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The Benefit of Bankruptcy to Society

Bankruptcy is a legal procedure by which an individual or a business can discharge its debts when the petitioner, the individual or business debtor filing for bankruptcy, does not have the means to pay it off within a reasonable time, thus, giving the debtor a fresh start. For individuals, in particular, in today’s environment of easy credit, it is very easy to fall deeply into debt will little hope of paying it off. This is not a good thing for either the individual or for society.

The purpose of earnings is to motivate people to work; if they have to pay most of their money to creditors, there would be little incentive to work any more than would be necessary to simply survive. Without bankruptcy, many people would become veritable slaves to credit card companies and other credit issuers, creating a massive amount of misery. Many of these people would turn to crime or find ways to earn money without reporting it.

Bankruptcy helps to prevent this scenario by giving debtors a fresh start, alleviating what could be a tremendous burden. But doesn’t this cheat creditors?

The business of credit—making money by charging interest.

The business of credit is much like investing—the greater the risk, the greater the potential profits. Any creditor, if it wishes, can simply extend credit to only the most creditworthy individuals or businesses, especially those with significant assets, thereby greatly reducing losses. However, this market is much smaller than the potential market. The competition for the most creditworthy individuals is keen. To get significant market share, a creditor would have to offer low interest rates, and other benefits that would cost the creditor, which would diminish profits.

Money can and is made by extending credit to less creditworthy individuals—the so-called subprime market. All creditors know about bankruptcy. They know that some portion of their customers will file for bankruptcy, yet they continue to extend credit to the same market. Why? Because it pays! They can charge higher interest rates and other fees, and they can tap a market where competition is lower. Like some investors, some creditors may take on too much risk, and go out of business, such as some of the mortgage companies that catered to the subprime market during the recent real estate boom. But this is the nature of business. You go into business hoping to make a profit, but you might lose instead. You take the risks because of the potential profits. These creditors entered the market willingly. No one forced them to extend credit to the subprime market. And it has been evident for years that large banks continue to cater to less creditworthy individuals, because, as Willie Sutton said about another place, that’s where the money is. If the big banks weren’t making money in the subprime market, they wouldn’t be there—but they are making money! Record profits, in fact!

Some people argue that bankruptcy raises prices for everyone. This simply isn’t true—it only raises prices for the subprime market for the same reason that an investment must have a greater payoff if it has a greater risk. If the subprime market was not profitable by itself, no one would extend credit to this market. Thus, the subprime market is not being subsidized by any other sector. The prime market, for instance, is not paying higher interest rates because of the subprime market—otherwise lenders would just cater to the prime market.

Some will argue that it raises prices for others in the subprime market. Well, it does, but only because it is a riskier market. If someone were not in the subprime market, then they would be in the prime market. There is no way to tell who will file for bankruptcy and who will not; if it were possible, then losses for creditors could be eliminated, but this isn’t possible, because anyone can file for bankruptcy. Instead, statistical methods are used to gauge the probability that one will default on a loan, or fail to pay on time.

Over the years, creditors and others have used statistical techniques to measure risk—indeed, this is the primary purpose of credit scores, which is a statistical analysis of the data in one’s credit reports that is condensed to a single number for easier comparison and processing, which measures the probability that the debtor will make timely payments on his loans, or will default. If someone in the subprime market wants better interest rates, he could simply do the things necessary to raise his credit score enough so that he will be in the prime market, but not everyone can do this. For whatever reason, some people are going to present a greater risk, and so, if they want credit, they will have to pay a higher price. If they didn’t pay a higher price, no business would extend them credit.

Thus, bankruptcy is beneficial for both individuals and society by giving people a fresh start, which is why it has been part of American law for over 100 years. When a creditor extends credit, there is always a risk it will not be paid back, even without bankruptcy, but this is the nature of the lending business. If a business doesn’t want to take this risk, then it can take some other risk by doing something else.

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