Did Bankruptcy Reform Trigger the Housing Crisis?
As discussed in John Colwell’s recent contribution here, housing – which seems to be at the center of the current economic downturn – is a long way from a rebound, and foreclosures may actually increase in the coming months. After reading Mr. Colwell’s article, I decided to learn a little more about the subject and came across this article which was published in BusinessWeek on October 29, 2007, near the beginning of the housing crisis. In this article, the author contends that the 2005 amendments to the Bankruptcy Code (also known as the Bankruptcy Abuse Prevention and Consumer Protection Act or BAPCPA) caused more people to walk away from their mortgages. The author explained: “foreclosures are soaring, while bankruptcies, though clearly on the upswing, are running roughly at half the 2001-2003 pace. The reason: [the BAPCPA] … makes it much harder for households to get out from under their consumer debt … [m]ore people [are] being forced to walk away from their homes, leaving lenders holding the bag.”
According to the 2007 Businessweek article, the old bankruptcy law was considered extremely housing-friendly. In practice, most Chapter 7 filers got to keep their homes, while the rest of their property and assets were sold off to pay a portion of unsecured debts such as credit-card and medical bills. When the assets ran out, the remaining loans were cancelled (with the exception of non-dischargeable debts like student loans, alimony and child support) and future paychecks could go to mortgage payments. Under the BAPCPA, however, more debtors are forced into Chapter 13 due to the means test, so they are still trying to make payments on car, credit card, medical, and other bills (which used to be discharged in Chapter 7) pursuant to their Chapter 13 plan. That makes meeting the mortgage more onerous.
I am surprised by how little attention this idea has received in the last few years. However, I did find this more recent working paper which tackled the issue and concluded that “personal bankruptcy law … played an important role” in the financial crisis of 2008. More specifically, these authors “estimate that the reform caused about 800,000 additional mortgage defaults and 250,000 additional foreclosures to occur in each of the past several years.” These authors suggest that “the 2005 bankruptcy reform should be at least partially reversed” because “lowering the cost of filing for bankruptcy will encourage more homeowners to file and therefore reduce foreclosures.”
