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Foreclosures on subprime mortgages surged nationwide after the bankruptcy abuse reform (BAR) took effect in October 2005.
Morgan, Iverson, and Botsch examine whether the surge was merely coincidental, or whether the reform may have played a role.
The authors explain that prior to BAR, overly indebted borrowers could file bankruptcy to free up income to pay their mortgage by discharging unsecured debts; this action enabled them to retain more income to pay secured debts, such as mortgages.
The reform eliminated that option for better-off filers through a means test and other requirements; these filers thus found it more difficult to save their home by filing bankruptcy.
The study concludes that BAR may have been one of several contributors to the surge in subprime foreclosures, joining declining home prices, expanded mortgage supply, looser lending standards, and agency problems associated with securitization.
BAR’s impact on filers was found to be greater where theory would predict it to have a more significant effect: in states with high bankruptcy exemptions; filers in low-exemption states were not very protected before BAR, so they were less likely to be affected.
Morgan, Iverson, and Botsch estimate that for a state with an average home equity exemption, the subprime foreclosure rate after BAR rose 11 percent relative to average before the reform; given the number of subprime mortgages in the United States, that figure translates into 29,000 additional subprime foreclosures per quarter nationwide.
The authors observe that BAR still may have served its intended, first purpose of curbing bankruptcy abuse. The strategy that BAR precludes in some cases is defaulting on unsecured debts to make it easier to pay secured debts; if that amounts to “robbing Peter to pay Paul,” then the reform may have worked.
About the Authors
Donald P. Morgan is an assistant vice president at the Federal Reserve Bank of New York; Benjamin Iverson is a graduate student at Harvard University; Matthew Botsch is a graduate student at the University of California at Berkeley.
The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve System, Harvard University, or the University of California at Berkeley.