How bankruptcy "reform" contributed to the current economic crisis

The "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005" made bankruptcy harder to come by. It was intended to protect financial institutions from becoming insolvent by making sure that people paid their debts rather than ducking out via bankruptcy. Ironically, the very same institutions that lobbied for "bankruptcy reform" are also the ones suffering most from it, for reasons that become clear if you look closely.

The primary issue right now is that the middle class in America is insolvent. Any extra money it gets -- from pay hikes, tax rebates, etc. -- is going towards paying on debts that are unpayable within their lifetimes. And because they're insolvent, they're not buying. That means that businesses aren't borrowing money to buy new equipment, open new stores, etc., instead they're cutting back.

What that means is that banks have money... but nobody to lend it to who has any chance of paying it back. The middle class is insolvent. The rich don't need to borrow. The poor can't pay it back. Business isn't interested in borrowing until demand turns back up. Demand can't turn back up until the middle class is solvent. The middle class can't be solvent until... well. They can't be, as long as they can't declare bankruptcy. And the banks can't be solvent until they can earn money on their deposits, which they can't because anybody they might loan to is insolvent and their insolvent customers are unable to pay off the loans currently on the books.

Bankruptcy was explicitly created to escape this insolvency trap. If bankruptcy were relatively easy, the middle class could declare bankruptcy and start buying again (albeit at a slower pace because they would not be able to borrow money). Businesses would start to borrow to invest in meeting the renewed demand, and banks could loan them money and make dough on the interest. The banks would have to write down the consumer loans of those who declared bankruptcy, but let's face facts, those loans are already bad and will never be paid back because the middle class is carrying more debt than could ever be paid back in their lifetimes, all that banks are doing by carrying these loans on the books is pretending that this isn't the case.

In short, our financial wizards shot themselves in the foot to spite their toe when they created bankruptcy "reform". By killing demand amongst insolvent (but incapable of declaring bankruptcy) people, they killed demand for their loan products too -- and thus any chance of making a profit. Yet another example of how short-sighted our financial industry was during the runup to the current mess... all of this could be foreseen, and *was* foreseen, but nooo... they had to whine about being "protected" from "irresponsible" consumers, and instead shot themselves in the foot. And the rest of us with them, alas.

-- Badtux the Economics Penguin