Was an increase in foreclosures an unintended consequence of the passage of bankruptcy reform? 

Following the implementation of bankruptcy abuse reform (BAR) in October 2005, foreclosures on subprime mortgages surged nationwide.  Three researchers have now published their findings from a study asking whether the surge was merely coincidental or whether reform played any role.

The paper, Subprime Foreclosures and the 2005 Bankruptcy Reform, published by the Federal Reserve Bank of New York and written by Donald P. Morgan, assistant vice president of the bank and graduate students Benjamin Iverson of Harvard University and Matthew Botsch of the University of California at Berkley, indicates that the reforms may well have shifted the burden of bankruptcy from unsecured creditors to subprime lenders.

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

Under BAR a means test determines which if either form a bankruptcy can take and sets the repayment plan.  It also requires credit counseling, extends the length of time between filing and discharge (to as long as five years,) and reduces the types of debt that can be discharged.  It also resulted in much higher legal costs to the debtor.

The authors posited that bankruptcy allowed many borrowers to keep their homes because, by eliminating unsecured debt, they had more free cash to service their mortgage payment and that, in fact, many filed for protection primarily for that reason.  Therefore, it would follow that limiting access to Chapter 7 should increase foreclosures.

A second hypothesis was that limiting access to Chapter 7 would have a greater effect in states with higher equity exemptions.  These bankruptcy exemption laws, often called "homestead exemptions" are present in all but three states and permit homeowners to exempt a portion of their home equity from bankruptcy proceedings, keeping that equity away from the courts and their creditors.  In eight states this exemption is unlimited; in the remainder the amounts range from $5000 to $500,000.  The authors reasoned that homeowners in states with low exemptions are less likely to demand Chapter 7 than those where more substantial levels of equity can be protected, so the BAR means test is less likely to affect those low exemption states and a larger impact on states with high exemptions and hence high demand for Chapter 7. 

The authors expected to find the inverse as well - that BAR would reduce delinquency rates on unsecured loans in states with high exemptions because lenders in those states had been most exposed to losses before BAR.  

The study found, first of all, that there was no relationship between foreclosures and prime mortgage foreclosure rates.  However, the estimated impact on subprime foreclosures was found to be substantial.  In a state with an average homestead exemption the authors found that the average subprime foreclosure rate over the seven quarters since BAR was implemented was 11 percent higher than the rate pre-BAR.  This translates to about 29,000 more foreclosures in each of those quarters that are attributable to the reform. 

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.

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