Did Bankruptcy Reform Cause Mortgage Default Rates to Rise?

30 Pages Posted: 19 May 2010

See all articles by Wenli Li

Wenli Li

Federal Reserve Bank of Philadelphia

Michelle J. White

University of California, San Diego (UCSD) - Department of Economics; National Bureau of Economic Research (NBER)

Ning Zhu

China Academy of Financial Research (CAFR); Yale School of Management; University of California, Davis - Graduate School of Management

Date Written: April 1, 2010

Abstract

This paper argues that the U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged — thus loosening debtors' budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. The authors argue that an unintended consequence of the reform was to cause mortgage default rates to rise. Using a large dataset of individual mortgages, they estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage default rates to rise. Their major result is that prime and subprime mortgage default rates rose by 14 percent and 16 percent, respectively, after bankruptcy reform. The authors also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. Overall, they calculate that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.

JEL Classification: K35, G21, G01, R21

Suggested Citation

Li, Wenli and White, Michelle J. and Zhu, Ning, Did Bankruptcy Reform Cause Mortgage Default Rates to Rise? (April 1, 2010). FRB of Philadelphia Working Paper No. 10-16. Available at SSRN: https://ssrn.com/abstract=1610264 or http://dx.doi.org/10.2139/ssrn.1610264

Wenli Li (Contact Author)

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Michelle J. White

University of California, San Diego (UCSD) - Department of Economics ( email )

9500 Gilman Drive
La Jolla, CA 92093-0508
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ning Zhu

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Yale School of Management ( email )

135 Prospect Street
Box 208200
New Haven, CT 06520-8200
United States

HOME PAGE: http://pantheon.yale.edu/~nz26/

University of California, Davis - Graduate School of Management ( email )

One Shields Avenue
Davis, CA 95616
United States
530-752-3871 (Phone)
530-752-2924 (Fax)

HOME PAGE: http://www.gsm.ucdavis.edu/Faculty/Zhu/

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