Bankruptcy and Home Loan Defaults

Balance that must exist between households and firms if markets are to function well.  I often use the market for consumer loans to demonstrate what many students initially find counterintuitive.  Consumers allow banks to take collateral to facilitate lending and banks support bankruptcy to facilitate borrowing.

This does not mean that laws support the correct balance between consumers and banks. In an American Economic Journal, Economic Policy article,  Li, White, and Zhu offer evidence supporting the hypothesis that 2005 bankruptcy reform that made it more difficult to write off debt through bankruptcy increased defaults on home loans after the housing bubble burst.  Their abstract reads

Homeowners in financial distress can use bankruptcy to avoid defaulting on their mortgages, since filing loosens their budget constraints.  But the 2005 bankruptcy reform made bankruptcy less favorable to homeowners and therefore caused mortgage defaults to rise. We test this relationship and find that the reform caused prime and subprime mortgage default rates to rise by 23% and 14%, respectively. Default rates rose even more for homeowners who were particularly negatively affected by the reform. We calculate that bankruptcy reform caused mortgage default rates to rise by one percentage point even before the start of the financial crisis.

It is interesting to note that banks were supporting laws making it harder to declare bankruptcy as they were lowering lending standards.