunity to choose to restrict their future options in exchange for better pricing. This would, IMO, kill the basis for the current revision - that abusers of the bankruptcy system impose costs on the rest of us.

I'd also love to see a system that had the ability to treat a second (and third, etc.) bankruptcy different from a first.

Interested in other thoughts.

Boonton writes:
Your response is most peculiar. This is actually something that can be taken for granted. We can indeed expect lower credit card rates. These companies must compete for our business. Are you perhaps hinting that they might be violating our antitrust laws? If so, please provide some evidence.

Imagine two credit card companies. One grants credit cards to everyone and charges roughly similar rates, the other grants cards only to people who are low risk and charges rates based on risk.

The first company has to charge high rates because a lot of their high risk clients wipe out their debts with bankruptcy. The second company can send all the low risk clients of the first an add basically saying 'transfer your balance to us and you'll get a lower rate'. Next thing you know the first company is stuck with just high risk clients while the second enjoys low risk ones. There is no cost of bankruptcy that is passed on to 'everyone else'. Competition has already made it so that 'everyone else' gets rates that are fairly based on their risk.

Well, yes, certainly. I couldn't agree more. But doesn't a smaller chance of someone declaring bankruptcy, and thus a greater chance that the company will continue to recover some of the debt, decrease risk? It seems axiomatic to me that it does decrease risk, which by your own arguments should decrease price.

Yes but for whom? Not for people whose intent are to abuse the system since this bill leaves loopholes open for them. Basically for people who are likely to get fouled up big time but have the ability to pay off a portion of their debt. Since this 'lowers the risk' for people who shouldn't have credit cards to begin with what public good is this really doing? Increasing consumption by the middle class?

Boonton writes:

Bob:

As the discussion has moved to slamming the bill, can we discuss what a good bankruptcy law would look like? I'd like to see a small number of (simple) regimes with the default being fairly generous to borrowers and the alternatives giving borrowers the opportunity to choose to restrict their future options in exchange for better pricing. This would, IMO, kill the basis for the current revision - that abusers of the bankruptcy system impose costs on the rest of us

I think such a debate should really begin with an honest examination of what is wrong with the current law. The argument has been that the number of bankruptcies soared in the 1990's. Yet we know now that in the 1990's there was a huge increase in the amount of credit being given to people with low credit scores. There's two explanations for why credit card companies did that:

1. It was rational, the losses due to increased bankruptcies were outweighed by the increased revenue they gained from new customers. In that case the decision was a good thing and an example of how a market orientated economy finds solutions for all types of problems.

2. It was irrational, they gave credit to people they shouldn't have and are now losing money despite the fact that they had plenty of lawyers, market researchers, forecasters etc. whose job it was to predict whether their lending was wise or not. In this case the bill represents nothing more than a bail out for businesses who made bad decisions. It is, therefore, destructive since it rewards bad decision making & would be a classic example of moral hazard.

David Thomson writes:

“And I find your comment most peculiar. I am hinting at nothing. I am merely suggesting that we wait for evidence before concluding that rates will drop.”

The empirical evidence is already available! There is not even one example that you can point to where competition does not lower prices. It simply does not ever occur in the free market. Thus, your point is absurd. We know that credit card rates will drop when everything else is equal. This is not even slightly debatable.

John Thacker writes:

Boonton--

Next thing you know the first company is stuck with just high risk clients while the second enjoys low risk ones. There is no cost of bankruptcy that is passed on to 'everyone else'. Competition has already made it so that 'everyone else' gets rates that are fairly based on their risk.
Since this 'lowers the risk' for people who shouldn't have credit cards to begin with what public good is this really doing? Increasing consumption by the middle class?

This would apply only if credit card companies could perfectly identify who was high risk and who was low risk. But moral hazard exists, as Prof. Kling points out. There are plenty of personal factors, including intent, that increase someone's chances to go into bankruptcy that the lender doesn't know about, but the person receiving the credit does. Is it "fair" for people who have a relaxed attitude about going into bankruptcy get the same rate as people who struggle as hard as they can to avoid it? Probably not, but the credit card companies can't distinguish between the two sets of people easily-- but the people applying sure know their own attitudes.

It's not about increasing consumption for the middle class. Since, as you point out, competition exists for low risk debtors, and the middle class has a low rate of bankruptcy, this bill will hardly effect them. (As Hedge Fund Guy says.)

The people who will be affected are the poor people with limited credit ratings who are able to pay back their loans, and whose credit profiles are otherwise indistinguishable from those who go into bankruptcy easily. Since they do look just as high risk as the poor people with a relaxed attitude towards bankruptcy, no credit card is going to come along and offer them a lower rate, not when they can't tell them from the others. If the bill is passed, then these people will be the biggest beneficiaries of lower rates, not the middle and upper class (who already look low-risk).

Now, it may be better to have easier bankruptcy, especially since bad luck affects people, and we want to encourage some risk-taking. But you should realize that your favored policy strongly hurts the poor who would be able to pay back their debts. Since they have little income and wealth, their initial interest rates will be very high, their credit profiles looking just like other high risk people. But this higher interest rate increases their own chances of going into bankruptcy, of not being able to pay back their debts, of not being able to profitably use the money, and of not being able to escape poverty.

Your view only holds if there is no moral hazard, if all bankruptcies are as forseeable by the lendors as by the debtors, and if no one is individually more susceptible to using bankruptcy as a means to escape debt. I don't believe that this is so, and the linked papers support this. Therefore, your policy punishes the successful (the lucky or the responsible, depending on viewpoint) poor in order for them to subsidize the others.

John Thacker writes:

Bernard--

What evidence? Competition. As bill opponent Boonton keeps saying, the credit card companies price the risk into their interest rates. Do you doubt that if more people declared bankruptcy then the credit card companies would raise their rates in order to cover their loss? If not, then why doubt the reverse? The credit card companies are greedy, raising and lowering their rates to the amount which maximizes profits. If the rate of bankruptcy for a certain class of customer decreases, someone will be able to make a profit at a lower rate.

"In the minds of the public, prices apparently go up when businesses suddenly start to feel greedier. Economists, in contrast, expect businesses to be greedy year-in, year-out; but depending on market conditions, greed may call for prices to go up, go down, or stay the same."-- Bryan Caplan

Randy writes:

Just a thought...

It seems to me that the alternative to declaring bankruptcy isn't not declaring bankruptcy, its simply not paying. Anybody got any numbers on the percentage of losses from write-offs as compared to bankruptcy?

Boonton writes:
Your view only holds if there is no moral hazard, if all bankruptcies are as forseeable by the lendors as by the debtors, and if no one is individually more susceptible to using bankruptcy as a means to escape debt. I don't believe that this is so, and the linked papers support this. Therefore, your policy punishes the successful (the lucky or the responsible, depending on viewpoint) poor in order for them to subsidize the others.

Such precision is not necessary. Statistical analysis can provide amazingly accurate estimates of these sorts of things, well within acceptable margins of error. The risk of bankruptcy is quantifiable hence controllable. Hence you should not expect many price drops due to this law.

I strongly suspect that the credit card companies were faced with a problem in the 90's. How do you make money when competition has driven the rates for low risk consumers rock bottom. Their answer was to increase their risk profiles. This can be done by two methods. Give people more credit (since risk is partially related to how much credit a person has) and give credit people who didn't qualify before. The result was a predictable increase in bad debts but also an increase in revenue.

From this perspective the bill is nothing more than a windfall for the credit card companies. What was once risky debt is now a bit less risky. Windfalls for one usually come at the expense of another and that group is the middle class. The poor are still protected since the bill exempts the lower 50% of a state's medium income. The rich are protected because the loopholes were preserved. Middle class 'con artists' are protected as well since those who intended to play the system can learn how to utilize the loopholes. That leaves one group, the ignorant middle class that, for a host of reasons, gets in over their heads.

If you fit this profile then indeed you may discover more credit options available to you. However what good has come from this policy? Savings rates are supposedly rock bottom, now we alter the law to make it cheaper for people who are suspectible to get 'getting in over their heads' to increase consumption through borrowing?

Boonton writes:

And Now, Ladies and Gentlemen, I take down Arnold!!

Tony Vila wrote, "The right seems far too eager to dismiss Krugman as a hack, quote him out of context, and mislead their readers about his views and explanations."...I actually think I tend to be too nice to Krugman. I could have quoted where he praised the so-called "medical bankruptcy study," which would have been laughed out of any college econometrics seminar.

According to Arnold, a type C argument focuses on Consquences. For example, "free trade might cause textile workers to lose their jobs but will result in increased prosperity that will be greater than the lost income." A type M argument focuses on motive. For example, "Congressman X supports free trade because Wal-Mart is giving him thousands of dollars. Wal-Mart supports free trade because cheaper products adds millions to their bottom line!" (Technically this is partially a C argument, free trade will result in Wal-Mart making more money which is a good thing from Wal-Mart's POV at least).

IF Arnold actually bothered to read Krugman's piece he would know this attack on Krugman is simplistic and a distortion of what he wrote. Yes Krugman did note one type M argument, credit card companies want this bill. Why is that bad to note. I'm sure Arnold wouldn't object if someone observed steel workers unions supported Bush imposing import quotas on steel.

More importantly, the core of Krugman's argument is pure C argument.

First he observes that many Americans have saw their income volality increase dramatically. Right after Krugman's 'M argument' he writes:

But the bill also fits into the broader context of what Jacob Hacker, a political scientist at Yale, calls "risk privatization": a steady erosion of the protection the government provides against personal misfortune, even as ordinary families face ever-growing economic insecurity.

Second Krugman observes the consquences:

The bill would make it much harder for families in distress to write off their debts and make a fresh start. Instead, many debtors would find themselves on an endless treadmill of payments.

Finally he notes that the bill leaves open the loopholes that are available for people who want to exploit the system:

One increasingly popular loophole is the creation of an "asset protection trust," which is worth doing only for the wealthy. Senator Charles Schumer introduced an amendment that would have limited the exemption on such trusts, but apparently it's O.K. to game the system if you're rich: 54 Republicans and 2 Democrats voted against the Schumer amendment.

Of course asset protection trusts may be worthwhile for the middle class too. If a person really planned things out ahead of time he could accumulate assets in a trust then suddenly run up his credit cards to the max then skip out thru bankruptcy. It may be worth doing for the really smart middle or upper-middle class person intent on abuse.


Arnold addresses none of Krugman's points and if you just read his commentary you would think that Krugman's argument was a simplistic "I hate credit card companies and this will make credit card companies happy so we shouldn't do it!". True Krugman appears to be somewhat wrong about the extent to which medical costs have caused bankruptcies. That would be a fair point to attack but it is still a side issue compared to his real argument.

Bernard Yomtov writes:

John Thacker and David Thomson,

Are you truly so in love with your theory that you see absolutely no need to wait for evidence? Do you truly not understand that not all markets conform to the textbook model of pure competition, that in fact few do? Did you read past chapter 2 in whatever book you are relying on?

Would CC companies raise their rates if more people declared bankruptcy? Not necessarily. It's at least possible they would devote effort to credit checking instead, or simply absorb the extra losses, or do something else. The idea is to minimize losses due to bankruptcy. Raising rates is not automatically the best way to so this. Raising rates will cost them customers (Remember that part of economics? It's called the Law of Demand if you want to look it up). They might not do anything differently, deciding that leaving things as they are is the best available strategy.

Assuming that they would raise rates to make up for more widespread bankruptcy is to assume, contrary to the quote from Caplan that you like so much, that they can simply raise prices arbitrarily with no negative effects.

Does competition lower prices? Yes, usually, but so what? How does this bill increase competition?

And I still await an answer to my question. If the market here is so wonderfully competitive that all the benefits will pass through to the consumer why do the CC companies care?

David Thomson writes:

“Do you truly not understand that not all markets conform to the textbook model of pure competition”

Huh? All business sectors drop prices when confronted with real competition. This is a dogma allowing no exceptions whatsoever in the history of human beings on this planet. Death, taxes, and competitive pricing are a sure thing. Is it possible that you might be able to offer us even one exception to his hard and fast rule? Just one? Prices stabilize only when one company does not gain an advantage (often temporarily) over another one.


“Does competition lower prices? Yes, usually, but so what? How does this bill increase competition?”

Oh my goodness, I feel like Barry Bonds being offered a slow pitch over the middle of the plate. This bill will lower the risks endured by the credit card companies. John Thacker is therefore right on the bull’s eye: “If the rate of bankruptcy for a certain class of customer decreases, someone will be able to make a profit at a lower rate.”

Boonton writes:
Oh my goodness, I feel like Barry Bonds being offered a slow pitch over the middle of the plate. This bill will lower the risks endured by the credit card companies.

It does not lower risk but transfers it. Krugman correctly concludes that bill transfers risk from credit card companies to middle class families. Risk might be lowered a tiny bit if it deters a few true 'abusors' who intend to run up debts ahead of time. However this is almost certainly a small portion of middle class bankruptcies. (don't forget, wealthy abusors still have the doors open). Hence the only logical conclusion is that middle class people now get the risk. Of course rates might go down but that's irrelevant. The prices should fall slightly if the middle class must endure more risk...just as if an insurance company raises a deductible the policy becomes less valuable.

Jon writes:

What is missing from this discussion is that only 3.5% of the bankruptcy's would be pushed from Chapter 7 to Chapter 13. Credit card "charge offs" (probably including some that never go to bankruptcy) are about 6%/year. Thus they could decrease their rates on average by about 20bp. On the affected population it would have to be far less than 350bp.

In reality, likely the credit card companies will respond with slightly lower rates for riskier people, but higher penalty fees. This would be rational because people are less likely to shop based on penalty fees, and the greater cost of bankruptcy for borrowers will mean they can keep more of the penalty fees.

This will make it harder for those people to dig out.

The benefits would be rather diffuse; the costs would be highly concentrated on those least able to bear it. Plus the administrative costs would be higher for those people.

David Thomson writes:

“It does not lower risk but transfers it. Krugman correctly concludes that bill transfers risk from credit card companies to middle class families.”

I hope for Paul Krugman’s sake that you’re taking him out of context. Alas, if you are not---the man is in deep trouble. You are inadvertently insulting the well known economist. The only thing that matters is whether the credit card companies will be able to engage in less risky behavior. Any savings will inevitably be passed along to their customers. People will low credit scores will find it easier to get credit. Once again, could you please offer us even one example when this has not occurred?

Bernard Yomtov writes:

Barry Bonds?

Don't flatter yourself, David. It's unbecoming.

As I have stressed in my previous comments, I do fully grasp the model on which your arguments are based. I simply want to see actual evidence that they apply to the market for credit card debt before I swallow the CC companies' claims whole.

Apparently, being a devout worshipper at the Church of the Holy Market, you don't need evidence. Well, arguing with religious fanatics is generally fruitless, and so it has proved again.

Fazal Majid writes:
By making it more difficult to abuse the system, it would allow lenders to offer better terms to high-risk borrowers. Therefore, bankruptcy reform could be win-win for most high-risk borrowers and for lenders.

We all know the savings rate in this country is too low, and consumer debt is too high. While there certainly are debtors who abuse the bankruptcy laws, it is also clear many credit card companies deliberately and aggressively push credit to people who make unsound financial decisions and rack up more debt than they can afford in the first place. Bankruptcy law provides a useful check for some credit card companies' reckless commercial practices, just as restrictions on advertising for tobacco companies serve another public policy interest.

MaxedOutMama writes:

Market pressures force lenders to look for the highest returns. The idea that this bankruptcy bill will lower average interest rates is fallacious. The rates of return on the most risky debt are currently sky-high, but the credit card companies feel they have a captive market in this segment. What, are these people going to turn to payday lenders or title pawn companies, and pay 600-800 % interest a year vs 150% a year? (Including late fees, phone-pay fees, interest rates up to 40%, and overlimit fees, that is effectively what a lot of people are paying on certain cards)

No, they are not. And that is why finance companies and credit card companies are actively targeting consumers in financial trouble or on the margin. What will be the incentive for them to ratchet this down? Nothing, if this bill is passed as it stands.

Lancelot Finn is right. Most people desperately do not want to go bankrupt, so they struggle for quite a while. It is not at all rare for people to pay 2 to 3 times their original principal back over the course of 3 to 5 years before they give up. Under these circumstances, the payoff is so high that these types of lenders actively seek such marginal credit risks. If this bill is passed as it stands the reward for this practice will not change and the risks of this practice will become even less, so you will see more, not less, of this type of lending.

Now what, I ask you, will change these incentives to lend irresponsibly with passage of this bill? Absolutely nothing, unless the bill is passed with additional restrictions upon credit card practices which, I can tell you with great certainty, will greatly reduce the enthusiasm for its passage among a segment of the bill's constitutuency.

I work in the field of banking regulatory compliance, and I can tell you that it is getting harder and harder for lenders who DO NOT indulge in such practices to compete, simply because their less ethical competitors are making so much money.

The truth is that credit card accounts for people who can afford to pay their balances in full or within six months or so are in general unprofitable. These are the people that can afford to go to a bank and get a loan at 6% to pay off their balances, so the credit card companies can't charge much more than 10% for convenience. But servicing the accounts of people who don't have other recourse is very profitable, and those people are actually paying for the accounts of those with more resources.

Lancelot Finn is right and you are wrong in this case. There has been a tremendous surge in predatory lending practices in the industry and it is time to curb it BEFORE bankruptcy reform is passed. Capital does flow to the areas of the least risk and greatest reward, and in this case it is to a segment of an industry which overall hurts the economy.

Boonton writes:
I hope for Paul Krugman’s sake that you’re taking him out of context. Alas, if you are not---the man is in deep trouble. You are inadvertently insulting the well known economist. The only thing that matters is whether the credit card companies will be able to engage in less risky behavior. Any savings will inevitably be passed along to their customers. People will low credit scores will find it easier to get credit. Once again, could you please offer us even one example when this has not occurred?

For the sake of the argument let us ignore the rare case of the middle class person who intentionally goes from $0 debt to high credit card bills he ditches in bankruptcy simply to abuse the system. As I pointed out, special efforts were made to keep loopholes open for such thoughtful abusors.

Let's consider the risk to a middle class debtor of a financial set back such as a lost job or unexpectedly large expense. Let us also consider the risk to the credit card company.

Debtor:
Bad Credit (aka inability to get future credit at good terms)
Collection Action (*)
Wage Infringement (*)
Loss of assets (*)

Creditor
Loss of interest income
Loss of principle

* Denotes risks that were partially removed from the debtor by bankrupty. Hence before this bill they increased the risk to the creditor because it limited the ability of the creditor to take action to recover their money. Now those risks are being transferred to the middle class debtor.

OF COURSE THERE SHOULD BE SOME LOWER COSTS TO THE DEBTOR! THE DEBTOR IS BEING ASKED TO TAKE ON MORE RISKS! Typically a home equity loan has a lower interest rate than a non-secured loan. Is this 'helping the consumer' in some special way? Not at all, the consumer is putting their home on the line for the home equity loan! Of course they would demand a lower rate from the lender and the lender is lowering his risk when he makes a home equity loan as opposed to a non-secured loan...it is proper that he get charged a premium in the form of a lower return!

Here's a hypothetical. Suppose Congress passed a law that, buried deep in fine print no one notices until later, basically turns any credit card debt into the equilivant of a home equity loan. Such a move would dramatically 'lower costs' for the credit card companies since a single missed payment would be sufficient to trigger forclosure on the cardholders house (well maybe a few missed payments). Would you say this move would generate true savings for the consumer, though?

Nothing has been done here to lower costs. If costs really were lowered then you would see true savings. Instead you've only acheived a little 'sticker savings' by transferring risks onto the consumer.

Deb McAdams writes:

Just to emphasize some important points already made -

Increased competition, in theory comes from things such as lowering barriers to entry and improving access to capital for potential competitors.

There has not been an argument made here that the bankruptcy bill increases competition in the credit industry. I doubt there is a reasonable argument to make that it does.

Increased competition prevents any party from profiting directly from its position in the market as opposed to profiting from the services it offers.

But if we are not increasing competition then all it is possible to do, even in theory, is to transfer wealth from one party to another.

If you can't point to increased competition - in other words if you can't point to a reason more different companies will be able to compete - then there is no reason, even if you are a religious believer in perfect markets, to expect lower overall prices.

At that point the only relevant question becomes to whom is wealth being transfered and from whom is that wealth coming.

It was pointed out and not refuted early in this discussion that a large number of borrowers took loans competitively priced at one set of terms and those terms was changed by government in favor of the borrowers.

That's about the end of the story.

The bill does not create produce new information for lenders that was unavailable before. It's purely a one-time transfer to borrowers.

Going forward these new terms will be priced in by the competitive market so it is not an ongoing transfer.

The question of why did the credit card companies buy this legistlation is exactly right though unanswered here by proponents of the bankruptcy bill.

Government collected some of this one-time transfer of wealth in the form of campaign contributions. Government lobbyists feed their families by participating in this skimming of government's transfer of wealth from credit card borrowers to lenders.

Supposed libertarians who support this should be deeply ashamed.

Deb McAdams writes:
For Discussion. Suppose that Congress wanted to protect homeowners by allowing a family to keep its house if it cannot pay the mortgage. How would this affect the mortgage market?

Pretty easy.

It would be a one-time transfer from lenders to borrowers.

After that, assuming competitive markets - and the credit markets in the United States are as close to perfectly competitive as any non-commodity markets anywhere in history - further mortgages would be made on market-clearing efficient terms with suitable interest rates and suitable availability of credit.

A pure one-time transfer.

Its just barely conceivable as a thought experiment when going from lenders to borrowers. It was just passed into law by the United States Congress when going from poorer credit card consumers to credit card companies.

Supposed libertarians who support this should be deeply ashamed.

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