Did Bankruptcy Reform Cause Mortgage Default to Rise?

[blockhead]

http://papers.nber.org/papers/w15968

by

Wenli Li, Michelle J. White, Ning Zhu

National Bureau of Economic Research

(text from link below)

This paper argues that the U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged—thus loosening debtors’ budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise.

We estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage defaults to rise, using a large dataset of individual mortgages. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. We find that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.

[newbie2]

No. Unemployment did.

[blessed]

That's what I was going to say, unemployment. People don't just walk away from their homes because they CAN. They do it out of necessity.

[HHM]

I saw that article. Not sure I agree with it. When I read it, I was left asking the question, okay...but what mechanism in the BK code is the culprit, I can't think of any.

There were no meaningful changes to the BK law in 2005 as it relates to how mortgages were treated.

At best there are 2 things that contributed.
1. on the margins, about 10% of filers who probably would have been chap 7 under old law are now 13 and their financial position was just too precarious to be in a chapter 13 (too large a mortgage in the first place)_.
2. The mandatory 60 month length of the chapter 13. This is causing the biggest problems.

The cause of the mortgage crisis is unemployment and banks making loans beyond the means of the borrower (50% payment to income ratios, etc).

[helpmeout]

No, it wasn't the bankruptcy reform act. It was a combination of items. The major ones being unemployment and the banks for approving just anybody without looking at the whole picture. They approved me even though the mortgage payment (with tax added) was at least 90% of my salary alone at the time (the child support was also used as income, which is why I qualified). They also didn't take into consideration that my childcare costs averaged $1,100 a month. It's not just the debt ratio that they need to look at.

And then there's the people who bought homes using an ARM. This allowed them to buy homes that they couldn't afford to buy if they were obtaining a fixed rate mortgage. And when the interest went up, they were in trouble.