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NY Fed: 2005 Bankruptcy Bill Led to Hundreds of Thousands of Unnecessary Foreclosures

Three economists at the New York Federal Reserve have put out a paper laying the rise in foreclosures partially at the feet of the 2005 bankruptcy bill. Economists Donald P. Morgan, Benjamin Iverson, and Matthew Botsch find that the subprime foreclosure rate increased by 29,000 per quarter nationwide after the passage of the bill, which equals well over 200,000 foreclosures that may not have occurred otherwise.

The bankruptcy bill of 2005, strongly supported by Republicans, bank lobbyists and the Democrats who own them (see Joe Biden, D-MBNA), forces households with higher incomes who file for bankruptcy into a means test that does not allow them to discharge their unsecured debts under Chapter 7, but instead puts them into Chapter 13, where they must still pay unsecured lenders. While mortgages are not unsecured, the money freed up through the discharge of the other debts could have gone to mortgage payments, thereby saving the home. In addition, bankruptcy judges were not allowed under the new reform to modify the terms of a primary residence mortgage, even though they could modify a yacht, a vacation home or the loan on most other assets. That was a longstanding practice that didn’t change in the 2005 law; however, under the new rules, bankruptcy filers under Chapter 13 are not able to cram down auto loans, either, again raising their monthly payments post-bankruptcy.

You can see in a chart on page 2 that the subprime mortgage foreclosure rate began its upward trend almost immediately after the implementation of the bankruptcy bill in 2005. That doesn’t mean the two things are perfectly correlated; the popping of the housing bubble had much to do with the rise in foreclosures. But the New York Fed economists think that what they call BAR (Bankruptcy Abuse Reform) had a role:

The estimated impact of BAR on subprime foreclosures is substantial. For a state with average home equity exemptions, the average subprime foreclosure rate over the seven quarters after BAR was 11 percent higher than the average rate before BAR. This translates to about 29,000 more subprime foreclosures nationwide per quarter attributable to the reform.

In addition, if more homes per quarter fell into foreclosure because of the inability to discharge credit card debt in bankruptcy, then that would necessarily lower home prices, putting more borrowers underwater and at threat of foreclosure. The economists surmise that the bankruptcy bill, then, indirectly added to foreclosures via lower home prices. This becomes a vicious circle.

This does not lead the New York Fed economists to conclude that the bankruptcy bill was a bad deal; in fact they explicitly say that it may have been “wise policy that simply came at a bad time,” when the subprime market crashed and foreclosures spiked. But that’s the entire point. The bankruptcy process is designed for bad times. It’s supposed to provide a backstop for borrowers who cannot keep up and have become overwhelmed with debt. Elizabeth Warren has called this a bedrock principle of America that has existed for hundreds of years, one of the strongest parts of the safety net, the ability to start over. That only exists for large financial institutions nowadays, not everyday people. And this research from the New York Fed proves it.

UPDATE: Zach Carter also got to this.

UPDATE II: One thing the NYFed found was an old quote from Business Wire showing how obvious this all was:

Although proponents of the reform may not have anticipated that BAR would have contributed to the surge in foreclosures, observers close to the facts saw the wave coming. Alexis McGee, President of, made this prediction six months before the reform took effect:

People get in over their heads by further encumbering their homes with equity lines of credit that are exhausted with purchases of consumer products and services such as cars and expensive vacations. Then, when interest rates rise, and home values stop increasing, they can no longer refinance and file a Chapter 7 bankruptcy petition to wipe out their [unsecured] debts and hold off foreclosure by their lender . . . . [Now] they must file under Chapter 13, and pay off their debt in 60 months or less. Middle income families in this position could face the loss of their homes (Business Wire, April 25, 2005).

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David Dayen

David Dayen