Bankruptcy, mortgage default, and foreclosure

Chris Farrell From chief economics correspondent Chris Farrell

Paul has been closely looking into foreclosures in Minnesota. With good reason: One of the more disturbing aspects of the recent financial crisis is how foreclosures soared while bankruptcies were relatively muted. It’s a real shift from previous experience.

To be sure, both foreclosure and bankruptcy are ways for financially distressed households to default on their mortgage. But foreclosure is far more damaging to neighborhoods than bankruptcy. So what accounts for the change? A major culprit is the dramatic shift in bankruptcy law in 2005.

This comes under the category of incentives matter.

In previous periods of economic turbulence, American households traditionally got out from under their onerous debts by declaring bankruptcy. They got a “fresh start” a “second chance.” The old bankruptcy law, in effect since 1978, was considered housing-friendly. Most distressed borrowers favored filing under Chapter 7, essentially a cheap, quick “debt liquidation” that in practice often allowed debtors to keep their homes. The rest of their property and assets were sold off to pay down unsecured debts, such as credit cards and medical bills.

Lenders complained bitterly for years that filing for bankruptcy was much too easy. There was no stigma left against filing. Yet the fact is that since financially strapped Americans could write off their credit card and other consumer debts, they had more money available to pay their mortgages.

The 2005 bankruptcy law was explicitly designed to be more pro-creditor. For one thing, only low-income borrowers could still file for Chapter 7. Everyone else is automatically put into Chapter 13, which forces households to accept five-year repayment plans of all debts — secured and unsecured. In other words, they’re still trying to make car, credit card, medical, and other bills that used to be discharged in Chapter 7.

That makes the mortgages more onerous. And while filing for Chapter 13 temporarily halts foreclosure proceedings, the protection only lasts as long as the borrower is making mortgage payments. The fees for filing for bankruptcy were also hiked. (You can learn more about the change in the American Radioworks documentary, Bankrupt: Maxed Out in America.)

The result: More people ended up in foreclosure, leaving lenders holding the bag. The new law caused an additional 800,000 mortgage defaults and 250,000 additional foreclosures to occur in each of the past several years, estimate economists Wenli Li

of the Federal Reserve Bank of Philadelphia and Michelle J. White of the University of California, San Diego in their paper Bankruptcy, mortgage default, and foreclosure You can read a summary of their paper here.

The scholars argue that foreclosure is a bad way to deal with the pressure to default on a mortgage. “Foreclosures have very high social costs, many of which are not borne by either borrowers or lenders,” they write. “The external costs of foreclosure instead fall residents of neighborhoods that become blighted because of foreclosures and on residents of towns and cities that are forced to cut public services because foreclosures caused property values and property tax revenues to fall.”

Instead, they advocate for lowering the cost of filing and more troubled homeowners should be encouraged to file for bankruptcy rather than go into foreclosure. In other words, let’s go back to the more housing friendly version of bankruptcy law.

They’d also like to see the foreclosure laws changed to make the process longer and more expensive for lenders. After all, economists know that incentives matter and a more costly foreclosure process for lenders will encourage them to modify mortgages rather than foreclose on homeowners.

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