The Effect of Principal Reduction on Household Distress: Evidence from Mortgage Cramdown

Abstract

Mortgage cramdown enabled bankruptcy judges to discharge the underwater portion of a mortgage during Chapter 13 bankruptcy until the Supreme Court disallowed this practice in 1993. We investigate the impact of mortgage cramdown on household distress exploiting the random assignment of cases to judges. We find that a successful bankruptcy filing reduced the three-year foreclosure rate by 27 percentage points in courts that allowed cramdown. These bankruptcy benefits were reduced by more than half after the Supreme Court disallowed cramdown. Our results suggest that large principal reductions considerably reduce homeowners’ distress.

Keywords: Debt Relief, Principal Reduction, Debt Overhang, Foreclosures, Consumer Bankruptcy, Housing Policies