Bankruptcy Reform’s Role in the Mortgage Crisis

BANKRUPTCY REFORM’S ROLE IN THE MORTGAGE CRISIS 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. The authors argue that an unintended consequence of the reform was to cause mortgage default rates to rise. Using a large data set of individual mortgages, they estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage default rates to rise. Their major result is that prime and subprime mortgage default rates rose by 14 percent and 16 percent, respectively, after bankruptcy reform. The authors 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. Overall, they calculate 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. Working Paper 10-16, “Did Bankruptcy Reform Cause Mortgage Default Rates to Rise?” Wenli Li, Federal Reserve Bank of Philadelphia; Michelle J. White, University of California-San Diego; and Ning Zhu, University of CaliforniaDavis