The Price of Inequality: How Today's Divided Society Endangers Our Future (31 page)

B
ANKRUPTCY
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AW

A host of other laws and regulations shape the market and thereby affect the distribution of income and well-being. Bankruptcy law (which specifies what happens when an individual or a corporation can’t pay back what is owed) has particular relevance to two parts of our society—those at the top (the bankers) and those at the bottom, who struggle to make ends meet.

Bankruptcy law is designed to give individuals a fresh start. The notion that under certain conditions debts should be forgiven has a long tradition that goes back at least as far as the Book of Leviticus, where debts were forgiven in the Jubilee year. Virtually every modern economy has a bankruptcy law. These laws can be either more debtor or more creditor friendly, making it easier or more difficult to discharge debts. How they are shaped obviously has strong distributional consequences, but the incentive effects can be equally powerful. If debts can’t be discharged, or can’t be discharged easily, lenders have less of an incentive to be careful in lending—and more of an incentive to engage in predatory lending.

In 2005, just as subprime mortgages were starting to boom, Congress passed a new creditor-friendly bankruptcy law that gave the banks even more of an upper hand, making it more difficult for distressed borrowers to discharge their debts. The change in the law introduced a system of “partial indentured servitude.” An individual with, say, debts equal to 100 percent of his income could be forced to hand over to the bank 25 percent of his gross, pretax income for the rest of his life. This is because the bank could add on, say, 30 percent interest each year to what a person owed. In the end, a mortgage holder would owe far more than the bank ever lent. The debtor would end up working, in effect, one-quarter time for the bank.
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Every loan has a willing lender and a willing borrower; the banks are supposed to be financially sophisticated, to know how much debt individuals can manage. But a distorted financial system put more emphasis on the up-front fees that showed up quickly in the banks’ bottom line than on the losses that might be incurred further down the line. Emboldened by the new bankruptcy law, they felt they could somehow squeeze money out of their hapless borrowers, whatever happened to the housing market and unemployment. This reckless lending, combined with deceptive practices and sometimes usurious interest rates, has put many households on the brink of financial ruin. In spite of so-called reforms, banks still sometimes charge rates nearing 30 percent a year (which means that a $100 debt can grow to $1,000 in a short span of nine years). On top of this, they can impose crippling fees. While some of the worst abuses have been curbed, such as those associated with overdrafts (which generated literally billions of dollars a year in profits
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—money taken out of the pockets of ordinary citizens), many continue.

When the new bankruptcy law was passed, property rights were changed, but in a way that favored the banks. At the time the borrowers had incurred their debt, a more humane bankruptcy law gave them a chance for a fresh start if the burden of debt repayment became too onerous. The banks didn’t complain about this change in property rights; after all, they had pushed for it vociferously. When things go the other way, of course, the owners of property complain that the rules of the game are being changed midcourse and demand compensation.
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Student loan programs

We saw earlier that inequality in the United States has been rising steeply and is likely to continue to increase. One of the reasons is the growing inequality of opportunity, related in part to educational opportunity. Young people and their parents know the importance of education, but we have created a system where the striving for education may actually be leading to more inequality. One reason for this is that over the past twenty-five years, the states have been withdrawing support from higher education.
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This problem grew in the recession.

Another reason is that aspiring students are becoming increasingly indebted.
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The 2005 bankruptcy law made it impossible for students to discharge their student debts even in bankruptcy.
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This eviscerates any incentives for banks, and the for-profit schools that they work with, to provide an education that will yield a return.
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Even if the education is worthless, the borrower is still on the hook. And for many students, the education is frequently almost worthless. Some 80 percent of the students do not graduate,
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and the real financial rewards of education come only upon completion of the programs—and even then they may not materialize. But in this conspiracy between the for-profit schools (many owned partly or largely by Wall Street firms) and the for-profit banks, the students are never warned. Rather than “Satisfaction guaranteed or your money back,” the reality is “Dissatisfaction is almost guaranteed, but you will be saddled with these debts for the rest of your life.” Neither the schools nor the lenders say, “You are almost certain
not
to get a good job, of the kind you dream of. We exploit your dreams; we don’t deliver on our promise.” When the government proposed standards—schools would qualify for government backed loans only if there was an adequate completion rate and enough student satisfaction, with at least a minimal number of students getting the jobs that were promised—the schools and the banks fought back, largely successfully.

It wasn’t as if the government was trying to regulate a private industry that was seemingly doing well on its own (though partly by exploiting the poor and less informed). The for-profit schools existed largely because of the federal government. Schools in the $30 billion a year for-profit education industry receive as much as 90 percent of their revenue from federal student loan programs and federal aid. They were enjoying the more than $26 billion they were getting from the federal government; it was enough money to make it worthwhile to invest heavily in lobbying and campaign contributions, to make sure that they were not held accountable.
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In the case of student loans, the banks managed for years to get rewards with almost no risk: in many instances, the government guaranteed the loans; in others, the fact that the loans can never be discharged—they are bankruptcy proof—makes them safer than other loans to similar individuals. And yet the interest rate charged to students was incommensurate with these risks: the banks have used the student loan programs (especially those with government guarantees) as an easy source of money—so much so that when the government finally scaled down the program in 2010, the government and the students could, between them, pocket tens of billions of dollars that previously had gone to the banks.
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America sets the pattern

Usury (charging exorbitant interest rates),
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of course, is not limited to the United States. In fact, around the world the poor are sinking in debt as a result of the spread of the same rogue capitalism. India had its own version of a subprime mortgage crisis: the hugely successful microcredit schemes that have provided credit to poor farmers and transformed their lives turned ugly once the profit motive was introduced. Initially developed by Muhammad Yunus of the Grameen Bank and Sir Fazle Hasan Abed of BRAC in Bangladesh, microcredit schemes transformed millions of lives by giving the poorest, who had never banked, access to small loans. Women were the main beneficiaries. Allowed to raise chickens and engage in other productive activities, they were able to improve living standards in their families and their communities. But then for-profit banks discovered that there “was money at the bottom of the pyramid.”
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Those on the bottom rung had little, but they were so numerous that taking a small amount from each of them was worth it. Banks all over the world enthusiastically embraced microfinance for the poor. In India the banks seized upon the new opportunities, realizing that poor Indian families would pay high interest rates for loans not just to improve livelihoods but to pay for medicines for sick parents or to finance a wedding for a daughter.
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They could cloak these loans in a mantle of civic virtue, describing them as “microcredit,” as if they were the same thing that Grameen and BRAC were doing in neighboring Bangladesh—until a wave of suicides from farmers overburdened with debt called attention to the fact that they were
not
the same.

T
HE
M
ORTGAGE
C
RISIS AND THE
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DMINISTRATION OF THE
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ULE OF
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When the subprime mortgage crisis finally broke wide open, precipitating the Great Recession of 2008, the country’s response to the ensuing flood of foreclosures provided a test of America”s “rule of law.” At the core of property rights and consumer protection are strong procedural safeguards (such as record keeping) to protect those who enter into contracts. Such safeguards were in place to protect homeowners as well as lenders. If the bank claimed that a person owed it money, then by law it had to provide proof before it could just throw someone out into the streets. When a mortgage (an IOU from a homeowner to a lender) is transferred from one lender to another, then by law a clear record of what the borrower has repaid, and what he owes, must accompany the mortgage.

The banks had issued so many mortgages, so rapidly, that they had given short shrift to basic procedural safeguards. And as the banks and other lenders rushed to lend more and more money, not surprisingly fraudulent practices became endemic. FBI investigations spiked.
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The combination of frequent fraudulent practices and a disregard of procedural safeguards was lethal.

The banks wanted a speedier and less costly way of transferring claims, so they created their own system, called MERS (Mortgage Electronic Registry System), but, like so much of what the banks had done in the gold rush days, it proved to be a deficient system, without safeguards, and amounted to an end run around a legal system intended to protect debtors. As one legal expert put it, “MERS and its members believed that they could rewrite property law without a democratic mandate.”
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When the housing bubble finally burst, the dangers of banks’ recklessness in lending and record keeping became apparent. By law, banks were supposed to be able to prove the amounts owed. It turned out that in many cases, they simply could not.

All of this has complicated the process of cleaning up the ensuing mess. The sheer numbers of mortgages in default, running in the millions, made the task even worse. The immensity of the task led the banks to invent “robo-signing.” Instead of hiring people to examine records, to verify that the individual did owe the amount claimed, signing an affidavit at the end that they had done so, many banks arranged for a single person to sign hundreds of these affidavits without even looking at the records. Checking records to comply with legal procedure would hurt the bank’s bottom line. The banks adopted a policy of
lying to the court
. Bank officers knew this—the system was set up in a way that made it impossible for them to examine the records, as they claimed to have done.

This brought a new twist to the old doctrine of too-big-to-fail. The big banks knew that they were so big that if they lost on their gambles of risky lending they would have to be bailed out. They also knew that they were so big that if they got caught lying, they were too big and powerful to be held accountable. What was the government to do? Reverse the millions of foreclosures that had already occurred? Fine the banks billions of dollars—as the authorities should have done? But this would have put the banks again in a precarious position, requiring another government bailout, for which it had neither the money nor the political will. Lying to a court is normally a very serious matter. Lying to the court routinely, hundreds of times, should have been an even greater offense. There was a true pattern of crime. If corporations had been people
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in a state that enforced a “three strikes” rule (three instances of shoplifting, and one faces a mandatory life sentence), these repeat offenders would have been sentenced to multiple life sentences, without parole. In fact, no bank officer has gone to jail for these offenses. Indeed, as this book goes to press, neither Attorney General Eric Holder nor any of the other U.S. district attorneys have brought suits for foreclosure fraud. By contrast, following the savings and loan crisis, by 1990, the Department of Justice had been sent 7,000 criminal referrals, resulting in 1,100 charges by 1992, and 839 convictions (of which around 650 led to a prison sentence).
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Today the banks are simply negotiating what their fines should be—and in some cases the fines may be less than the profits that they have garnered from their illicit activity.
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What the banks did was not just a matter of failing to comply with a few technicalities. This was not a victimless crime. To many bankers, the perjury committed as they signed affidavits to rush the foreclosures was just a detail that could be overlooked. But a basic principle of the rule of law and property rights is that you shouldn’t throw someone out of his home when you can’t prove he owes you money. But so assiduously did the banks pursue their foreclosures that some people were thrown out of their homes who did not owe any money. To some lenders this is just collateral damage as the banks tell millions of Americans they must give up their homes—some eight million since the crisis began, and an estimated three to four million still to go.
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The pace of foreclosures would have been even higher had it not been for government intervention to stop the robo-signing.

The banks’ defense—that most of the people thrown out of their homes did owe money—was evidence that America had strayed from the rule of law and from a basic understanding of it. One is supposed to be innocent until proven guilty. But in the banks’ logic, the homeowner had to prove that he was not guilty, that he didn’t owe money. In our system of justice it is unconscionable to convict an innocent person, and it should be equally unconscionable to evict anyone who doesn’t owe money on her home. We are supposed to have a system that protects the innocent. The U.S. justice system requires a burden of proof and establishes procedural safeguards to help meet that requirement. But the banks short-circuited these safeguards.