Working Paper: NBER ID: w15968
Authors: Wenli Li; Michelle J. White; Ning Zhu
Abstract: This paper argues that the U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged--thus loosening debtors' budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. \n\nWe estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage defaults to rise, using a large dataset of individual mortgages. Our major result is that prime and subprime mortgage default rates rose by 23% and 14%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that their default rates rose even more. Overall, we calculate that bankruptcy reform caused the mortgage default rate to rise by one percentage point even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.
Keywords: bankruptcy reform; mortgage default; financial crisis
JEL Codes: G21; K35; R21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| 2005 bankruptcy reform (K35) | increase in mortgage defaults (G21) |
| 2005 bankruptcy reform (K35) | increase in defaults for homeowners subject to new income-only means test (K35) |
| 2005 bankruptcy reform (K35) | increase in defaults for homeowners affected by income-asset means test (G33) |
| 2005 bankruptcy reform (K35) | increase in defaults for homeowners impacted by homestead exemption cap (G33) |
| 2005 bankruptcy reform (K35) | overall increase in mortgage default rate (G21) |