Sunday, August 26, 2007

Bankruptcy Dichotomies

Elizabeth Warren has written about the dichotomy (i.e. hypocrisy) of protections for corporations and large debtors in bankruptcy with the protections (or lack thereof) for consumer debtors in the same situation in her post The Onion Plan.

Bankruptcy law is the final arbiter of debtor-creditor rights, but here's an interesting asymmetry in the law: If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy. But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable.

More details: A company that cannot pay its mortgage can declare Chapter 11 and do two things: 1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion. So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged. The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure. The second insight is that this is precisely the risk the lender took: that the property would decline in value and the debtor couldn't pay. The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral.

But notice: If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments--in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%. In other words, homeowners get a lot less protection in bankruptcy than do businesses.

There are a lot of "asymmetries" in Chapter 11 bankruptcies and other chapters of the bankruptcy code. I have written about it before in regards to "retention bonuses" paid to corporate executives immediately before bankruptcy and consumer debtors who attempt to give assets to their relatives within a year of filing bankruptcy. These are but two examples of how the bankruptcy code works for the benefit of the wealthy in inconsistent ways to the detriment of the poor and middle-class. It shows in a glaring way why we need to change government regulation to bring more consistentcy and equality in the law's treatment of persons with disparities in income and wealth. In theory, that is always supposed to be true for persons who come before the Court. Obviously it's not.

1 comment:

Independent Accountant said...

In 1992 or thereabouts, there was an excellent article in the Yale LJ about reforming bankruptcy law. My answer: end chapter 11 and auction all corporate assets. That a bankruptcy like Enron's can use $500 million in fees is obscene. All management contracts get cancelled in bankruptcy and old management given the heave ho.