The Impact of State Foreclosure and Bankruptcy Laws on Higher-Risk Lending: Evidence from FHA and Subprime Mortgage Originations

Abstract

State foreclosure and bankruptcy laws govern the rights of mortgage lenders and borrowers during foreclosure and bankruptcy proceedings and thereby affect lenders’ exposure to credit risk. This paper seeks to understand the impact of these laws on the types of mortgages originated. The empirical identification is based on state-level variations in foreclosure and bankruptcy laws and a border estimation strategy. We find that higher-risk loans (FHA and subprime loans) are more likely to be originated in states with lender-friendly foreclosure laws. Also, higher-risk loans are less likely to be originated in states with a more generous bankruptcy homestead exemption. In addition, our results are consistent with the idea that FHA and subprime loans share a similar clientele and are close substitutes. These results are robust without the ordering assumption among conventional prime, FHA and subprime loans.