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Did Bankruptcy Reform Contribute to the Mortgage Crisis?

June 04, 2011

Before 2005 bankruptcy reform, homeowners in financial distress could use bankruptcy to help save their homes. Homeowners could have their unsecured debts discharged in Chapter 7, thus freeing up funds to make their mortgage payments. Homeowners who were in default on their mortgages could stop foreclosure by filing under Chapter 13 and could use Chapter 13 repayment plans to repay their mortgage arrears over several years. Most homeowners who filed for bankruptcy were not obliged to repay anything to their unsecured creditors.
But the 2005 bankruptcy reform made filing for bankruptcy less useful as a saveyour-home procedure. Debtors’ cost of filing increased sharply after the reform. Also the homestead exemption in bankruptcy was capped at $125,000, thus making it impossible for homeowners with high home equity to keep their homes in bankruptcy. A new “means test” increased higher-income debtors’ obligation to repay their unsecured debt in bankruptcy.
Because these changes reduced homeowners’ gain from filing for bankruptcy, they reduce default rates on unsecured debt. And because homeowners’ ability-to-pay is fixed in the short-run, these changes are predicted to increase default rates on mortgages. In the paper, we test whether adoption of the 2005 bankruptcy reform led to higher rates of mortgage default. We use a large dataset of prime and subprime mortgages.
Our main result is that bankruptcy reform caused mortgage default rates to rise.
Comparing default rates three months before versus after bankruptcy reform, the increase was 36% for prime mortgages and 11% for subprime mortgages. Using a longer period of one year before versus after the reform, the increase was 50% for prime mortgages and 7% for subprime mortgages. Homeowners subject to the cap on the homestead exemption were 50% more likely to default after the reform, regardless of whether their mortgages were prime or subprime. Homeowners with subprime mortgages were 13% more likely to default if they were subject to the new means test, but default rates of those with prime mortgages did not change.