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Friday, December 12, 2008

Bankruptcy Reform Caused More Foreclosures

This research is from the NY Fed. It finds that bankruptcy reform shifted default risk from credit card lenders to mortgage lenders and in doing so increased the number of foreclosures:

Seismic Effects of the Bankruptcy Reform, by Donald P. Morgan, Benjamin Iverson, and Matthew Botsch, Federal Reserve Bank of New York Staff Reports, no. 358, November 2008: Is it just coincidence that the surge in subprime foreclosures that has rocked financial markets came right after the bankruptcy reform in 2005 (Chart 1)? Is that surge just about falling home prices, bad mortgage decisions, and weak economic conditions? No and no. Indeed, we would be surprised if the answers were otherwise. Bankruptcy is about protection, after all, and foreclosure is what mortgagors most want to protect against. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the first overhaul of U.S. personal bankruptcy law in over a quarter century, made filing bankruptcy much less protective and much more expensive. How could that not matter?

Bac_2

Our specific argument is that the bankruptcy abuse reform (BAR) contributed to the surge in subprime foreclosures by shifting risk from credit card lenders to mortgage lenders. Before BAR, any household could file Ch. 7 bankruptcy and have credit cards and other unsecured debts discharged. Sidestepping unsecured debts left more income to pay the mortgage. BAR blocked that maneuver by way of a means test that forces better-off households who demand bankruptcy to file Ch. 13, where they must continue paying unsecured lenders. When the means test binds, cash constrained mortgagors who might have saved their home by filing Ch. 7 are more likely to face foreclosure. ...

The estimated impact of BAR on subprime foreclosures is substantial. [It] translates to just over 32,000 more subprime foreclosures nationwide per quarter due to BAR. Auxiliary findings suggest BAR also contributed to subprime foreclosures through another channel. Before BAR, the difference between the par value of an automobile loan and the current value of the automobile securing the loan could be discharged under bankruptcy.

BAR prohibits cram-down for cars owned less than 910 days. ... BAR contributed to foreclosures on subprime mortgagors by making auto lenders more secure. ...

Taken together, our research adds the bankruptcy reform to the list of reasons why subprime foreclosures surged. ...

There have been nearly twelve quarters since BAC went into effect in January 2006, call it 11 2/3. At 32,000 extra foreclosures per quarter, that comes to a bit over 373,000 additional foreclosures due to the new bankruptcy reform law.

That's on the negative side, but credit card companies are probably better off, and credit card abuse may be down. So what's the impact overall?:

The welfare impact of BAR is beyond our ken. That calculus depends firstly on the tradeoff between the insurance that soft bankruptcy laws provide and the moral hazard (abuse) such insurance invites, and secondly on how successfully BAR curbs bankruptcy abuse.

So it comes down to, basically, a comparison of the insurance benefit that is available when unforeseen catastrophic events hit a household (e.g. health problems), and the abuse induced by moral hazard. I place a high premium on the insurance value, and would rather leave it to the credit card companies to monitor credit more effectively instead of having them rely upon courts to do it for them, so I see the welfare change as negative.

    Posted by on Friday, December 12, 2008 at 02:43 PM in Economics, Housing, Policy | Permalink  TrackBack (0)  Comments (37)

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