Study Finds Bankruptcy Reform Led to Rise in Mortgage Defaults

While it's undeniable that the financial crisis and recession were triggered by the bursting of the housing[IMAGE]

bubble and the subprime mortgage crisis that began in late 2006 to early 2007, a working paper recently released by the research department of the ""Federal Reserve Bank of Philadelphia"":http://www.philadelphiafed.org/index.cfm suggests that reform to personal bankruptcy law also played an important role.

According to the paper, ""Did Bankruptcy Reform Cause Mortgage Default Rates to Rise?"":http://www.philadelphiafed.org/research-and-data/publications/working-papers/2010/wp10-16.pdf, when debtors file for bankruptcy, credit card debt and other types of debt are discharged, which loosens debtors' budget constraints. As a result, homeowners in financial distress can use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages, the paper explained.

However, a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged, causing bankruptcy filings to decline sharply. In fact, according to the latest ""structured finance newsletter"":http://www.dbrs.com/research/232639?docId=232639 released by ""DBRS"":http://www.dbrs.com/, U.S. personal bankruptcy filings increased dramatically prior to the reform and then dropped to levels which were well below those experienced historically.

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The paper argues that by closing off a popular procedure that previously helped many financially distressed homeowners pay their mortgages, this reform unintentionally caused mortgage defaults rates to increase and therefore contributed to the severity of the mortgage crisis.

Wenli Li, Michelle J. White, and Ning Zhu, researchers and authors of the paper, used a large dataset of individual mortgages to test whether the 2005 bankruptcy reform actually caused mortgage defaults to rise. Each sample consisted of 300,000 to 400,000 separate mortgages used for home purchase or refinance between January 2004 and December 2005, and the researchers followed the status of these mortgages until they were repaid in full, went into default, or until the sample period ended.

Using the results from the sample period three months before to three months after bankruptcy reform, the researchers found that prime and subprime mortgage defaults rose by 14 percent and 16 percent, respectively, after the reform went into effect. In addition, they found that default rates of homeowners with high income or high assets â€" those particularly negatively affected by bankruptcy reform â€" rose even more.

Overall, the researchers calculated 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. This, they said, suggests that the reform increased the severity of the crisis when it came.

The researchers said their results suggest that a simple change such as rolling back the cost of filing for a bankruptcy to pre-2005 levels would help in dealing with the housing crisis by reducing the number of mortgage defaults.