A conservative argument for bankruptcy reform – Part 1 – The necessity of cramdown

As a Jacksonville Florida bankruptcy attorney, I have come to understand bankruptcy not just as a social safety net but also as a necessary market tool.  Without the threat of bankruptcy, lenders engage in unnatural business behavior that is not only bad for individuals, it is bad for our society as a whole.

Unnatural Behavior

Three examples of this unnatural behavior are home loans, automobile loans and student loans.  These three types of loans are treated differently than every other type of loan in bankruptcy, and the result has been devastating to our society.

With two exceptions, the balance due on every type of secured loan can be reduced to the fair market value of the collateral in Chapter 13 bankruptcy through a process known as “cramdown.”  Lenders are aware of this fact and “build in” the threat of cramdown when deciding whether to make a consumer loan.

One of the two exceptions is a long-standing rule that forbids bankruptcy judges from reducing the balance on primary residences.  As a result, lenders were emboldened to make risky loans at up to 125% of a home’s value.  This behavior makes no sense in a rational marketplace, but such lending was commonplace for two reasons: (a) increasing real estate values and (b) no threat of bankruptcy cramdown.  The result has been catastrophic to our economy and has fuelled a global economic meltdown.

The second exception to cramdown is an automobile owned by the debtor less than 910 days prior to filing bankruptcy.  This exception was created when the 2005 amendments to the bankruptcy code went into effect (known as BAPCPA).

Because they were protected from bankruptcy, automotive lenders began to act irrationally.  It did not matter if a buyer’s trade-in was worth less than the balance owed because lenders were willing to “roll” the negative equity into the price of a new car purchase.  As a result, buyers became more willing to pay a higher price for that new car, and today more Americans than ever are stuck driving cars that are worth far less than the balance owed.

But perhaps the greatest abuse to the American public, as a result of bankruptcy immunity, is by the higher education community.  In Part 2, I discuss how the non-dischargeability of student loans is slowly eroding our stature in the educated world.

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