Do Tougher Bankruptcy Laws Increase Mortgage Defaults?


It used to be that when people got into more financial trouble than they could manage on their own, they would declare personal bankruptcy.

Then, in 2005, U.S. bankruptcy laws became more stringent: The amount of home equity that was protected from creditors was subject to tougher rules and, along with additional costs, filing bankruptcy was not the "fresh start" for the many who had used it before.

Now the National Bureau of Economic Research (NBER) has released research that argues that the change in bankruptcy rules actually forced more homeowners into mortgage default than otherwise would have been the case. The group of economists that authored the report say that nearly 200,000 mortgages are delinquent or have gone into default because of the new laws.

Could more homeowners have held on to their homes if bankruptcy laws were preserved?
The authors of a working paper titled "Did Bankruptcy Reform Cause Mortgage Default Rates to Rise?" say the answer is yes. Authors Wenli Li of the Federal Reserve Bank of Philadelphia, Ning Zhu of the University of California, and Michelle J. White of the UC and NBER write that "an unintended consequence of the reform was to cause mortgage default rates to rise."

How? They point out that bankruptcy can free up the funds of homeowners who are carrying credit card debt and other obligations. Homeowners can then shift their funds from those debts in order to pay their mortgages. However, reform made it costlier to file for bankruptcy, and cut the amount of debt that could be unloaded.

The data is clear in one respect: The number of bankruptcy filings dropped markedly after 2005, while the default rate on mortgages climbed -- by 14 percent for prime mortgages and 16 percent for sub-prime.

But does the argument hold up?

Li, White and Zhu use all kinds of graphs and charts to prove their point. But the bigger question is, could pre-2005 bankruptcy laws really have helped all those sub-prime, ARM, and other types of mortgage-holders avoid the disaster that was to come?

Consider this: Personal bankruptcy laws were changed around the same time that mortgage-lending practices got out of hand. (No money down? No problem. Sign here.) Personal savings rates were in negative territory for part of the past decade. (It is only since the crisis that people have begun saving again).

The impact of too much credit, combined with a high unemployment rate, declining home values and a tough credit market have pushed many to the brink. Would those who suffered the double whammy of a job loss and an underwater mortgage really have been able to swim to the surface by declaring personal bankruptcy? Might they be walking away from their mortgage anyway?

While the Obama administration's loan modification program has helped about 300,000 homeowners get new loans, the year-old Making Home Affordable program, which has 637,000 households in a trial phase, has been criticized for its slow start and low number of applicants.

Even the authors of the report admit, "The Bush and Obama Administration have both tried a number of programs to deal with the housing crisis by encouraging mortgage lenders to renegotiate mortgages rather than foreclose when homeowners default. None of these programs have worked very well."

And a new report by Standard & Poor's states the default rate for mortgages decreased in the month of April, which raises a question: While it's possible that easier bankruptcy filings could help thousands more stay in their homes, with the current national unemployment rate at 9.9 percent and a personal savings rate at 2.7 percent, maybe the bad deals just need to work their way out of the system before people can truly think about a fresh start?

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