Bankruptcy Reform Contributed to Foreclosure Crisis

By admin • May 19th, 2010

According to a WSJ report, Wenli Li of the Federal Reserve Bank of Philadelphia made some strong arguments regarding repealing the bankruptcy laws.  She notes of the serious consequences that arose from the tightening of the federal bankruptcy laws in 2005 that contributed to a significant increase in home loan defaults.  The study concluded that the bankruptcy changes led to an additional 200,000 mortgage loan defaults per year.   The legislation raised the cost of filing for bankruptcy and reduced the amount of debt that it wipes out. As we reported recently, people whose home loan payments are reduced through loan modifications find themselves buried in other debt as well. The loan-modification experience could be compared to using a “Small Band-Aid to try to cover up a mortar-sized wound”.  She contends that we have been relying too heavily on that limited foreclosure prevention-methods partly because another more complete form of debt relief, bankruptcy, is no longer as attractive to consumers.

Bankruptcy has always been a way for distressed borrowers to save their homes by allowing them to shed other debts and concentrate their resources on mortgage payments. But the 2005 legislation raised the costs of filing for bankruptcy and decreased the amount of debt that is wiped out. “We argue that an unintended consequence of reform was to cause mortgage defaults to rise,” the paper says.

The WSJ article considers the mortgage loans originated in 2004 and 2005 and concludes that the bankruptcy changes led to an additional 200,000 mortgage defaults per year. The paper doesn’t provide estimates for mortgages originated after 2005.  Of course, shoddy mortgage lending standards and crashing home prices would have led to an epidemic of mortgage defaults in any case.

According to the Mortgage Bankers Association nearly 8 million American households–around 15% of those home mortgages were late on their mortgage payments at the end of 2009.  The bankruptcy-law changes may have made a terrible situation even worse.  The authors of the paper suggest “rolling back” the cost of filing for bankruptcy to pre-2005 levels.

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