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Bankruptcy Law Change Could Help Consumers Recover: Experts

As Americans struggle to pay off underwater mortgages and student loan debt, some experts say simple changes to bankruptcy law could provide many with financial relief and potentially help the economy.

David Gould | Getty Images

These experts say Congress should amend the Bankruptcy Code to allow people burdened by underwater mortgages and student loans to discharge their debts in bankruptcy, which is extremely difficult to do under the current law.

“I emphatically believe that the bankruptcy system is the best place to sort out the current consumer debt mess,” says Jason Kilborn, scholar in residence at American Bankruptcy Institute.

The pool of potential beneficiaries could be substantial.

Almost 11 million homeowners are currently underwater on their mortgages, and outstanding student loan debt is approaching $1 trillion, with delinquencies continuing to rise.

Kilborn believes the amendments could help put more money in consumers’ pockets.

Chris Christopher, a senior principal economist at IHS Global Insight, says it would be “a very positive development” since consumer spending represents more than 70 percent of the U.S. economy.

Dean Baker, co-director of the Center for Economic and Policy Research, agrees and says: “People can overplay the importance of debt relief, but it would certainly help if people could get out from under their burdens.”

The bankruptcy mortgage-debt modification would only help underwater homeowners avoid foreclosure. They would be able to write down mortgages to the current value of the home and make reduced payments.

But bankruptcy would do little for people with inadequate income whose houses are properly valued.

Kilborn believes the mortgage-related amendment would bring back stability into the housing market and by extension help put economy on a path to recovery.

“Right now, we have a valuation problem—we don’t know what these houses are really worth,” says Kilborn. “That what bankruptcy courts could solve.”

But Joshua Shapiro, chief economist at MFR, doesn’t like the idea.

“In the longer-term it would diminish the availability of credit, as lenders balk at extending credit to borrowers who have easy means of shirking their debts,” says Shapiro.

Julia Coronado, chief economist for North America at BNP Paribas, agrees and says it punishes those who were prudent. “They may also be having hard times because of the tough job market but would not receive any assistance as they never took on debt they couldn't afford.”

Kilborn disagrees and says history has proven these arguments to be baseless. He adds that the topic of debt forgiveness has always been controversial.

In 2009, lawmakers already shot down the legislation introduced by Sen. Dick Durbin to allow mortgage-debt modification in bankruptcy.

A proposalto allow a discharge of private student loans is currently pending in Congress.

Some economists go even further and call for a "Debt Jubilee" to forgive excess mortgage, student loans and credit card debt for some borrowers.

Prominent economist Stephen Roach, who is also a non-executive chairman at Morgan Stanley Asia, is one of them.

“The American consumer is going nowhere,” Roach said in an August appearance on CNBC. “If we don’t address that, all the public policy aimed at the fiscal and monetary stimuli are going to be pushing on a string.”

But Michael Feroli, chief US economist at JPMorgan Chase, says he is not convinced debt relief through bankruptcy is the best way to address the consumer debt crisis.

“Making existing contract invalid is not conducive to a healthy economy,” says Feroli.

Questions? Comments? Email us at marketinsider@cnbc.com and follow me on twitter @kfrayter

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC's Senior Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

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