Tuesday, April 05, 2005

Becker and Posner Go Bankrupt

by Tom Bozzo

It's not just me. At the Talking Points Memo Bankruptcy Bill section, Elizabeth Warren takes on the unrealism of the Becker-Posner Blog's bankruptcy reform debate.
I expected a real treat, but their recent comments on the pending bankruptcy bill are so out of touch (and out of date) that I was amazed to see them advanced. Posner and Becker’s entire discussion rests on the standard chestnut that the bankruptcy bill will benefit consumers because it will reduce creditors’ risk and therefore cut interest rates. That argument not only ignores twenty years of data; it also perpetuates a plodding “perfect markets” model of consumer credit that most theorists have long since abandoned.
Read the rest!
In fact, it will do the opposite. It rewards more dicey lending practices.

Assume you lend me $100 at 24% ($2 interest/month). If I am near-bankruptcy, I pay you only $2 every month. Under the bankruptcy bill, my liability to you after filing would be: $100.

By contrast, if you lend that money to someone with perfect credit, you get $100 back the next month: no interest, and you have to find someone else to borrow that money again.

Sub-prime borrowers become preferred customers, while the most creditworthy among us will appear more expensive.

If anything, the bankruptcy bill will raise rates, as the best and the most worthy will be charged more.
Interesting point, Ken. I've wondered whether, with annual fees less common, credit card account holders who don't carry balances generate enough revenues related to transaction volume (merchant fees, etc.) to be profitable to the card issuers. The introduction of fees for foreign currency transactions and the shaving of grace periods may suggest not.

For the most part, though, I'd assumed (esp. thinking about installment loans and the like) that the most creditworthy borrowers were already being charged prices that factored in the very low probability of default. (It's also difficult to see how accounts that don't pay interest or fees could be subsidizing defaulters.) If that's the case, fiddling with the bankruptcy laws is unlikely to make life any cheaper for the creditworthy.

I think it comes down to ROC. Started to write a comment about it, but it got too long.

The short version is "The bill encourages risky behavior. Risky behavior reduces your expected ROC. That must be compensated for somewhere, and Willie Sutton is still correct."
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