The Problem with Bankruptcy Laws
When faced with a collapsing housing market and mounting real burden of debt, it's entirely rational for households suffering negative equity to simply walk away. This is a major problem in the United States, and has exacerbated the banking crisis caused by defaulting borrowers. Many of these consumers might suffer a terrible credit rating as a result, but it still makes sense for them. It seems odd that the market would allow such an insidious example of moral hazard to wreak havoc with the banking system. The guilt of the real culprit is less surprising.
In the United States, defaulting homeowners can walk away from their problem after declaring bankruptcy under Chapter 7. There are significant advantages to this option. It allows these people to make a new start, and return to the labor market free from debt. The risk of such defaults is built into banking models, and the costs are distributed among other borrowers. However, this system has never been tested under the extremely stressful conditions of a bursting asset-price bubble. [more]