Morgan Housel | The Motley Fool Investor: Trump, Truman and bankruptcy

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Donald Trump has bankrupted businesses. And he's damn proud of it.

After being criticized for past bankruptcies at a recent presidential debate, he rebutted:

"First of all, like many other very big businessmen ... almost all of them, they've all used the chapter laws, the bankruptcy laws, to their own benefit ...

"Now hundreds of companies I've opened. I've used (bankruptcy) three times, maybe four times. Came out great ... I'm glad I did it.

"Four times I've taken advantage of the laws. And frankly, so has everybody else in my position.

"I used the laws of the country to my benefit, I'm sorry."

He's right that bankruptcy is common. More than 50,000 businesses filed for bankruptcy in 2013. About the same number of people filed for personal bankruptcy in 2010 as earned Bachelor's degrees (1.6 million). We really like our second chances.

Not that common

But we haven't always been as nonchalant toward bankruptcy as Trump describes. Ironically, a former president spent a quarter of his life in financial ruin because he refused to use the bankruptcy code.

Twenty years before he was president, Harry Truman owned a men's clothing store. It thrived for a while, but a recession in 1921 sent sales plunging.

Truman tried deep discounts to save the store. It didn't work. The business failed in 1922, deeply in debt.

But Truman and his partners didn't file bankruptcy. As David McCullough wrote in his biography of Truman, they willingly kept paying their debts decades after the store closed:

"After much discussion, the partners decided not to file for bankruptcy — and thereby wipe out their debts — but to try to pay off their creditors as best they could, little by little as time went on ... Fifteen years after the store went under, Harry would still be paying off on the haberdashery, and as a consequence would be strapped for money for 20 years."

Truman and his partners found it immoral to leave creditors with losses. The store's failure was the owners' fault, not the lenders'. Debt was to be repaid no matter how long it took. In 2012, the Truman Library paid a $7 debt the former president allegedly owed a paperboy from 1947.

Rarer than now

How common was this practice? It's hard to say. But we know for sure: Bankruptcy filings were far more rare in Truman's day than they are today. Personal bankruptcies per capita are more than 80 times higher today than they were 100 years ago.

From 1960 to 2004 the U.S. economy grew by an average of 3.4 percent per year, while bankruptcy filings grew more than 8 percent a year.

There are a few reasons why.

Bankruptcy today is a pretty orderly process. In most cases you file, your credit score is ruined, you move on.

In the past it left people devastated, with bankruptcy judges foreclosing assets with so little sympathy that people were left nearly starving. In his book on life during the 1930s, Frederick Lewis Allen wrote of communities left so penniless by bankruptcy that "a mob dragged a judge from his courtroom, beat him, hanged him by the neck till he fainted — all because he was carrying out the law."

In his biography of the Great Depression, lawyer Benjamin Roth describes neighbors showing up at liquidation auctions to buy foreclosed assets on the cheap to be returned to their former owners. "Mobs of angry farmers gathered at bankruptcy proceedings and farm auctions, carrying clubs and swinging a noose around a nearby tree to deter outside bidding," he wrote. "A New York Life Insurance officer was attacked by a mob when he offered a price for a farm that was less than the value of the mortgage."

The laws changed over the years to make bankruptcy friendlier for borrowers. The Chandler Act of 1938 introduced debt reorganization, creating a softer way to start over. The Bankruptcy Reform Act of 1978 gave borrowers more rights and streamlined the filing process.

The social stigma of bankruptcy also shifted. Rafael Efrat of California State University Northridge found "a noticeable shift, beginning in the 1960s, in public attitudes toward individuals filing personal bankruptcy."

He explained: "People began to ascribe more sympathetic feelings toward the bankrupt. This sympathetic mind set was largely due to a shift in societal attribution of fault for financial failure." Banks started looking like the bad guys who got borrowers into trouble. Gainfully employed borrowers bragged about walking away from their mortgages during the housing crash, like it was an honorable thing to do.

Trump echoed this view. "Let me just tell you about the lenders," he said at the debate. "These lenders aren't babies. These are total killers. These are not the nice, sweet little people, OK?"

OK.

What works better?

What I want to know is, which system was better? Truman's day of honoring your debts, or Trump's day of walking away with pride?

Those who lived through the Great Depression held a lifelong aversion to borrowing. To the extent this is a good thing — banking and credit crises were rare in the decades after — harsh bankruptcy laws kept people out of trouble. Truman never waded back into debt-fueled life. Trump has.

And no one should want borrowers who are able to pay their debts to walk away because it's convenient, like we saw in the housing crash. Companies owned by private equity firms do this, too. Lenders can price in the odds of a business failing. It's far more difficult to price in the odds of greed exploiting a loophole. And the cost is ultimately paid by more honorable borrowers. Strict laws here make a lot of sense.

But every smart invention was the result of an experiment, not all of which are successful. For capitalism to work, the whole system — entrepreneurs, investors, bankers, consumers — has to accept that failure is not only an option, but desirable. We're doing something terribly wrong if lots of companies aren't going down in flames each year, and something far worse if we're not giving their former owners a second chance. A forgiving bankruptcy code helps that process. There's a positive correlation between loose bankruptcy laws and entrepreneurship. So much of why America innovates better than other countries is because we accept that a failed business doesn't mean a failed person, or even a failed idea. Everyone gets a second shot. And that's a great thing.


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