Did Bankruptcy Reform Contribute to the Mortgage Crisis?

Abstract

Before 2005 bankruptcy reform, debtors could file for bankruptcy and have their unsecured debt discharged in Chapter 7 without losing their homes, as long as their home equity was less than their state’s homestead exemption. Chapter 7 bankruptcy thus made it easier for financially distressed homeowners to meet their mortgage payments and keep their homes. But the 2005 bankruptcy reform made filing for bankruptcy less attractive. First, debtors’ cost of filing for bankruptcy increased sharply after the reform. Second, a new “means test” prevents some higher-income debtors from filing under Chapter 7. Third, the homestead exemption in Chapter 7 bankruptcy is capped at $125,000 for some debtors who live in high-exemption states. Because these changes reduce the debtors’ gain from filing for bankruptcy, they reduce debtors’ likelihood of defaulting on their unsecured debt. And because debtors’ ability-to-pay is fixed in the short-run, they increase debtors’ likelihood of defaulting on their mortgages. In the paper, we test whether adoption of the 2005 bankruptcy reform led to higher rates of mortgage default. We examine a three month period before versus after bankruptcy reform in order to separate the effect of bankruptcy reform from the effect of the financial crisis. We also plan to extend the analysis to examine how default rates changed in 2007-08 after the mortgage crisis began. We use the McDash mortgage dataset, which includes detailed information for a large sample of mortgages, including detailed characteristics of the mortgage at the time of origination and information on whether/when the debtor defaulted. Both prime and subprime mortgages are included. Our main results are, first, that bankruptcy reform caused mortgage default rates to rise, at least temporarily. The increase was 45% for prime mortgage-holders and 22% for subprime mortgage-holders. Second the new means test in bankruptcy caused mortgage default rates to rise by more for higher-income debtors: default rates of prime and subprime mortgage-holders who are subject to the means test increased by 26% and 22%, respectively, relative to the increase for lower-income debtors not subject to the means test. But we did not find a significant impact of the cap on homestead exemptions. We are currently expanding our tests to a longer period to see if the effect of bankruptcy reform on mortgage default rates continued into the financial crisis.