Bankruptcy Code Modifications and Mortgage Markets

10 Pages Posted: 31 Oct 2008 Last revised: 3 Dec 2008

Date Written: October 2008

Abstract

This paper analyzes the potential impact of two different modifications to the bankruptcy code, which might reduce foreclosures and help end the mortgage crisis. The first type of modification involving repeal or modification of the newly enacted bankruptcy means test is motivated by two recent papers Bernstein (2008a) and Credit Suisse (2008), which found the 2005 bankruptcy law increased foreclosures. Changes in the means test could be applied to all debtors in bankruptcy (both homeowners and renters) or could be narrowly tailored towards homeowners facing foreclosure. The second proposed modification involves allowing for the revision of mortgages for households in bankruptcy. The economic literature does not rule out the possibility that providing broad authority for the revision of all mortgages in bankruptcy would adversely impact mortgage markets. However, limited mortgage revision authority for second liens, predatory first liens, and some non-predatory first liens would substantially reduce foreclosures and could create incentives for safer lending practices in the future. The economic case for allowing the revision of second liens in bankruptcy and for targeting mortgage rescue programs on second liens is especially compelling. The revision of second liens in bankruptcy would prevent many first-lien defaults, reduce financial institution losses, and would even reduce future first-lien interest rates. A rule allowing mortgage modifications on predatory loans in bankruptcy could help curb abusive lending practices. The revision of non-predatory first-liens in bankruptcy should be fairly limited and used only when other debt reduction options have been exhausted.

Keywords: bankruptcy, foreclosure, second mortgage, predatory loan, BAPCPA, interest rate, risk, consumer credit

JEL Classification: G10, G21, K35, R33

Suggested Citation

Bernstein, David P., Bankruptcy Code Modifications and Mortgage Markets (October 2008). Available at SSRN: https://ssrn.com/abstract=1292336 or http://dx.doi.org/10.2139/ssrn.1292336

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