The Effect of Bankruptcy Strip-Down on Mortgage Markets

Abstract

This paper summarizes the initial findings of our study on the effect of bankruptcy strip-down and modification on principal home residence mortgage rates, loan origination volumes, loan-to-value ratios, and bankruptcy filing rates. We tested the impact of mortgage strip-down using both current and historic mortgage data. Current mortgage rates, private mortgage insurance premiums, and Fannie Mae/Freddie Mac delivery fees indicate that mortgage markets are indifferent to bankruptcy modification risk, including strip-down. Our findings from the current mortgage data are consistent with our findings from analysis of historical data. Using mortgage data from the 1980s and 1990s, we tested whether the impact of changes in federal judicial rulings on residential mortgage strip-down - the bifurcation of an undersecured mortgage lender's claim into a secured claim for the value of the collateral property and a general unsecured claim for the deficiency. Historically, our results suggest, permitting unlimited strip-down had no effect on origination rates or the number of bankruptcy filings. It appears to have increased median mortgage interest rates slightly, but our findings are statistically distinguishable from zero effect in only some specifications. We find, however, some evidence that allowing strip-down in an unlimited regime historically had a larger impact on interest rates in states where Chapter 13 filing is more common. We also find that permitting strip-down historically resulted in a slight decrease in loan-to-value ratios and that this decrease was more pronounced for higher cost loans, incurred by presumably riskier borrowers. We explain the lack of market sensitivity to strip-down risk by reference to two sets of consumer bankruptcy data, one from 2001 and one from 2007, both of which suggests that lenders' losses in strip-down would be extremely limited both in scope and magnitude and often total less than those they would incur in foreclosure. Taken as a whole our analysis of the current and historical data suggests that permitting bankruptcy modification of mortgages would have no or little impact on mortgage markets.