Don't let it get away!
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Henry Ford did it. Walt Disney had to do it. Even Sam Walton went through it. Yet with so many eventual success stories coming from people who hit rock bottom financially and took advantage of bankruptcy protection rather than repaying their debts, why are today's homeowners getting treated like garbage for walking away from their underwater mortgages?
Few things provoke more controversy these days than homeowners who decide that they're too far in debt on their homes ever to pay off their mortgages. Yet while many turn financial decisions into a hotbed of moral argument, it's America's protection of those who fail financially that has given some of the country's best-known entrepreneurs the courage and support they needed in order to succeed eventually.
The ultimate safety net
Historically, those who couldn't pay off their debts were dealt with harshly. Debtors' prisons existed solely for borrowers who didn't repay their creditors, and extreme physical punishments were often imposed.
Against that backdrop, the U.S. system of bankruptcy stands out for its relative leniency on debtors. The Constitution called for Congress to establish uniform federal bankruptcy laws, and although several fits and starts resulted in temporary bankruptcy laws, it wasn't until 1898 that a permanent bankruptcy code took its place in American law.
The idea behind today's federal bankruptcy laws is simple: By giving relief to borrowers who have little or no chance to recover from their financial difficulties, bankruptcy provides a fresh start to those who would otherwise likely spend the rest of their lives in futile attempts to repay their debts. Although you'll always be able to find some who abuse the bankruptcy system, both creditors and debtors alike have full knowledge that the system exists -- and each should structure its finances accordingly.
The availability of bankruptcy protection also acts as a powerful incentive. When individuals and businesses know that they can start over in the event of a cataclysmic financial event, then they can afford to take much greater risks than they would if they had to bear the full cost of potential failure themselves.
In addition, bankruptcy can resurrect companies from an early grave. PG&E's Pacific Gas & Electric utility subsidiary filed for bankruptcy protection in early 2001 and took years to restructure its debts. Yet even the original shareholders didn't lose out, as the stock rose from a low of $6.50 during the bankruptcy proceedings to its current level around $44. Similarly, USG faced liability problems related to potential asbestos exposure, yet the stock went from $4 to as high as $100 before falling back in the aftermath of the housing bust.
More often, of course, bankruptcy is far from a win-win scenario. Shareholders of General Motors, for instance, emerged with nothing, and even bondholders didn't get full recoveries. Bankruptcy wiped out previous Kmart shareholders in 2002, but Eddie Lampert gained control of the post-bankruptcy company and rode strong share gains to buy out rival Sears and created Sears Holdings a couple years later.
Entire industries have stayed afloat with the aid of bankruptcy. Among airlines, for instance, US Airways has gone through bankruptcy multiple times. Several other major airlines, including Delta in 2005, have had to file at least once.
Dealing with homeowners
Against this backdrop, does it really make sense to demonize homeowners who walk away from their mortgages? Even though Wells Fargo (NYSE: WFC ) , Bank of America (NYSE: BAC ) , and other institutions that served hard-hit real estate markets suffered big losses, they certainly must have understood the risks involved in making nonrecourse mortgage loans.
With no incentive to pay off underwater mortgages and every incentive to get the fresh start offered by walking away, mortgage borrowers are simply making the economic choices that countless individuals and corporations have made before them. And in fact, letting homeowners get a quick fresh start rather than forcing them to linger in financial difficulty for years or even decades is the fastest way to stimulate a true recovery.
Before you conclude that underwater homeowners are all immoral for choosing to breach their contracts and give up on their obligations, consider that bankruptcy laws that have existed for more than a century have long given borrowers similar rights. There will always be winners and losers when debtors give up the ghost. But overall, experience has shown that leniency in bankruptcy does more good than harm for society as a whole. That's arguably one of the most important success stories of the American experiment.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.