Fed Study: Add Bankruptcy Reform to List of Foreclosure Triggers

Was anrnincrease in foreclosures an unintended consequence of the passage of bankruptcyrnreform?  </p

Following the implementation ofrnbankruptcy abuse reform (BAR) in October 2005, foreclosures on subprimernmortgages surged nationwide.  Threernresearchers have now published their findings from a study asking whether thernsurge was merely coincidental or whether reform played any role. </p

Thernpaper, Subprime Foreclosures and the 2005 Bankruptcy Reform, publishedrnby the Federal Reserve Bank of New York and written by Donald P. Morgan,rnassistant vice president of the bank and graduate students Benjamin Iverson ofrnHarvard University and Matthew Botsch of the University of California atrnBerkley, indicates that the reforms may well have shifted the burden ofrnbankruptcy from unsecured creditors to subprime lenders.</p

Prior tornreform, a debtor could chose to file either a Chapter 7 or a Chapter 13rnbankruptcy in order to seek protection from creditors.  Under Chapter 7 all non-government related unsecuredrndebt could be discharged; under Chapter 13 the debtor established a plan tornenable repayment of debt over time.  Creditors did have the option of forcing arnChapter 7 filing into Chapter 13 if they felt some recovery was possible.</p

Under BARrna means test determines which if either form a bankruptcy can take and sets thernrepayment plan.  It also requires creditrncounseling, extends the length of time between filing and discharge (to as longrnas five years,) and reduces the types of debt that can be discharged.  It also resulted in much higher legal costsrnto the debtor.</p

Thernauthors posited that bankruptcy allowed many borrowers to keep their homesrnbecause, by eliminating unsecured debt, they had more free cash to servicerntheir mortgage payment and that, in fact, many filed for protection primarily forrnthat reason.  Therefore, it would followrnthat limiting access to Chapter 7 should increase foreclosures. </p

A secondrnhypothesis was that limiting access to Chapter 7 would have a greater effect inrnstates with higher equity exemptions. rnThese bankruptcy exemption laws, often called “homestead exemptions”rnare present in all but three states and permit homeowners to exempt a portionrnof their home equity from bankruptcy proceedings, keeping that equity away fromrnthe courts and their creditors.  In eightrnstates this exemption is unlimited; in the remainder the amounts range fromrn$5000 to $500,000.  The authors reasonedrnthat homeowners in states with low exemptions are less likely to demand Chapterrn7 than those where more substantial levels of equity can be protected, so thernBAR means test is less likely to affect those low exemption states and a largerrnimpact on states with high exemptions and hence high demand for Chapter 7.  </p

Thernauthors expected to find the inverse as well – that BAR would reducerndelinquency rates on unsecured loans in states with high exemptions becausernlenders in those states had been most exposed to losses before BAR.  </p

Thernstudy found, first of all, that there was no relationship between foreclosuresrnand prime mortgage foreclosure rates. rnHowever, the estimated impact on subprime foreclosures was found to bernsubstantial.  In a state with an averagernhomestead exemption the authors found that the average subprime foreclosurernrate over the seven quarters since BAR was implemented was 11 percent higherrnthan the rate pre-BAR.  This translatesrnto about 29,000 more foreclosures in each of those quarters that arernattributable to the reform.  </p

The authors observe that BAR still may have served its intended firstrnpurpose of curbing bankruptcy abuse. The strategy that BAR precludes in somerncases is defaulting on unsecured debts to make it easier to pay secured debts;rnif that amounts to “robbing Peter to pay Paul,” then the reform may havernworked.</p

While BAR,rnas the authors maintain, appears to have shifted the burden of bankruptcy fromrnthe unsecured creditor to the secured creditor, it is worth noting that it may alsornhave shifted some of the burden to the American taxpayer. 

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