1. Did Bankruptcy Reform Contribute to the Mortgage Crisis? Wenli Li, FRB Philadelphia Michelle J. White, UCSD and NBER Ning Zhu, UC Davis

2. Basic idea Major bankruptcy reform occurred in 2005: – made it more costly to file for bankruptcy and – more difficult to have unsecured debt discharged. So post-2005, homeowners must repay more unsecured debt. With fixed funds in the short-run, they are more likely to default on their mortgages. We test this hypothesis.

3. Basics of bankruptcy Two Chapters – 7 and 13 Both discharge some or all unsecured debt. Before 2005, debtors were only obliged to use their non-exempt home equity to repay unsecured debt – most repaid nothing. Neither Chapter allows mortgages on primary residences to be changed.

4. Chapter 7 and Homeowners Chapter 7 helps homeowners since having less unsecured debt to pay means more money to pay the mortgage. Chapter 7 delays foreclosure, but not for very long. So it doesn’t help if homeowners have large mortgage arrears.

5. Chapter 13 and Homeowners Homeowners file voluntarily. They can repay mortgage arrears over 3 – 5 years, following a repayment plan. No foreclosure while homeowner is following the plan. If arrears repaid in full, the mortgage contract is reinstated. So Ch 13 helps homeowners who have defaulted on mortgages, but wish to keep their homes.

6. Both Chapters and Bankruptcy Both Chapters delay foreclosure, so homeowners get cost-free housing during foreclosure/eviction. – Ch 7: 3 months – Ch 13: 1 year or more (varies across states). Good for those with negative equity (less important in our time period).

7. Bankruptcy Reform of 2005 – What did it do? Raised debtors’ cost of filing by more than 50%, so less gain from filing. Capped the homestead exemption at $125,000 for homeowners with < 3½ years’ tenure, so some high-asset homeowners must repay more credit card debt. Instituted a “means test” that requires high- income homeowners to repay unsecured debt from future income.

8. More on the Means Test Can avoid repaying unsecured debt if family income < median family income in the state. Otherwise, compute income exemption by adding formula expenses + secured debt payments + some other stuff. Compute non-exempt income = (family income – income exemption)*5. If non-exempt income > $10,000, must use it all to repay debt over 5 years. Repay mortgage arrears first, then unsec debt.

9. So the Means Test means: Some homeowners can’t file under Chapter 7. Some homeowners who file under Chapter 13 to save their homes must repay more in bankruptcy. This applies if: – Non-exempt income over five years > $10,000, and – Non-exempt income > non-exempt home equity For others, bankruptcy did not change.

10. Testable hypotheses: All homeowners gain less from filing for bankruptcy due to filing cost increase--they are more likely to default on their mortgages. Homeowners subject to the $125,000 cap are particularly discouraged from filing; more likely to default. Homeowners with non-exempt income > 0 or non-exempt income > non-exempt home equity gain less; more likely to default.

11. Data Individual first-lien mortgages originated from Jan 2004 – October 2005 (McDash/LPS). Observed at origination and each month thereafter, Mortgages are followed until they are repaid in full, go into default, or the period ends. Default is defined as being delinquent for 2 months or more.

12. Data Mortgages are matched to HMDA to get more household characteristics, Look at prime and subprime mortgages separately, Two samples: – 3 months before/after bankruptcy reform, and – 1 year before/after. (Both end before the mortgage crisis.)

13. Mortgage default rates before/after bankruptcy reform (+- 3 mos)

14. Mortgage default rates before/after bankruptcy reform (longer period)

15. Empirical Model of Default Decision D = aB + bHC + cMT1 + dMT2 + f(HC)(B) + g(MT1)(B) + h(MT2)(B) + iX + e HC, MT1 and MT2 are dummies for features of bankruptcy reform B = bankruptcy reform dummy (B)(HC), (B)(MT1) and (B)(MT2) are diff-in-diff terms Coefficients of interest are a, f, g, h. All are predicted to be positive.

16. Key Variables B = bankruptcy reform dummy. Captures effect of higher filing costs. HC = 1 if homeowner subject to the $125,000 cap Two means test variables: – MT1 = 1 if non-exempt income > 0 and non-exempt home equity = 0 (previously didn’t repay unsec). – MT2 = 1 if non-exempt home equity > 0 and non- exempt income > non-exempt home equity (previously repaid, now must repay more).

17. More Details Home equity: re-computed each month using house value at origination, the change in home value each month in the metro area, and the current mortgage principle. Non-exempt income: we proxy for it using income at origination - state median income level. Not updated.

18. Control variables: Race, sex, income, if married FICO score Debt/income ratio Loan/value ratio Property characteristics Average unemployment, income growth in metro area State legal variables

19. More Details: State and year dummies included. We drop October 2005. Standard errors clustered by mortgage. Probit estimation Significance indicated by *** (.001), ** (.01) and * (.05).

20. Default Model: 3 mo before/after (Probit) PrimeSubprime Bank. Reform (B).00038***.0019*** (HC)(B).00041.0019 (MT1)(B)-.000068.0019*** (MT2)(B)-.00021.0029**

21. Percent Changes PrimeSubprime Bank. Reform (B)2.9%14% (HC)(B)14% (MT1)(B)14% (MT2)(B)22%

22. Default Model: 3 mo before/after (Cox Prop. Hazard) PrimeSubprime Bank. Reform (B)1.39***.90*** (HC)(B)1.381.20 (MT1)(B)0.901.18*** (MT2)(B)0.811.24**

23. Default Model: 6 mo. before/after (Probit) PrimeSubprime Bank. Reform (B).00045***.0030*** (HC)(B).00030.000058 (MT1)(B)-.000072.0017*** (MT2)(B)-.00023*.0015**

24. Percent Changes PrimeSubprime Bank. Reform (B)3.4%22% (HC)(B) (MT1)(B)15% (MT2)(B)13%

25. Conclusions Bankruptcy reform caused mortgage default rates to rise, even before the mortgage crisis. For prime mortgages, default rates rose generally. For subprime mortgages, default rates rose mainly for those with higher-incomes. Suggests that bankruptcy reform might have made the mortgage crisis more severe.

26. More issues (from another paper): In general (but not here), bankruptcy and mortgage default are complements, not substitutes. Bankruptcy and foreclosure are also complements. Why? – Because filing for bankruptcy reduces homeowners’ cost of losing their homes. – Because bankruptcy helps homeowners save their homes, but most of them fail. So a pro-debtor bankruptcy law encourages both bankruptcies and defaults/foreclosures. And v.v.

27. Foreclosure is socially costly. Therefore bankruptcy law should be pro- creditor, in order to reduce bankruptcy filings and therefore reduce default/foreclosure. But foreclosure law should be pro-debtor to reduce foreclosures. So make foreclosure difficult for lenders.