Russ Roberts

Zywicki on Debt and Bankruptcy

EconTalk Episode with Todd Zywicki
Hosted by Russ Roberts
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Todd Zywicki, of George Mason University Law School, talks with EconTalk host Russ Roberts about the evolving world of consumer debt and how institutions and public policy have influenced consumer access to debt and credit. Zywicki defends consumer credit as a crucial benefit to consumers and that innovation has made credit cheaper and more effective. He also talks about how misleading it can be to look at only one piece or another of credit picture. The conversation concludes with a discussion of the evolution of bankruptcy law in the United States.

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0:36Intro. [Recording date: Feb. 11, 2009] Debt. People argue that our prosperity is an illusion because we've built it on debt. Recent problems in the housing market related to debts that didn't get repaid. In the housing market, there was an unrealistic level of debt. What people usually have in mind is that people have too much consumer debt, credit card debt. Look back over course of history, theme that sky is falling is almost as old as America itself. In 1873, the NY Times expressed concern that Americans were "running in debt," and by 1877 concerned that Americans were "borrowing trouble." Repeated concerns; in 1940 debt "threatening democracy." Fear of poor house, debtors' prison. What we've learned from this crisis is: Debt's bad. We overcompensate. When credit easy we perhaps borrow too much. Is there a pendulum aspect to this? We do have a schizophrenic view of debt. We think of it as credit is good but debt is bad, even though they are the same thing, empower people to start businesses and make their lives easier. Recognize that there is fear. As long as we've had debt, there have been people who cannot manage it well. With financial innovations and the growth of consumer choice consumers have more power now in dealing with debt and credit than 50 years ago, when banker could charge you whatever he wanted to. Over last two or three decades, great proliferation of consumer choice. Previously went to appliance store and open a line of credit, charged you 30-40% interest buried in price of refrigerator. Installment credit transactions if you didn't have enough cash if your car was broken. People used pawn shops, borrowed from friends and family. For items that have a long life, reasonable that you wouldn't want to pay up front if you didn't have the cash, rational. Everybody knows Ford "invented" the automobile, but by the 1930s, '40s, General Motors had eclipsed Ford as the largest motor company in America because they were willing to sell people cars on credit; Ford believed people had to save up enough first. Useful to have a car to drive yourself to work.
7:20Others point to debt as a measure that we are living beyond our means. Forty or fifty years ago, furnishing their houses, cars, pianos, paying on time: installment loans. Since then, credit cards have substituted for a lot of those transactions. Actual data: the growth in credit card debt, which is huge, is come 100% as a substitution for those other forms of debt. Credit cards also have lower rates of interest than the former forms of debt. Really are much less expensive. Unhooks credit transaction from the goods transaction. Can go online and buy from Amazon; sellers compete with each other and creditors compete with each other; better deal with each. More transparent, allows specialization. Unacknowledged thing about the credit freeze: rolling back of the clock. Device of lower income people used to be the layaway plan, common in old days: pay for the goods in installment payments before you could get it. Lay the item away on a shelf till it is paid. Ford's model. We'd gotten rid of that: people can have the goods while they pay because the innovation of credit cards empowered people. Christmas season this past fall: stores were bringing back layaway because of the credit crunch; people unable to get credit. Middle income consumers starting to use pawn shops again, pay-day lenders. That's the real cost. Some people will go without credit, but mostly people will use much less attractive forms of credit. Even Tony Soprano is willing to offer you credit if you can't get it somewhere else.
13:29Old days, 2 or 3 credit card offers a day; that has slacked off. A lot of people think credit card companies are predatory, offering you good deals up front but getting you deep in debt. Things you read in the paper: Paulson worried about credit cards freezing up, credit card loans bundled together and issued as securities. Is it a good thing that we have less of that? Stories of payday loans coming back--are people losing their credit cards now or just not using them? As long as there has been credit there have been people who have gotten in over their heads. 1910s, 1920s, average person might have had as many as 12 pawn shop tickets in their pocket during the winter when the mills were closed because of water power. Always been people living on the edge, multiple credit cards; and no doubt that some credit card lenders don't treat consumers well, disclosures not what they should be. Credit cards much more complicated now than they used to be. In 1970s, 18% interest rate, annual fee, no frequent flier miles. More complicated now because of consumer demand; possibility that some consumers will make a mistake. Look at how they behave, they kind of know what's going on. No idea what the interest rate is on your credit card, but are aware of annual fee, how many frequent flier miles; transactional user, convenience, pay it off every month. Those who pay off their credit slowly shop for credit cards by interest rates and know exactly what the interest rate is. Credit cards are more complicated; people have the incentives and act as we'd expect, shop on the margins that matter. World of today: do we have a problem in the credit card market? Systematic data not easy; but all reports point to idea that credit card lenders are tightening up. Consumers often smarter than we give them credit; when economy slips into recession they don't walk like zombies to the cliff and fall off. They start planning for the recession, scaling back on purchases before losing job, saving more, borrowing less. Credit card issuers are aware economy is going soft and people will lose their jobs, so issuers know someone could start revolving and could become a worse risk than before. Home equity lines of credit explosion around 2003-04, consuming some of the equity of homes. Some of that has disappeared. Consumers plan ahead for the long term as well. If the value of your house goes up, you are wealthier. Permanent income hypothesis: Milton Friedman's idea, when you are planning your life you try to average out your consumption over the span of your life. If you are making $100,000 now, you save some for retirement; you don't spend it all now; try to smooth out your consumption over your lifespan. If your house goes up in value and stays up, you are wealthier in the future. People expected their home values would stay up, banked on that, and went out and borrowed against it, smoothing their consumption stream. 60% of value of homes spent typically. Drew it down perhaps in an overzealous way.
24:44Consequence: leads to problems that extend beyond the issuers of the lines of credit. Two sides to every transaction. Dramatic rise in foreclosures. Bankruptcy: how does it work? Take out a bunch of credit cards, can't pay them back for various reasons. What are the consequences of declaring bankruptcy? Changes in law recently. Do-over is to some extent kind of accurate. Two types of debt: secured debt, house, car--collateral that lender can take. Bankruptcy doesn't help you much with that kind of debt; even if you discharge your mortgage debt, lender can come and take your house as the law stands now. Confused: suppose I buy a house and can't make the payments, declare bankruptcy. Eventually lose the house. Bankruptcy slows down the process and allows you to try to get your act together; in the end, have to pay the full amount in order to keep the house. In exchange for the collateral, you get a lower interest rate up front. If you lose your house, the bank takes it; you still owe the money to the bank but bankruptcy wipes it out. Do-over is for unsecured debt--pharmacy doesn't come back for the pills. Student loans, unsecured, but provisions are that you can't wipe them out except in certain circumstances. Lose home, car: in the old days, you go to jail. In U.S. till the 1930s, a lot of states still had debtors' prisons; businesses treated differently, could reorganize. In 19th century could move out to the frontier, ditched your debts. Even with the tightening of the bankruptcy law a few years ago, U.S. has the most generous system, reflecting entrepreneurship, spirit of risk-taking, and charitable nature. The easier you make it to walk away from your debt, the harder it will be to borrow. Application of the Coase theorem: if you punish the imprudent borrower then people are more eager to lend credit because they can count on that to deter fraud; if you reward the borrower, the opposite; changes the terms of the deal up front. Student loan: you lose the house, still have to pay off the student loan with any money left or eventually when you get a job; non-dischargeable. Can put a lien on your earnings, garnish your earnings; can seize your bank account, take your tax refund. For most debt, bankruptcy creates a cleavage in time, after which you are born anew. For some debts, you jump the gap. Why those rules? Fresh start is idea that is deeply rooted in American economic system and psyche, but balance that against other social goals. If you borrow backed by the government, you not the taxpayer has to pay it off.
35:41If I walk away from my credit card loan, what happens? Not liable for the balances but take a big hit on your credit card score making it harder to borrow in the future. Main cost is that the more generous you make the bankruptcy system the more subject it is to abuse and the more everybody else has to pay for it. Example: study done, Memphis, Tennessee, bankruptcy capital of America. About 4-5% of the residents file bankruptcy every year. Implications: Memphis won't take an out of state check. Downpayment on a car is the wholesale price of the car--afraid if they extend you credit you will file bankruptcy. Collateral is expensive. If you increase protection for people after the fact you make it more risky to lend to them before the fact. Always some price, never a free lunch.
38:10Bankruptcy law changed recently, 2005. What was the political impetus for that? Major overhaul in 1978, substantially loosened the bankruptcy laws. People moved out to the suburbs, bought houses and cars in the 1950s and 1960s; started to use credit. Made bankruptcy cheaper and easier because more people had more credit. Agricultural economy shrunk a lot, people less self-reliant, needed more modern, more borrower-friendly bankruptcy system. In 1980, had about 250,000 personal bankruptcies a year; in 2005, about million and a half a year. In 1980s and 1990s, low inflation, high prosperity, yet bankruptcy filing rate quintupled--but it wasn't very high, though getting to be a big number. Trend wasn't good; didn't seem to fit with economic reality: expect bankruptcies to rise when economy turns bad, which is what we're seeing currently. Congress said: want to preserve it for those who need it but some are gaming the system; tightened up the laws, new accountability, in 2005. Provisions: want to help but don't want to make it a system of fraud and abuse. Made you file tax returns when you filed bankruptcy. Previously people just didn't tell the court, put money under bed, told courts they didn't have bank accounts when they did. Required those who make above their state median income adjusted for family size are required to repay some of their debt: not a full do-over but a limited do-over. Means testing. Two ways of filing bankruptcy: Full do-over, Chapter 7; and Chapter 13, enter into a repayment plan going forward. Traditionally, with Chapter 7, put everything in a bucket and if there is not enough to repay the creditors, too bad for the creditors. Protects future income but not wealth. In practice you can protect a lot of your wealth. Chapter 13 allowed you to protect your wealth but not your income, wouldn't be required to give up your house. In Chapter 7, if you own your car outright, you give up your car; in Chapter 13, you keep your car but have to pay creditors in the future, give up some future income. Turned out that a lot of high income people could go into Chapter 7 and because of the way property rules operate could get out of having to repay. So one of the things the 2005 bill did was push people who have high income to repay a portion of their debt. So in 2005-2006, bankruptcies fell. Bill enacted in April, didn't go into effect until October 17. The two-week period preceding that, half a million people filed for bankruptcy; in the week before, 350,000 filed for bankruptcy under the old scheme. Then dropped from 2 million to 650,000 in 2006; in 2008 about a million. Bankruptcy reform a success. Bankruptcies rising but not the anomaly as in the 1980s. Struck a new balance.
46:59Quibble with analysis is with phrase "we've made a decision"--really no "we" there. Decision emerged. Bill passed with about 75% in House and Senate. Only opposition was liberal Democrats. Balancing responsibility against a fresh start. Art, not a science. Public choice side: framed so far as a benevolent dictator, but assume some special interests. Public choice factors are fascinating, book with chapter dedicated to this. Bankruptcy lawyers have a vested interest in having more bankruptcies and have always pushed for looser and more complicated laws; creditors want to have the opposite. In the long run they kind of balance each other out. Ideological result: in years the of the Democrats controlling Congress, laws favored debtors; when Republicans controlled Congress, laws favored creditors. Of a piece with welfare reform.
49:42Mortgage market. Talked about subprime mortgage problem, negative equity. If you bought a house with no money down and price went down, rational to walk away from that house. Immoral since you made a promise, so some conscience issues; bankruptcy means some consequences. When push comes to shove, that's the root of the foreclosure crisis. Three different factors: macroeconomic conditions, e.g., Detroit, Ohio, Indiana--no jobs. Hurricane comes through, foreclosures in its wake. Foreclosures started rising before economy went down. Two other factors: distress caused by changes in interest rates. That does seem to be a bit of a factor. Adjustable rate mortgages were not a creation of subprime mortgages. In 1984, 61% of the mortgages written in the U.S. were adjustable rate mortgages. In 1988, 56%. Over time, when spread between short and long term interest rates get wider, so adjustable rate gets lower in short run, people switch toward adjustable rate mortgages. In the past, lots of adjustable rate mortgages. Teaser rate that rose over time. Most of the loans that defaulted did so in the first 12 months. Huge difference in the foreclosure rates between adjustable rate mortgages and fixed rate mortgages; adjustable rates weren't a risk factor in the past but are now. Between 2000 and 2004, adjustable rate mortgages were pushed artificially low by Fed monetary policy, and adjustable rate mortgages went up to where fixed rate mortgages were. Why do you need that? Problem is declining price of houses. Buy a house with 5% down and it goes down in price, have negative equity. Some stigma, cost, but if house has gone down 25%, might just walk away. Matters because there seem to be some people out there who want to keep their houses but their interest rates have gone up. May be that you have to have the second factor, interest up, have positive equity, can sell the house. Negative equity: can think of your house like a financial option, a call option; if it goes up in value you can sell or refinance; when it goes down can think of it as a put option, give it back to the bank and walk away. Several states have anti-deficiency laws: CA and AZ. If you walk away, bank is allowed to take back your house but not allowed to sue you no matter how wealthy you are. Like a get-out-of-jail free card, do-over. When house prices fall, people in an area with an anti-deficiency law are 2-3 times more likely to walk away from their house than they would be if the lender was allowed to come after them. Immoral to walk away, but another way to think about is just what is rational behavior. What if somebody knocked on door and offered $3 million? Would walk away then. People respond rationally to the incentives. Bankruptcy law: anti-deficiency clause is in 8 states. Rest of the country, if you walk away, borrowed $400,000, house goes down to $300,000; if you walk away bank has the right to sue you for the $100,000. Bank cuts a deal rather than your trashing the house. Flip side of the anti-deficiency law: bank threatens foreclosure, then trash the house, don't spend money on upkeep, etc. Not just that the house goes down in price now; expectations of when the price will go up. Some areas of the country are just overbuilt. Around Las Vegas, Virginia, overbuilt; no expectation of prices rising; people just walk away.
1:02:35Innovations in mortgage market, mortgage backed securities, had a benefit: a lot of people got access to credit that historically they would not have had access to. It has changed the ability to do these work-outs--when someone has fallen on hard times, they cannot as easily as before go to their lender and work something out. When these have been bundled and tranched and sliced and resold to a Swiss pension fund, there is no individual owner of the stream of payments. Is that a problem? When created, no anticipation of what happened, didn't really think about this. There were benefits. Almost every single credit device that has ever been introduced has gone through a boom and bust cycle. Credit cards; subprime auto lending. Get rid of the excesses and keep the core value, don't want to overreact. We've learned a lot of very expensive lessons, but let's keep in mind that we have learned lessons.

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COMMENTS (30 to date)
halbhh writes:

While Todd reasonably points out the advantages of credit cards such as shopping around, I was left wondering about the quick dismissal of the idea consumers are too far in debt. That question is/should-be a matter of numbers, ratios, not of adjectives or hand-waving.

What are the ratios (revolving debt vs income, etc)? That would be meaningful information.

For that matter, public debt is an obligation of consumers of course, so total debt of all kinds vs GDP is relevant. After all, this isn't 1946. Other nations have manufacturing capacity.

To even discuss this topic without the basic information.

The elephant in the room, sitting on us is whether the debt levels will force a debt-deflation spiral.

I just don't understand talking about this without the basic numbers.

Jim writes:

Really wonderful podcast. Thank you.


Russ Roberts writes:

halbhh,

Here is Zywicki's Congressional testimony that has lots of data on debt...


http://banking.senate.gov/public/_files/ZywickiCreditCardTestimonySenate2122009.pdf

Bo Zimmerman writes:

Another awesome, informative, and entertaining podcast Mr. Roberts.

Early in the podcast, you asked your guest about some of the negative comments and bearish feelings related to the credit/debt crisis, to which he corrected responded that "Hey, Credit is how things have worked for a long long time!". I would only add that many of the loudest critics of our credit/debt crisis are Austrians, who aren't upset about debt per se so much as the Source and Artificiality of the credit being extended. i.e. That interest rates below the natural market rate expand peoples capacity for credit far beyond our ability to produce the goods to satisfy it, thus driving up the prices of those goods. When the credit is put into long-term durable goods, this problem is exacerbated when the credit reaches its limit and the bubble bursts. At least, that's my reading of how Aus. business cycle theory would apply to that part of our situation.

Ethnic Austrian writes:

I was completely baffled and taken aback when Todd Zywicki explained that in the olden days, people would purchase pianos, furniture and appliances with monthly installment payments.

Well that is exactly how it is done in Austria and Germany to this day. I assumed that this would be the case anywhere in the western world. But I looked at the IKEA website and there are indeed no monthly installemnt options available with IKEA in France, Spain or the United States. IKEA tries to push a special IKEA credit card in these places though.
I also couldn't find monthly payment options at french, spanish or american Piano dealers.

I was even more stunned, when Russ and Todd agreed that the substitution with credit cards were a good thing and provided cheaper rates for consumers.

The general wisdom in the german speaking world is exactly the opposite. Revolving credit card debt is the worst kind of deal you can get and generally considered to be the work of the devil. Well, it is better than loan shark territory, I guess.

Negotiating a loan with your own bank is the best option (if you've got a good relationship with your bank), shortly followed by discount cash loans and installment payments.

The APR for monthly installments at IKEA is 8,95% (eurozone!). Piano dealers are in the same territory. Mail order firms charge rates much closer to credit cards.

It only makes sense that default probability would be different on different product categories. I presume that the customer base for pianos differs from that for car sound systems. Plus pianos can be repossessed. Vacations can't.

Monthly payments also provide implicit accounting. Consumers know exactly what items they make their payments for, whereas with a credit card, all of your expenditures are lumped together.

We use ATM cards for transactions, meaning that you can pay with your ATM card in many stores.

Credit cards are popular for vacations and online shopping. But those are actually debit cards, which are tied to a bank account. Credit is done via regular overdraft on your bank account at 9% APR. Only few people opt into the revolving credit option. That is probably an example for unintentional libertarian paternalism.

I basically fail to see, how "rolling back of the clock" in the US is anything but a good thing.

Unit writes:

Patri Friedman new ad: "Wiped out? Bankrupt? No one willing to lend you a buck? Join us out to sea! Help us build a new future, oceans or bust!"

halbhh writes:

Russ, thanks for the link. It suggests an interesting possibility -- a large part of individual consumer debt trouble comes from buying too much house, and if so, foreclosures then have a stimulating effect for the general economy as they free up more discretionary spending (in many cases). This all bears more study. Again, thanks for the link.

Hal

Julien Couvreur writes:

Tim Harford had a recent article related to this topic. He illustrates how the financial and banking innovations have helped many including the poor.
http://timharford.com/2009/02/does-nobody-want-to-take-money-from-the-poor/

Cheers,
Julien

Bryan MacKinnon writes:

Russ, great show.

There seems to be an implicit assumption with all discussions about housing values is that they must go up over time or all sorts of bad things happen. This is not the case in Japan and never has been. Housing structures tend to depreciate in value Japan while the land value will fluctuate up and down.

When considering the relevance of Japan's "lost decade" to the current crisis, I suggest a holistic approach be considered. Not only are the housing price assumptions different, a goal of the government was to minimize the unemployment rate and they were quite successful at that. Given a choice, the average Japanese would rather have a job and slow economic growth than the option that the US tends to take.

David Quigg writes:

The recent experience of buying a dishwasher makes me wonder if Zywicki can possibly be comparing apples to apples in his analysis.

So as not to be contrary, I'll just stipulate that Zywicki is correct that it's better to buy a dishwasher using my credit card than to purchase it on an installment plan from my local appliance store. But who's better off: the person in 1969 who uses an installment plan to buy a dishwasher that (properly maintained) can last for decades or the person today who uses a credit card to buy a dishwasher that (according to a repairman I consulted before buying) is invariably built to last five to seven years?

There are probably factors I'm not considering here. But I think we probably make a mistake -- both in our individual buying decisions as well as our big-picture economic analysis -- if we apply the catch-all label of "durable goods" to products that apparently are no longer built to last as long as they once did.

Gu Si Fang writes:

Thanks for this great podcast. I learned lots of things about past lending practice, existing differences between home mortgages, credit cards and student loans, or bankruptcy law.

I remain frustrated about the first part, though, which boils down to a discussion around the theme "is debt good or bad?" Well, I never heard mentioned the fact that a thing must be produced before it can be borrowed or exchanged. Therefore, saving must have occured before borrowing. It does not have to be the buyer who has saved, as Ford and others believed. It can technically be someone else who does the saving first, and then lends his production to the borrower. Or it can be the buyer who saves his money first and then exchanges it for a car (cf. Ford). In both case, saving has occurred prior to consumption.

This gives us a criterion to answer the question about good/bad debt : legal tender and other laws allow banks and central banks to confer artificial market value to valueless pieces of paper which they can produce at no cost. They are therefore in a position to "lend" even when no prior production and saving has taken place. That is how U.S. consumers came into trouble, not so much because they have a huge amount of debt, but because there are no savings to match these debts.

Kit writes:

Another form of borrowing was renting. In the UK, high-street shop chains, such as the long gone Radio Rentals, would rent everything from TVs to Fridges.

tw writes:

Russ,

Another very good podcast. I especially enjoyed the discussion of the evolution of the different credit instruments: Credit cards, layaways, payday loans, etc.

Carol writes:

Whew! I'm 4 minutes and 28 seconds into this podcast, and I'm strugging not to turn it off. I'm feel like we're being taken back to the silly times we just lived through, where it was sensible, in fact desirable, to borrow to finance current consumption. But why put yourself at risk of disaster should you lose your job? This is what we're seeing play out now.

I'm the child of parents who lived through the (previous) Great Depression. My parents saw firsthand what trauma can be caused by debt, and taught me to save before spending.

I'll try to listen to the rest since you, Russ, usually seem to develop useful insights in any conversation. As for debt - bah humbug.

david writes:

Professor Roberts:

I've listened to your podcasts for about a year. I often disagree with what is said, but I have learned a great deal. You and your guests have challenged a number of my pre-existing assumptions. I appreciate the time and effort you put into EconTalk.


I question Mr. Zywicki's assertion that credit cards have replaced other loan options such as pawn shops and pay-day lenders. I live in a town of about 60,000 in the western part of the U.S. and, if anything, the number of pawn shops and pay-day lenders has exploded over the past five to ten years. From what I can see -- which admittedly is geographically limited -- credit cards have not so much replaced the pawn shops, etc., as supplemented the overall growth in the lending industry.

I acknowledge that the creation of the credit card has provided a number of benefits to the consumer. But, I also think the industry has profited enormously by the confusion engendered by its lending practices. At bottom, the credit industry is a simple business -- borrow money, pay it back in time, no charge. Pay it back late, pay extra. Simple enough, unless you actually try to read a credit card agreement. I wonder how many consumers actually understand what "double-cycle" billing is or how their interest rate is actually calculated. It seems to me that there is a large asymetry of information between consumers and the credit card industry. At least pawn shops and pay-day lenders have the virtue of providing comprehensible lending terms to their customers.

One thing I have wondered is whether the 2005 bankruptcy reform created a moral hazard for the lending industry. By making it harder on consumers to discharge debt, did the reforms reduce lender incentive to conduct due diligence before advancing credit? Is there any evidence of credit expansion after the reforms were passed?

As a counterpoint to Mr. Zywicki, Elizabeth Warren might be a good guest for a future podcast. Thanks again for your informative podcasts.

Carol writes:

I posted above that I had listened to the first four minutes of the podcast before getting frustrated. I got through about 17 minutes before getting so irritated that I had to stop listening, something I have never done before with your podcasts. I'm afraid I have to say that regardless of his credentials, your guest sounds like an apologist for the credit card industry.

Please look at the chart in the link below.

http://www.npr.org/blogs/money/2009/02/household_debt_vs_gdp.html?ft=1&f=93559255

After looking at that chart, please tell me why debt is not a problem?

As david describes in the previous comment, credit cards have become extremely complex instruments that are hard for most people to understand. It's not that people gained choices between the tired old debt instruments and spiffy wonderful ones, rather that they lost the opportunity to be free of debt.

I look forward to your future podcasts; they are usually very insightful.

Kevin writes:

Why the complaints about credit card evolution? Consumers vote with their wallets every day, and they choose so-called "complex" billing arrangements over the old-school 18%, $40 annual fee "simple" products of the past.

Regarding whether debt financing of consumption is a good or a bad thing, I didn't get the impression from the podcast that anyone was advocating debt as an intelligent way to finance current consumption. To finance future consumption, sure, but even then only as far as such consumption increased the consumer's productivity. The discussion of the new car made perfect sense.

Also, the difficult-for-some-to-understand terms of credit card agreements come to us courtesy of the federal government. I think most bankers would prefer more accessible documentation, but the government won't let you lend on an executive summary.

Robert writes:

Zywicki states that the 2005 bankruptcy reform legislation reflected the will of the country because it passed congress with a substantal majority.
TARP also passed congress with a big majority although the public was heavily opposed to it.
I suggest both bills passed do more to lobbying by special interests then any mythical "will of the country".
In general way too much opining by Mr Zywicki and too few facts.

Joe Green writes:

Prof. Zywicki makes a slightly confusing statement about options. To clarify, I think that if I buy a house and finance it with a mortgage, I have the equivalent of a call option on that house. I do not own the equivalent of a put option, as Zywicki states.

As an owner of the call option I have the right, but not the obligation, to purchase the house outright from the bank holding my mortgage for the outstanding amount of the loan (i.e., the strike price). I will exercise that right if the value of house is greater than the outstanding loan amount. I will walk away if the house value is below the loan amount.

However, I don't have a put option. I do not have any right to sell the house at the value of the loan amount (strike price) when the market value of the house is less than the mortgage.

Joe

Salaam Yitbarek writes:

As other commentators have said, it is indeed the artificiality of the debt that is in question, especially given most personal debt in the US is mortgage debt.

Russ, I'm sure you've considered having a pair of guests on at once, not for a cheap debate, but for an honest and thorough devil's advocate analysis. Taleb is currently pondering on the dangers of debt - he may have been a good match with Zywicki.

NormD writes:

The problem is not credit cards, its living beyond your means. I assume a person that overuses a credit card could just as easily overuse layaway.

Layaway must be a nightmare for stores. How do they handle price drops, tracking who is buying what, model changes, warehousing costs, buyers who change their mind about many things, customers returns, etc., etc. And I assume there are a whole raft of laws that vary from state to state and store to store protecting consumers from predatory retailers. It sounds like a quaint totally impracticable system.

Joe writes:

Great podcast. They are all great!

I have one comment about the question of "is walking away from your home and mortgage a moral issue?"

Isn't the mortgage an agreement? That is, you agree to pay in return for the payments the bank permits you to live in the (bank owned) home until it's "paid off." And if you don't pay, then the bank gets to take back the house (throw you out of it.) Why is either outcome more moral than the other? Isn't walking away from the house part of the agreement? (I.e. "if I fail to make payments, I will leave the house and turn it over to you.")

Like if you lent a guy ten dollars on Tuesday and said to both agreed either he would pay you back $11 on Saturday or let you punch him in the face. Well, suppose Saturday comes along and he says "I don't have the money, you can punch me in the face." And you do. Doesn't that fulfill the agreement?

(You might argue the agreement was that he would "try to pay back the loan" and that was the preferred outcome and the face punching was only a last less desirable outcome -- so let me try a more neutral example.)

Suppose you buy a guy lunch on Tuesday and you both agree that on Saturday he must pay you $10 cash, or he must give you his gold pen you notice in his pocket. He agrees. And on Saturday he says he doesn't have the money, and give you the gold pen. Doesn't that fulfill the agreement? Is paying the cash have some moral preference over giving the pen?

Martin Hansen writes:

Joe Green, I disagree - the "no recourse walking away" does indeed correspond to a put option (with strike price equal to the debt value). When the home owner walks away, he loses the debt and the house. Hence, his position is the same as it would be if he was able to sell the house at the debt value and use the proceeds to pay off the debt.

On the other hand, I don't see how the home owner has a call option since he already owns the house. A better analogy is that he owns a stock bought for borrowed money but also owns a put option on the stock with a strike price equal to the amount borrowed.

Martin Hansen writes:

I think walking away is a moral question. You could say it is just the terms of the agreement and would have been priced in to the interestrate. On the other hand, it probably wasn't within the spirit of the agreement since probably few anticipated the current situation. Clearly, these loans are leading to massive losses so you could argue it wasn't priced it. Furthermore, walking away can make home values falling further, hurting other home owners and can self-accelerate the whole process, leading to disasterous consequences to the whole financial system, pension funds, society etc. So I think it is true to say that it is a moral question: Because lenders were stupid you now have the right to walk away, but do you really want to take advantage of that right given the huge damage it is causing?

Compare it to the situation of bankruptcy where the borrower is released from his obligations even though it might have been his own fault to overextend himself. The corresponding thing for lenders would be a situation where borrowers were continuing to pay back their loans even though they were contractually able to walk away from them.

General: I disagree with Zywicki on some points, I think the level of consumer debt (especially if you include HELOC) is a problem and that many people are living beyond their means. But it is ultimately due to many other gross imbalances in the financial system and it doesn't represent the cause of the current crisis.

The primary problem today is that too many people anticipated permanently lower interest rates and permanently rising asset prices, but they are to some extend mutually exclusive since (market) interest rates eventually go up when inflation goes up. The root cause of the problem is that the central bank can fix some interest rates but not others (in my opinion they shouldn't fix any). Now that the spread between the rates the central banks can fix and that they can't fix is increasing, the central banks are trying to broaden their influence by intervening in what was previously market-set interest rates. This will ultimately lead to high inflation and perhaps the breakdown of the financial system.

Joe writes:

I question if "walking away" is part of "the problem" (whatever "the problem" is) maybe individuals doing what is best in their own self-interest is part of the fix?

Seann Thomas writes:

I agree with a bunch of prior folks, few numbers for some bold (and inconsiderate) claims.

How are credit cards predatory? Few folks (only quacks) say the concept of credit, and credit cards are inherently predatory. In the podcast credit card nightmares are quickly written off as the "teaser rate" argument. There is much more to it then just a teaser rate. Look at the billing practices. Most credit card companies very intentionally have shortened the billing cycle such that, depending on your locale, you can send in your payment the day it's received, and you still end up late. Minor infractions, like sending in your payment the day you receive the bill, result in not only a large $60 penalty, but also a sudden jump from 16% to 29% in your interest rate. Not just the rate on new stuff, but on your entire balance. By the way, the same banks squeel like stuck pigs at the concept of cram downs, or any mandated home loan restructuring that are the exact practice they use, but in reverse.

So because of intentional action on the part of the credit card company, folks find themselves with payments that more than double despite good faith efforts to repay. It is precisely this sort of situation that folks make noise about regarding credit card companies being predatory, not the "teaser rate".

Many examples abound, including whistle blowers pointing out institutional fraud, but since there is competition amongst banks, the free market must be at work, and the free market can do no wrong. Must just be the whiners...

Erik writes:

That was the best econtalk podcast yet to date. Mr. Zywicki is exceptionally eloquent, and the conversation flowed brilliantly. The funny thing is, I generally don't agree with Zywicki's views, but still wonderful anyways!

Cheers,
Erik

Hammclov writes:

I'm a newcomer to your podcasts Russ, and while I disagree with your policy slant, I always learn some great stuff.

One thing that bothered me about Zywicki's comments on Bankruptcy reform, and it bothered at least one other commentator as well, was that it makes a show of saying that bankruptcy's spiked in 2004 right before the law was passed. At the same time he states that the intervening years of wealth acretion from the passage of the 1978 bill, to the present, presents a contradiction to the growing number of bankruptcy's. Coming from the leftside of the fence, I'd like to say a few things.

First of all, the massive wealth aggregation of the last twenty years (with minor mishaps) seems to directly correlate with the growing number of bankruptcy's, and is not contradictory or misaligned.

Furthermore, the BLS has released a ton of statistical data on the flatlining wages of the majority of Americans for the past thirty years. This, in particular says to me that we were not witness to escalating bankruptcy abuse, but in fact were witnessing a massive redistribution of wealth. I'd really like some numbers on the reality of bankruptcy abuse, it seems to me a redherring like Reagan and Gingrich's welfare queens, a tool to motivate policy not a correction to a negative data trend.

William Cain writes:

Dear Russ,

I am very, very disappointed. I normally love your podcasts, but what happened to the academic rigor you usually uphold? Dr. Zywicki's own data refutes his position completely (thank you for linking to this or we would have been even more in the dark!):

http://banking.senate.gov/public/_files/ZywickiCreditCardTestimonySenate2122009.pdf

Just look at the graph on page 13 from 1945, when consumer credit was 1% of assets, to 1970 through today, when consumer credit has been consistently 3.5% of assets. That is a 250% increase!!! That is nothing if not a trend that refutes the idea that consumer credit is no higher today than in the past. And Dr. Zywicki doesn't even cite the source for this data!

An even deeper problem is that Dr. Zywicki, like too many analysts, doesn't go far back enough in time when looking at trends. Are we talking about 1970 to now? If so, then indeed things are "normal" these days. But what about 1945? Completely different story, as we've just seen. What about pre-1900? During these economic times, we have to look at precedents like that, because we are clearly in the middle of a long-term cycle of some sort, with a period on the order of magnitude of 100 years or so (whether it's really 30 [70s or 80s again] or 300 [downfall of various monarchies] is up for debate). He mentions the 1800s in passing, but even though the federal government may have been in debt then, what about consumers? I can't imagine things back then were just like the 1970s to now, because there was no easy access to credit! More data could potentially back up Dr. Zywicki's claims, but that data is lacking, and the best data that he *does* provide drastically refutes his assumptions.

I agree that availability of credit is a good thing, and I don't advocate restricting access to it, within reason, especially because it can be a powerful tool for uplifting people out of poverty. However, I disagree vehemently that there is nothing wrong with our American society that thinks absurd levels of *long-term* personal debt (not just credit cards that we pay off each month) and using long-term debt to finance all sorts of nonessential purchases is simply "okay" or "normal."

If it isn't necessary to stay alive and healthy or to improve your career (e.g. getting education, buying a car to commute, or starting a business), then it's a bad idea to finance it.

Concerned, confused, and feeling betrayed,

William

Michael Manocchio writes:

One comment on the "morality" of bankruptcy.

Mortgage interest rates are priced to include the probability of default of some percentage of borrowers. Therefore, in a non recourse situation, when the market value of equity in your home is sufficiently negative, it is not only rational -- it is essential (to quote Dr. Strangelove) -- to walk away from your home.

Two points of clarification -- I say sufficiently negative to allow for the frictional costs of bankruptcy (lawyers, black marks on credit, etc). Also, market value of equity is a different standard than book value of equity because book value only accounts for the present state of the market. The optionality that Dr. Zywicki mentions encompasses the future value also. Thus, it is only if the "call option" value of your house is not positive enough to offset the current negative equity.

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