February 3, 2010

Capital Sources
Experts debate bankruptcy ‘contagion theory’

A University of Chicago economics professor posed a question in a recent guest column that is echoing
with bankruptcy lawyers across South Florida.

As high as the home foreclosure rate is, Richard Thaler wrote in The New York Times, why is the mortgage
default rate not even higher?

“After all, millions of American homeowners are ‘underwater,’ meaning that they owe more on their
mortgages than their homes are worth,” Thaler writes. “Yet most of them are dutifully continuing to pay their
mortgages, despite substantial financial incentives for walking away from them.”

The same trend, of course, extends into business and into consumer finance such as credit card usage.

Thaler poses that perhaps some homeowners keep paying because they think it’s immoral to default. But
with so many people in foreclosure, filing for bankruptcy and generally walking away from their obligations, is
that moral code coming unglued?

“An important implication is that we could be facing another wave of foreclosures, spurred less by spells of
unemployment and more by strategic thinking,” Thaler said. “Research shows that bankruptcies and
foreclosures are ‘contagious.’ People are less likely to think it’s immoral to walk away from their home if they
know others who have done so. And if enough people do it, the stigma begins to erode.”

Attorney Luis Salazar, a partner at Infante Zumpano Hudson & Miloch in Coral Gables, says he’s already
seeing it.

“I think that stigma is virtually gone,” said Salazar, who chairs the firm’s corporate reorganization and
bankruptcy department. “Given these hard economic times, people are looking at bankruptcy objectively –—
as an economic proposal. Will the debt I get rid of forever be worth the impact to my already damaged
credit?”

These days, he said, people answer by saying, ‘‘Absolutely yes!’’

Add to that the perception that the nation’s banks caused the credit mess, and “the moral barrier to filing
bankruptcy is seriously eroded,” Salazar said.

The “stigma theory” of bankruptcy has always been promoted as a barrier to filing on both the individual and
corporate side, said Scott Baena, a partner with Bilzin Sumberg Baena Price & Axelrod, and chair of the law
firm’s restructuring and bankruptcy group.

“Bankruptcy filings are higher than they’ve ever been nationally, and the percentage increase is so
significant that I don’t know if there’s all that much validity to the notion that people have been afraid of being
stigmatized,” Baena said.

As people become more aware of others undertaking bankruptcy, “I would assume that it would become a
little less stigmatic,” he said.
Steven Solomon, a partner in GrayRobinson’s Miami office, notes the fallout from the downturn in the
economy has touched a social and economic strata not typically associated with the “deadbeat” profile.

“Especially among the entrepreneurs, I hear continuing complaints about struggling sales and dwindling
margins,” Solomon said, noting that he agrees with Thaler’s conclusions. “As foreclosure, bankruptcy and
insolvency become more epidemic among this new class of debtors, the stigma associated with bankruptcy
and foreclosure will most likely lose out to the greater strategic goal. Regardless, while I agree this may lead
to perceived social acceptance, there are still long-term credit and business factors which must be seriously
considered.”

'A Human Nature Issue'

Arnstein & Lehr attorney Philip Hudson describes the dilemma

as “a human nature issue.” He said there are several reasons why
people are hanging tough for now. Beyond a moral desire to do the
right thing, there is also a natural desire to avoid change, a lack of
knowledge about alternatives and, in some cases, “no other
option.”

Hudson said that if the market begins an upward move soon, there
may not be a second round of foreclosures, but if it moves in the
other direction, there almost certainly will.

“We see banks finally pulling the trigger on foreclosures, so the

next six to 12 months will be interesting,” he said.

Thaler cites a paper by Brent White, a University of Arizona law

professor who argues that borrowers suffer from “norm
asymmetry,” a sense of obligation to repay loans because it’s the
right thing to do, even if it is not in their financial interest, while their lenders do whatever it takes to
maximize profits.

“That norm might have been appropriate when the lender was the local banker,” Thaler writes. “More
commonly these days, however, the loan was initiated by an aggressive mortgage broker who maximized
his fees at the expense of the borrower’s costs, while the debt was packaged and sold to investors who
bought mortgage-backed securities in the hope of earning high returns, using models that predicted possible
default rates.”

Of course, there are other factors in play that keep the payment checks coming, including moving costs,
emotional ties and detrimental effects on credit ratings. Even then, Thaler notes, these costs might in some
cases be less than the cost of paying off an underwater mortgage.
Attorney Thomas Lehman, a partner at Levine Kellogg Lehman Schneider & Grossman in Miami, said one
place where he has not seen a contagion is with corporations.

“They’re trying to work deals out,” Lehman said. “Generally, businesses have individuals who guarantee
debt, unless they’re publicly traded. So there are all kinds of incentives to work things out. There is a limited
amount of capital for funding a bankruptcy.”

Baena said any reluctance on businesses’ part to file bankruptcy is not based on stigma. “Obviously, today,
corporate bankruptcy bears no stigma at all, virtually,” he said. “But I can assure you 20 years ago, it was
anathema for most business people.”

Lehman said changes to the bankruptcy code in 2005 make it extremely unpleasant for an individual to file
bankruptcy.

“Some of the advantages of being a Florida resident filing for bankruptcy have been reduced by the
amendments Congress adopted five years ago,” he said. “Now, there’s a careful examination of the conduct
of the debtor… and how they have handled the assets that they have.”
Lehman says he advises against individual bankruptcies “unless their life is so miserable because of
creditors with judgments disrupting their life. If they’re still in foreclosure, try to work something out where
you give the property back to the lender.”

Only when the lender tries to collect a money judgment against the borrower does it get to be miserable and
disruptive, Lehman said.

“I think that there are situations where people have some sort of moral compass and say, ‘This is just not
right,’ ” Solomon said. He does believe that fiscally responsible people who got into financial distress
through no fault of their own will be seen more as victims if they end up in foreclosure or bankruptcy.

“There is a rationalization that ‘this is not my fault,’ that ‘I did everything I could,’ ” Solomon said. “I think with
that comes a little more social acceptance. There are lots of new justifications that we didn’t have before,
where people are not in these situations because of their own personal mismanagement.”

Conditions Cited

Baena said it’s common today to hear businesses in bankruptcy cite macroeconomic conditions, whether or
not their position is justified. “It’s certainly one way to deflect from any personal responsibility.”

Thaler turns to a pair of University of Chicago colleagues, Eric Posner and Luigi Zingales, for one possible
solution: “Any homeowner whose mortgage is underwater and who lives in a ZIP code where home prices
have fallen at least 20 percent should be eligible for a loan modification.

“The bank would be required to reduce the mortgage by the average price reduction of homes in the
neighborhood. In return, it would get 50 percent of the average gain in neighborhood prices — if there is one
— when the house is eventually sold.”

That would get homes back to the surface and motivate homeowners to hang in because “if they later sold
for more than the average price increase, they would keep all the extra profit.”

Thaler’s argument is that while lenders are only reluctantly renegotiating mortgages, and banks are unlikely
to sign on as long as people pay on their mortgages, a new wave of foreclosures could bring them around to
the idea.

“Rather than getting only the house’s foreclosure value, they would also get part of the eventual up side
when the owner voluntarily sold the house,” Thaler says. “This plan, which would require congressional
action, would not cost the government anything. It may not be perfect, but something like it may be
necessary to head off a tsunami of strategic defaults.”

Solomon said while some may be more justified than others in giving up on their debts, no one should do so
without making every effort to avoid it.

“People should do whatever they can reasonably do to work out their financial issues,” he said. Bankruptcy
and foreclosure are “not an appropriate way for us to get the economy back in shape.”

Wayne Tompkins can be reached at wtompkins@alm.com or at (305) 347-6645.