My title might seem to herald an extended discussion about the reluctance of Americans who are deeply in debt to file for bankruptcy. The question of whether the stigma of bankruptcy curbs the number of bankruptcy filings has indeed been the subject of a long, hotly contested debate. On the one hand, interviews with debtors suggest that most file for bankruptcy only reluctantly and as a last resort. A surprising number of Americans believe that the 2005 amendments to the bankruptcy laws abolished bankruptcy, and thus that they could not file for bankruptcy even if they wanted to. On the other hand, enormous numbers of Americans have made use of bankruptcy, both in the past generation and in the past year. After averaging over 1,000,000 a year starting in the mid-1990s, bankruptcy filings dropped precipitously after the 2005 amendments, to 618,000 in 2006. But they have been climbing ever since, to 851,000 in 2007, and back to over 1,000,000 once again last year.
I do think there are links between the stigma debate and the bankruptcy phobia I have in mind. As with stigma, perceptions of bankruptcy and their effect on the use or avoidance of bankruptcy will figure prominently in the discussion that follows. But the focus of this Essay will be a little different. Rather than asking whether ordinary Americans have an aversion to filing for bankruptcy, the discussion that follows will consider the puzzling—and, I will argue, costly—aversion of regulators and lawmakers to bankruptcy: the bankruptcy phobia as it played out in Washington and as regulators descended on troubled investment banks in New York and struggling automakers in Detroit.
As the recent economic crisis has unfolded, bankruptcy has offered possible solutions at several key junctures. The first of these solutions was geared toward homeowners who faced the loss of their homes in the months—now several years—since the start of the subprime crisis. As several million consumers have defaulted or faced default on their mortgages over the last year or so, lawmakers have debated a reform that would allow homeowners to restructure their mortgages in bankruptcy. Under current law, a bankruptcy debtor cannot reduce the principal balance of a mortgage on her primary residence. If she owes $1,000 on her mortgage, for instance, but the value of the house has dropped to $700, she must pay the full $1,000 in order to keep her house. First offered in similar versions by Senator Durbin and Representative Conyers, and variously referred to as “cramdown,” “stripdown,” or “mortgage modification,” the proposed reform would allow the homeowner to restructure the mortgage, reducing it to $700, thus giving it the same treatment as most other assets in bankruptcy. At least in theory, this might both help many homeowners keep their homes and contribute to price discovery in the real estate markets. While lawmakers and the Obama administration have adopted a variety of other proposals that are designed to help homeowners, Congress has repeatedly stymied the mortgage modification solution.
On the corporate side, Chapter 11 was an obvious alternative when large nonbank financial institutions like Bear Stearns and AIG stumbled in 2008, and with General Motors and Chrysler as well. But regulators consistently shied away from bankruptcy. The first exception, Lehman Brothers, was an anomaly. By bailing out Bear Stearns in early 2008, the government had strongly signaled its intent to rescue large, troubled financial institutions. Against this backdrop, the decision by then Treasury Secretary Henry Paulson and others to withhold financing from Lehman took Lehman, its buyer, and the markets by surprise. Similarly, the Treasury put the car companies in bankruptcy only after they received roughly $13.4 billion in bailout money and other options had proven fruitless. “[A] GM or Chrysler bankruptcy ‘would be the start of a cascade of failures,’” a typical article concluded during the months when the car companies refused to even consider the possibility of a bankruptcy filing.
Bankruptcy has been resisted for often inconsistent reasons. The principal opponents of the mortgage modification proposal are conservatives, who decry it as an unconscionable interference with markets and the sanctity of contract. “We look at this bill as a bailout. But worse than that, it is interfering with contracts,” a spokesman for the Bush administration stated when the mortgage modification proposal was announced. Critics of using bankruptcy to resolve the financial distress of nonbank financial institutions and the carmakers, on the other hand, often have included liberals who complain that bankruptcy means leaving too much to the markets, and that it is a dangerously market-oriented response.
This shared aversion to bankruptcy, which seems to pervade all sides of the political spectrum, is the bankruptcy phobia that I would like to explore in this Essay. I will begin by speculating in more detail about the reasons for resisting bankruptcy-based solutions. Although this initial analysis will be descriptive, my own view that the aversion to bankruptcy was quite costly, and that it steered regulators and lawmakers away from promising responses to the economic crisis, will seep through. The third and fourth parts of the Essay will then put the recent crisis in historical perspective. While the absence of bankruptcy solutions and new bankruptcy reforms at the outset of the crisis was puzzling, the historical analysis suggests that it is consistent with the pattern of previous crises. Using the late nineteenth century and the Great Depression as my principal examples, I will argue that significant bankruptcy reform, in striking contrast to major corporate reform, has often come well after a financial crisis was underway, and that the proliferation of dramatically different proposed bankruptcy and nonbankruptcy solutions that we see today is also consistent with historical patterns. I will conclude by speculating about some of the implications for bankruptcy reform. Although the government’s use of bankruptcy for Chrysler and GM could mitigate the bankruptcy phobia, its circumvention of ordinary bankruptcy processes makes this unlikely. The prospects for legislative reform—particularly the undoing of several costly 2005 changes—are more promising.