Does Bankruptcy Reduce Foreclosure? Wenli Li, Federal Reserve Bank of Philadelphia. Michelle J. White, UC San Diego, Cheung Kong G.S.B.

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1 Does Bankruptcy Reduce Foreclosure? Wenli Li, Federal Reserve Bank of Philadelphia Michelle J. White, UC San Diego, Cheung Kong G.S.B., and NBER July 2011 Preliminary draft not for quotation Abstract In the paper, we examine whether filing for bankruptcy delays or prevents foreclosure, using a new household-level panel dataset that combines large samples of prime and subprime mortgages with information on homeowners non-mortgage debt. Bankruptcy is predicted to delay foreclosure both because legal actions against debtors are stayed for several months during the bankruptcy process and because homeowners gain financially from discharge of unsecured debt in bankruptcy and may use their gains to save their homes. Our main result is that bankruptcy reduces the probability of both foreclosure starting and foreclosure ending in sale of the house. We find that the elasticity of the start of foreclosure with respect to bankruptcy is around -.04 for homeowners with both prime and subprime mortgages and the elasticity of foreclosure sale with respect to bankruptcy is -.02 for prime mortgages and -.15 for subprime mortgages. All of these results are strongly statistically significant. We also examine whether bankruptcy delays foreclosure by longer for homeowners who behave strategically versus nonstrategically. For homeowners with prime mortgages, we find that the delay effect of bankruptcy is larger for those that behave strategically, but there is no significant difference for homeowners with subprime mortgages. We argue that this result suggests that lenders are able to identify individual homeowners types, but only if they have prime rather than subprime mortgages. *The views expressed here are the authors and do not represent those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Michelle White is grateful for research support and hospitality from Cheung Kong Graduate School of Business, Beijing. 1

2 Introduction Homeowners in financial distress are likely to default on their mortgage payments and lenders respond by initiating foreclosure. But homeowners may also file for bankruptcy in order to prevent or delay foreclosure. There are several reasons why filing for bankruptcy delays foreclosure. First, when homeowners file for bankruptcy, all legal actions against them including foreclosure are stayed. Lenders can only resume legal actions against debtors when the bankruptcy court trustee lifts the stay, which takes at least a few months. Bankruptcy particularly delays foreclosure in states that do not require a judicial proceeding (a judge s order) for foreclosure, since the foreclosure process in these states is very quick. Second, filing for bankruptcy improves homeowners financial positions by discharging some unsecured debt and ending wage garnishment. This increases homeowners ability to pay and if they wish to save their homes they may use the additional funds to avoid defaulting on their mortgages or to repay mortgage arrears if they have already defaulted. Third, if homeowners plan to give up their homes, then filing for bankruptcy allows them to live in their homes rent-free for longer. This paper explores whether bankruptcy delays or prevents foreclosure. It also explores whether the delay effect of bankruptcy is larger for homeowners that behave strategically. Bankruptcy and mortgage default/foreclosure have not generally been recognized to be related and most academic research has tended to analyze bankruptcy decisions and mortgage default decisions separately. Figure 1 gives bankruptcy filings per year as a proportion of U.S. population and the fraction of mortgage debt in the U.S. that entered foreclosure each year over the period 1980 to Both figures are set equal to one in Between 1980 and 2004, both bankruptcy and foreclosure rates increased rapidly, with the foreclosure rate tripling and the bankruptcy filing rate rising 5-fold over the period. However the adoption of the 2005 bankruptcy reform caused the bankruptcy filing rate to drop sharply in 2006, while the foreclosure rate began accelerating soon afterward with the start of the subprime mortgage crisis. Since 2007, both rates have continued to rise, but foreclosure rate has risen much faster than the bankruptcy rate. Figure 1 suggests that, except for the drop caused by the 2005 bankruptcy reform, bankruptcy and foreclosure rates tend to be positively related. This positive relationship 2

3 in the aggregate data is contrary to our hypothesis that bankruptcy and foreclosure are negatively related at the individual homeowner level. 1 In the paper, we examine the bankruptcy-foreclosure relationship, using a new householdlevel dataset that combines large samples of prime and subprime mortgages with information on homeowners non-mortgage debt. We examine how filing for bankruptcy affects whether foreclosure starts and whether foreclosure ends in sale of the property. Our main result is that bankruptcy is negatively related to both foreclosure outcomes the elasticity of the start of foreclosure with respect to bankruptcy is around -.04 for both prime and subprime mortgages and the elasticity of foreclosure sale with respect to bankruptcy is -.02 for prime mortgages and -.15 for subprime mortgages. All of these results are strongly statistically significant. We also examine whether bankruptcy delays foreclosure by longer for homeowners who behave strategically than those who behave non-strategically. We find that the delay effect of bankruptcy is larger for strategic homeowners and we argue that this result suggests that lenders are able to identify whether individual homeowners behave strategically or not. Section II of the paper discusses U.S. bankruptcy and foreclosure law and our hypotheses concerning how bankruptcy affects mortgage default and foreclosure. Section III discusses our data and section IV gives results. Section V concludes and discusses policy implications. Foreclosure and Bankruptcy Law In this section, we discuss the mortgage foreclosure process in the U.S. and how bankruptcy affects homeowners incentives to default on their mortgages and lenders incentives to foreclose. Because our sample of mortgages covers the years , we also consider how the 2005 bankruptcy reform and the financial crisis changed homeowners incentives. Foreclosure. Lenders have the right to foreclose when homeowners fail to make their mortgage payments in full. The foreclosure process is governed by state laws, which vary in how long and how formal it is. In some states, mortgage lenders must get a court order to foreclose, while in others, they can proceed without court involvement. If the mortgage arrears aren t repaid or the mortgage contract modified, the lender eventually sells the property which we refer to as foreclosure sale. The proceeds after expenses are used, first, to repay the first 1 See White and Li (2009) for discussion of the timing of bankruptcy relative to mortgage default and foreclosure. 3

4 mortgage in full, including principal and interest, fees, and penalties. Next, the second and third mortgages, if any, are repaid in full. Third, homeowners receive an amount up the state s homestead exemption. Homestead exemptions vary widely across states, from zero in a few states to unlimited in seven states. If anything is left, it goes to unsecured creditors. In most foreclosures, the sale price of the house is insufficient to repay the mortgage(s) otherwise homeowners would have sold the house themselves outside of foreclosure. Some states allow mortgage lenders to pursue deficiency judgments against former homeowners, which are unsecured claims for the difference between the amount owed on the mortgage and the foreclosure sale price. 2 Most states also allow homeowners to reclaim the property for a period after foreclosure by repaying the mortgage in full. These periods can last up to a year. Homeowners can remain in their homes for varying periods after default. Some states force them to leave before the foreclosure sale, while others allow them to stay, in which case they become tenants and the new owner must go through an eviction procedure to force them to leave. During the foreclosure process, (ex-)homeowners do not owe any mortgage or rent payments. The period from default to eviction ranges from a few months to more than a year and homeowners can extend it by filing for bankruptcy. Consider homeowners decisions to default. Homeowners may default because they experience economic stress that reduces their ability-to-pay or they may default strategically because doing so makes them better off. Homeowners gain financially from defaulting if the present value of the future cost of owning (PVCO) exceeds the present value of the future cost of renting alternative housing (PVCR), or if PVCO > PVCR. This condition is more likely to hold if home equity is negative, if homeowners expect home values to fall in the future, or if the terms of the mortgage contract are unfavorable to the homeowner such as a high interest rate or a teaser rate that is about to increase sharply. Homeowners that default on their mortgages also have an incentive to default on nonmortgage debt, because both types of default trigger a drop in their credit scores. Thus the additional drop in credit scores when homeowners default on both types of debt is likely to be small. Defaulting on non-mortgage debt causes lenders to pursue collection techniques, including calling debtors at home and at work to demand payment and taking legal action to 2 To prevent mortgage lenders from selling foreclosed homes for less than market value, some states allow lenders to claim deficiency judgments only if the foreclosure sale has received court approval. See Elias (2008) for discussion of foreclosure law. 4

5 garnish debtors wages if debtors are employed and seize money in debtors bank accounts if these accounts can be located. Federal law prevents garnishment of more than 25% of debtors wages and some states restrict garnishment further or prohibit it entirely. Bankruptcy. How does filing for bankruptcy affect homeowners gain from defaulting on their mortgages and on their non-mortgage debts? 3 There are two separate personal bankruptcy procedures in the U.S., called Chapters 7 and 13, and most homeowners are allowed to choose between them. Filing for bankruptcy under either procedure stops creditors collection efforts, ends wage garnishment, and stops foreclosure at least temporarily. Some or all unsecured debts including credit card debts, installment loans, medical bills, and unpaid rent are discharged. Chapter 7. Consider Chapter 7 first. Most unsecured debts are quickly discharged in Chapter 7, 4 but mortgage debt contracts cannot be changed. 5 Debtors are obliged to use assets above their state s exemption level to repay unsecured debt, but they are not obliged to use future earnings to repay debt even if their earnings are high. States have separate exemptions for different types of assets, but the exemption for home equity the homestead exemption is nearly always the largest. In states with high homestead exemptions, even debtors with high incomes and high assets do not have to repay any of their unsecured debt in bankruptcy. 6 Chapter 7 can help financially distressed homeowners save their homes by discharging some of their unsecured debts, thus increasing their ability to pay their mortgages. Because foreclosure is stopped during the bankruptcy proceeding, homeowners in bankruptcy also get several extra months to repay their mortgage arrears. 7 They are allowed to keep their homes in Chapter 7 as long as their home equity is below the state s homestead exemption and they repay 3 See White and Zhu (2010) and Lin and White (2001) for discussion of the relationship between homeowners mortgage default and bankruptcy decisions. Fay, Hurst, and White (2003) provide evidence that debtors are more likely to file for bankruptcy when their financial gain from filing is higher, although their analysis does not distinguish between homeowners and non-homeowners. 4 Unsecured debts not discharged in bankruptcy include unpaid child support, taxes owed, debts incurred by fraud, student loans, and costs of bankruptcy itself. 5 The prohibition on changing mortgage terms in bankruptcy is based on the Supreme Court s decision in Nobleman v. American Savings Bank, 508 US 324 (1993) and on 11 U.S.C. 1322(b)(2), which prevents bankruptcy judges from discharging mortgage debt that is secured only by a primary residence, even if the value of the house is below the mortgage principle. For discussion, see Levitin and Goodman (2008). 6 Bankruptcy law in the U.S. is Federal law, so that it is uniform all over the country. But U.S. bankruptcy law allows states to set their own homestead and other exemptions for assets. 7 Berkowitz and Hynes (1999) first suggested that filing for bankruptcy increases debtors ability to repay their mortgages by discharging unsecured debt. 5

6 the mortgage arrears during the bankruptcy process. Homeowners also gain from filing under Chapter 7 if they do not intend to save their homes or cannot afford to do so. If they have positive home equity, then using bankruptcy to delay foreclosure gives them more time to sell their homes privately, which is likely to bring a higher price. If homeowners do not have positive home equity, then filing for bankruptcy gives them more time to live in their homes cost-free. Deficiency judgments are discharged in Chapter 7, which benefits debtors who have already given up their homes. Homeowners gain from filing under Chapter 7 can be expressed as: GainChapter 7= U H C 7 + H7+ max[ Q,0] max[ A X,0] U 7 is the value of unsecured debt discharged in Chapter 7. Homeowners receive this subsidy in bankruptcy regardless of whether they keep their homes or not. H7 is the change in the present value of future housing costs when homeowners file under Chapter 7. If homeowners save their homes in Chapter 7, then H 7 = 0. But if they give up their homes, then H 7 equals the reduction in the housing costs when homeowners become renters, or H7 = ( PVCO7 PVCR7 ). This may include the gain from having cost-free housing for several months by delaying foreclosure, the gain from having a deficiency judgment discharged, and/or the gain from moving to rental housing that costs less. max[q,0] is the value of the homeowner s home equity, assuming that it is positive. We assume that homeowners who have positive home equity lose it in bankruptcy, since they are forced to give up their homes in bankruptcy and homes sold in bankruptcy auctions are unlikely to sell for more than the mortgage balance. But homeowners in bankruptcy can often delay foreclosure long enough to sell their homes privately, thus receiving a higher price and keeping their home equity. max[ A X A,0 ] is the value of non-exempt assets that homeowners must use to repay unsecured debt in bankruptcy, where A is the value of homeowners assets and X A is the exemption for assets in the homeowner s state of residence (including the combined value of the homestead exemption and other asset exemptions). In practice, max[ A X A,0 ] nearly always equals zero, since homeowners can convert their assets into exempt home equity or exempt retirement accounts before filing. C 7 is homeowners cost of filing for bankruptcy under Chapter

7 Chapter 13. Now turn to Chapter 13. Homeowners in financial distress who wish to save their homes often use this procedure if they have large mortgage arrears that they cannot repay within a few months. Homeowners must have regular earnings and must propose a plan to repay their mortgage arrears over 3 to 5 years. Lenders cannot foreclose while homeowners are making regular payments under the plan and, if they repay all of their mortgage arrears and make all of their regular mortgage payments, then the original mortgage contract is reinstated. 8 filing under Chapter 13 and proposing a repayment plan delays foreclosure for up to 5 years. Thus The terms of first mortgages cannot otherwise be changed in Chapter 13. But second mortgages and home equity loans can be partially or fully discharged in Chapter 13 if the value of the house is less than the total amount of the mortgages and some car loans can also be reduced in Chapter 13. Bankruptcy trustees also may challenge fees and penalties that lenders add to mortgages following default. 9 Filing under Chapter 13 also delays foreclosure for homeowners who give up their homes. Homeowners who file under Chapter 13 often propose repayment plans, but fail to make all the payments. In this situation, foreclosure is delayed until the bankruptcy judge lifts the stay following default. Alternately, homeowners who file under Chapter 13 may intend to give up their homes from the beginning, but they lengthen the stay on foreclosure by proposing and then withdrawing several Chapter 13 repayment plans. 10 longer in Chapter 13 than in Chapter 7. Homeowners gain from filing under Chapter 13 can be expressed as: In both situations, foreclosure is delayed for GainChapter 13= U13+ S13+ H13+ max[ Q,0] max[ A X A,0] E13 C13. Here U 13 is the value of unsecured debt discharged in Chapter 13, which may be larger than the value of unsecured debt discharged in Chapter 7. S 13 is the value of secured (car) loans that can be discharged in Chapter 13, but not in Chapter 7. H 13 is the reduction in the cost of housing when homeowners file under Chapter 13, which tends to be larger in Chapter 13 than in Chapter 7 regardless of whether homeowners keep their homes or shift to rental housing in part because of longer delays. max[q,0] is again the value of home equity that would be lost in foreclosure if 8 11 U.S.C. 1322(c)(1) allows debtors to cure defaults on their mortgages in Chapter See Porter (2009) and Elias (2009) for discussion. 10 Carroll and Li (2008) present data showing that homeowners who file for bankruptcy in order to save their homes often fail. Zhu (2010?) provides a description of a sample of Chapter 13 filers. 7

8 homeowners did not file for bankruptcy and max[ A X A,0 ] is again the value of non-exempt assets that must be used to repay unsecured debt these are assumed to be the same in both bankruptcy chapters. E 13 is the value of homeowners obligation to use future earnings to repay unsecured debt in Chapter 13 (if any) this was generally zero in pre-bankruptcy reform Chapter 13 repayment plans, since most homeowners repayment plans only covered their mortgage arrears. Finally, C 13 is the cost of filing for bankruptcy under Chapter 13. Comparing homeowners gain from filing for bankruptcy under Chapters 7 versus 13, in general the benefits of filing under Chapter 13 are higher for some homeowners, while the costs of filing under Chapter 13 are higher for all homeowners. Thus Chapter 13 mainly appealed to homeowners with high home equity and large mortgage arrears. The 2005 bankruptcy reform. The 2005 bankruptcy reform changed homeowners gain from filing for bankruptcy. First, the costs of filing under both chapters, C7 and C 13, increased substantially, thus discouraging all homeowners from filing for bankruptcy. Second, a new means test was introduced that prevents some homeowners with incomes above the median level in their states from filing for bankruptcy under Chapter 7. These homeowners must file under Chapter 13 if they file for bankruptcy at all and must use some of their future income to repay debt, which raised E13 for some high-income homeowners. Third, a cap of $125,000 on the homestead exemption was introduced for homeowners who live in states with high homestead exemptions and have lived in their homes for less than 3½ years. This raises max[ A X A,0 ] for affected homeowners. Thus the 2005 bankruptcy reform discouraged all homeowners from filing for bankruptcy and particularly discouraged some homeowners with high income and high assets from filing. 11 As a result, fewer homeowners are predicted to file for bankruptcy after 2005, since their gain from filing must be larger to justify the higher costs of filing and possibly greater repayment obligation. But those who do file still gain because bankruptcy delays foreclosure. The financial crisis. The financial crisis and the subsequent recession also affected homeowners incentives to default and to file for bankruptcy, mainly by wiping out many 11 See Li, White and Zhu (2010) for discussion of the effect of the 2005 bankruptcy reform on mortgage default. Morgan et al (forthcoming) and Li et al (2010) show that mortgage defaults and foreclosures both increased after the reform. 8

9 homeowners home equity. This raised the cost of continuing to own, while having little effect on the cost of renting. It therefore gave homeowners a larger incentive to default on their mortgages and give up their homes. But homeowners still gain from filing for bankruptcy because it delays foreclosure. In our empirical work, we examine how the bankruptcyforeclosure relationship changes after the crisis. Strategic versus non-strategic behavior by homeowners. Suppose homeowners fall into two types, strategic versus non-strategic. Non-strategic homeowners default on their mortgages only when their ability-to-pay falls; while strategic homeowners default because they gain financially from doing so. Does bankruptcy delay foreclosure by different amounts for strategic versus nonstrategic homeowners? Following mortgage default, lenders must decide between initiating foreclosure quickly versus delaying. One possibility is that lenders prefer to delay foreclosure when homeowners behave non-strategically, since non-strategic homeowners will cure their mortgage defaults by repaying the arrears if their financial situations change for the better. But lenders best strategy is to foreclose quickly when homeowners behave strategically, since these homeowners will not repay their arrears as long as house values remain low. Suppose mortgage lenders are able to identify individual homeowners types using their mortgage payment records and other information that lenders can obtain from credit bureaus. Because lenders delay foreclosure following default by non-strategic homeowners, these homeowners do not need to file for bankruptcy in order to delay foreclosure. But because lenders quickly foreclose following default by strategic homeowners, these homeowners file in order to delay foreclosure. Thus bankruptcy is predicted to delay foreclosure by longer for homeowners who behave strategically than for those that behave non-strategically. An alternative possibility is that is that lenders best strategy is the opposite: to delay foreclosure when homeowners behave strategically and foreclosure quickly when homeowners behave non-strategically. This could be because strategic homeowners have the ability to pay and will resume mortgage payments if lenders renegotiate their mortgages. But non-strategic homeowners, in contrast, cannot pay their mortgages even if the payments are cut and therefore 9

10 lenders gain nothing from delaying foreclosure. Under these assumptions, bankruptcy is predicted to delay foreclosure by longer for homeowners who behave non-strategically. 12 A third possibility is that lenders cannot identify individual homeowners types. Then they must respond in the same way to default by all homeowners and their best strategy is to play mixed by sometimes delaying foreclosure and sometimes foreclosing quickly. (The best mixture for lenders depends on the proportion of strategic homeowners in the population, which we assume that lenders know.) In this situation, the effect of bankruptcy on foreclosure is predicted to be the same for both types of homeowners. This means that if we find that bankruptcy delays foreclosure by a different amount for strategic versus non-strategic homeowners, then the result provides indirect support for the hypothesis that lenders can identify individual homeowners types. In our empirical work, we examine whether bankruptcy delays foreclosure by different amounts for strategic versus non-strategic homeowners. To identify homeowners who behave strategically, we use a combination of high income, high home equity, and value of nonmortgage loans. (Our information is similar to that available to mortgage lenders.) Data and summary statistics Our dataset combines three separate sources. The first is a large sample of prime and subprime mortgages from LPS Applied Analytics, Inc. We include only first mortgages. For each mortgage, we have information concerning homeowners financial situation, the property, and characteristics of the mortgage at the time of origination, plus updates on whether homeowners paid in full or defaulted, whether they filed for bankruptcy, whether lenders started foreclosure and whether the home was sold in foreclosure. 13 The second is the FRB Consumer Credit Panel Data, which is a 5% random sample of all individuals in the U.S. that have credit bureau files. We have information on all types of loans, including credit card loans, installment loans, car loans, student loans, and first and second mortgages. For each loan, we have quarterly 12 Articles in the trade press appear to support both strategies. For example, a recent New York Times article suggested that Bank of America forecloses quickly on non-strategic homeowners, while renegotiating mortgage terms with strategic homeowners. But a recent press release by Experian suggests the opposite. See Schwartz (2011) and Experian (2011). 13 Our bankruptcy variable equals one if either the FRB Consumer Credit Panel or the LPS dataset indicates that a borrower filed for bankruptcy during a particular quarter. The bankruptcy indicators from the two datasets mostly coincide except for some instances when the bankruptcy filing dates are off by one quarter due to reporting lags. 10

11 updates concerning the loan principle, credit limits where applicable, and whether default occurred. The third dataset is from the Home Mortgage Disclosure Act (HMDA), which includes information on all mortgage originations in the U.S. HMDA also provides a few homeowner demographic characteristics at the time of the mortgage application these are race, marital status, sex, age, and income. We also add a number of legal and macroeconomic variables discussed below. The merged dataset consists of individual first mortgages that originated in any of the years 2004, 2005 or 2006, combined with information on homeowners non-mortgage debts We follow these mortgages from the date or origination or the first quarter of 2005, whichever is later, until the date of termination or the second quarter of 2010, whichever is earlier. 16 Terminations may occur before the end of the sample because of sale of the home, refinance, transfer to a different servicer, or foreclosure. 17 It should be noted that mortgages in our sample originated near the peak of the housing bubble. Following the mortgage default literature, we separate prime versus subprime mortgages. 18 Our prime sample consists of 253,250 separate mortgages, for which we have about 2.6 million quarterly observations. Our subprime sample consists of 35,417 separate mortgages, for which we have about 333,000 quarterly observations. 19 In our prime sample, 23% of mortgages become at least 30 days delinquent at some point during our sample period of 39 quarters, 11% 14 We merge the HMDA data with LPS, the FRB Consumer Credit Panel with LPS and, through the LPS match, with each other. The match between HMDA and LPS is done by linking mortgages based on the zipcode of the house, the date of origination of the mortgage (within 5 days), the origination amount (within $500), the purpose of the loan (purchase, refinance or other), the type of mortgage (conventional, VA guaranteed, FHA guaranteed or other), occupancy type (owner-occupied or non-owner-occupied), and lien status (first lien or other). We delete observations with missing information on the age of the borrower, age of the loan, or appraisal amount, or if the mortgage principle was less than $2,000 at origination. We also delete mortgages from counties that were affected by Hurricanes Katrina and Rita, which occurred in August and September This is because many homeowners in these counties delayed making mortgage payments after the hurricanes and their delinquencies were recorded as defaults. 15 The match rates for LPS and HMDA are 35-47%, depending on year. The match rates with the FRB Consumer Credit Panel are 3-4%, depending on year. Note that the low match rates with the FRB Consumer Credit Panel stem from the fact that the Panel covers only 5% of consumers with credit bureau files. 16 The LPS coverage of subprime mortgages improved substantially after January 2005 because a major subprime mortgage lender began reporting to LPS at this time. 17 For the default variables from LPS that varies by month, we define the quarterly default status to be default within any month of the quarter. 18 Much of the literature on mortgage default considers only subprime mortgages. See, for example, Jiang et al (2010), Demyanyk and van Hemet (forthcoming), and Keys et al (2010). For comparison of prime versus subprime mortgage default behavior, see Li, White and Zhu (forthcoming). 19 We take a 50% random sample of the matched prime mortgages, but keep all the matched subprime mortgages because the subprime sample is much smaller. 11

12 default by at least 90 days, foreclosure starts for 7.8%, and foreclosure sale occurs for 3.2%. The fraction of prime mortgage-holders that files for bankruptcy at some point during our sample period is 4.3%. In our subprime sample, the figures are higher: 55% become 30 days delinquent, 35% default by 90 days, 27% start foreclosure, and foreclosure sale occurs for 12%. The fraction of subprime mortgage-holders that files for bankruptcy is 10%. 20 When we divide the samples according to whether homeowners filed for bankruptcy, we find that homeowners who file for bankruptcy are much more likely to default or enter foreclosure. For our prime mortgage sample, foreclosure starts for 44% for homeowners who file for bankruptcy, compared to only 6.2% of homeowners not in bankruptcy. For our subprime mortgage sample, these figures are 61% and 23%, respectively. Similarly, 20% of homes with prime mortgages and 28% of homes with subprime mortgages are sold in foreclosure if homeowners file for bankruptcy, compared to only 2.5% and 10%, respectively, if homeowners do not file. Thus homeowners who file for bankruptcy are much more likely to default on their mortgages and foreclosure is more likely both to start and to proceed to sale. See Table 1. Specification and Results Now turn to our empirical specification. Suppose Eit denotes an event for mortgage i that occurs in quarter t, where the event can be 90-day default, the start of foreclosure, or sale of the property in foreclosure. Also suppose B it equals 1 if homeowner i files for bankruptcy in quarter t. We estimate the following model using probit: E µ it = a bbit cxit+ dtt + fsi+ it (1) X it denotes a vector of control variables (some of which may be lagged), Tt is a vector of quarter fixed effects, and S i is a vector of state fixed effects. We drop mortgages in the quarter following event E it or, if homeowners file for bankruptcy, in the quarter following the bankruptcy filing. The hypothesis being tested is therefore that event Eit is less likely to occur in quarter t if the homeowner files for bankruptcy in the same quarter. (Below, we also test the effect of bankruptcy filings in quarter t on whether default or foreclosure occur in quarter t+1.) 12

13 Because of concerns that many of the same financial factors explain both bankruptcy filings and default or foreclosure, we instrument for homeowners bankruptcy decisions. Our instruments are the aggregate bankruptcy filing rate in the homeowner s bankruptcy court district in the previous quarter and the homestead and personal property exemption levels in the homeowner s state of residence. Bankruptcy court districts are co-terminus with states for small states, but larger states are divided into two to four districts. Previous 13 research has shown that both the homestead exemption and the aggregate district-level bankruptcy filing rate are positively associated with individuals decisions to file for bankruptcy see Fay, Hurst and White (2003). However the two instruments are likely to capture different factors affecting bankruptcy decisions. The aggregate bankruptcy filing rate in the district is related to persistent district-level legal conditions and to the strength of network effects involving individuals hearing about bankruptcy from friends and co-workers who have filed. In contrast, the home equity and personal property exemptions are related to homeowners financial gain from filing for bankruptcy, since more unsecured debt is discharged in bankruptcy when the exemptions are larger. We use the results from the first stage regression to calculate homeowners predicted probability of filing for bankruptcy Bˆ it, and then enter Bˆ it in the second stage model. Table 2 gives summary statistics for the control variables, using the sample in which mortgages are dropped one quarter after they become 90 days delinquent. 23 Control variables include the age and age squared of the mortgage, 24 homeowners income at the date of the mortgage application, homeowners total revolving debt balance lagged one quarter, 25 whether homeowners are currently using more than 80% of their available revolving credit used as a measure of whether homeowners are liquidity-constrained, whether the mortgage is a jumbo, home equity lagged one quarter, 26 homeowners demographic characteristics, their risk score at the time of the mortgage application, a set of mortgage and property characteristics taken from 21 We are grateful to Ted Eisenberg for providing us with a program that assigns counties to bankruptcy districts. 22 In states that have unlimited homestead exemptions, we set the value of the homestead exemption at one million dollars. Data concerning bankruptcy exemptions is taken from Elias (2008b), various editions. 23 In contrast to the figures in Table 1, the figures in Table 2 are average values over all mortgage-quarter observations. 24 See Demyanyk and van Hemert (forthcoming), Jiang et al (2010), and Li et al (forthcoming) for discussion of the role of mortgage age in homeowners mortgage default decisions. 25 The only previous paper to examine the effect of non-mortgage debt on homeowners mortgage default decision is Elul et al (2010). 26 Home equity is updated each quarter by updating the value of the house at the time of mortgage origination using the average increase in housing values in the metropolitan area since the mortgage originated. Then the mortgage principle in the current quarter is subtracted.

14 the mortgage application, information concerning how the mortgage originated (whether the bank acquired the mortgage from a correspondent bank or wholesale; the omitted category is mortgages originated directly by the lender), whether the mortgage became part of a private mortgage securitization, and whether the mortgage was guaranteed by FHA or VA. We also include a measure of homeowners gain from refinancing each quarter. 27 Regional macroeconomic variables include the unemployment rate in the metropolitan area lagged one quarter (obtained from the Bureau of Labor Statistics), the rate of growth of housing prices in the metropolitan area lagged one quarter (from the Federal Housing Finance Agency), and the divorce rate in the state lagged one year (from the Division of Vital Statistics, National Center for Health Statistics). 28 Variables that are updated each quarter are marked with asterisks in Table 2. Among the interesting figures in Table 2 is the fact that subprime mortgages are likely to be located in districts with higher aggregate bankruptcy filing rates. Subprime mortgage-holders have lower average risk scores than prime mortgage-holders, but are more likely to have provided full documentation of income and assets when they applied for their mortgages (although the information might not have been accurate). Homeowners with subprime mortgage also have less non-mortgage debt than homeowners with prime mortgages, but are more likely to be liquidity-constrained. Subprime mortgages are less likely to be fixed-rate and much more likely to be in private mortgage securitizations. Table 3 shows the results of the first-stage regressions explaining whether homeowners file for bankruptcy. 29 (State and quarter dummies are included in all regressions and errors are clustered by mortgage.) Figures given in the tables are marginal effects, with p-values in parentheses. The results show that the lagged district-level bankruptcy filing rate is positive and significant in explaining bankruptcy in both samples. The homestead and personal property 27 The measure is {r 0 [1-(1+r t ) t-m ]}/{ r t [1-(1+r 0 ) t-m ]}, where r 0 is the interest rate on the homeowner s existing mortgage, r t is the interest rate currently available on new mortgages, and M is the remaining term of the mortgage. See Richard and Roll (1989). When this measure is higher, the gain from refinancing is greater. 28 We use non-msa house price index of the state for zipcodes that do not fall into the MSAs covered by Federal Housing Finance Agency or the state index when non-msa house price indexes are not available. The divorce states are available for most years in our sample. When missing, we take the average of the two adjacent years or the adjacent year for 2005 and We run the first-stage regression separately for each second-stage regression. This is because the samples for the second-stage regression are slightly different in each regression (mortgages are dropped following 90-day default in the regressions explaining 90-day default, etc.). The results shown in Table 3 are the first stage regressions for the models explaining 90-day default; other results are similar. 14

15 exemptions are positive as expected in both regressions, but only the homestead exemption in the prime mortgage regression is significant (p =.045). As expected, higher unsecured/revolving debt is strongly positively related to whether homeowners file for bankruptcy the revolving debt balance and the liquidity-constraint indicator are both significant at the 1% level in both regressions. However, the dummy variable for jumbo mortgages is negatively rather than positively related to bankruptcy, suggesting that homeowners are not more likely to file for bankruptcy when they have high mortgage debt, holding everything else constant. In addition, the lagged home equity variable is negatively related to bankruptcy, which does not support the hypothesis that homeowners file for bankruptcy to save their homes when doing so is worthwhile. Table 3 shows the results of estimating the second stage regression, eq. (1), without instruments. The top panel is for prime mortgages and the bottom panel is for subprime mortgages. Each panel gives separate regression results explaining 90-day default, the start of foreclosure, and foreclosure sale. Figures in the table are marginal effects, with p-values in parentheses. The bankruptcy dummy equals one if homeowners filed for bankruptcy in the same quarter as event Eit occurred. The main result is that the coefficients of bankruptcy are all positive and significant at the 1% level, suggesting that filing for bankruptcy increases rather than decreases the probabilities that homeowners default and lenders foreclose. Homeowners with both types of mortgages are more likely to default and foreclosure is more likely to occur if they have jumbo mortgages. For prime mortgage-holders, default and foreclosure are less likely to occur if home equity is higher. Being liquidity-constrained increases the probability of mortgage default and the start of foreclosure for both types of mortgages. But having a larger revolving debt balance itself is not significantly related to default/foreclosure for prime mortgage-holders, while the relationship is negative and significant for subprime mortgagesholders. These results suggest that having more unsecured debt does not raise homeowners probability of defaulting on their mortgages, but being liquidity-constrained on unsecured debt does. Table 4 shows the results explaining how bankruptcy affects mortgage default and foreclosure when we instrument for the bankruptcy decision. Only the results for the bankruptcy variable are shown (results for other variables are similar to those shown in table 3). The figures given are marginal effects and elasticities of bankruptcy on the probability of event 15 Eit occurring. The

16 main result is that the sign of the bankruptcy term changes from positive to negative when we instrument. For the prime sample, all of the predicted bankruptcy coefficients are negative and significant at the 1% level and the elasticities of 90-day default, foreclosure start and foreclosure sale with respect to bankruptcy are all around In the subprime sample, the bankruptcy coefficients are also negative and significant at the 1% level (except for in the regression explaining the start of foreclosure). The elasticity of 90-day default with respect to bankruptcy is and the elasticity of foreclosure sale with respect to bankruptcy is Overall these results imply that filing for bankruptcy slightly reduces the probability of mortgage default and foreclosure for both prime mortgage-holders, but greatly reduces the probability of mortgage default and foreclosure sale for subprime mortgage-holders. We also re-ran the same model for a subsample of mortgages that have been 30 days delinquent during at least one quarter of our sample. The IV results for the predicted bankruptcy variable are shown in the bottom panel of table 4. For prime mortgages ever in default, the elasticities of 90-day default, the start of foreclosure, and foreclosure sale with respect to bankruptcy are larger they are , and , respectively, and all are significant at the 1% level. Thus for prime mortgages that are financially shaky, filing for bankruptcy has much larger and more negative effect on all three events than it has for the whole sample. For subprime mortgages ever in default, only the relationship between bankruptcy and foreclosure sale is significant, probably because the sample sizes become quite small. The elasticity of foreclosure sale with respect to bankruptcy is -.22, which is only slightly different from its value in the full sample. Filing for bankruptcy may reduce the probability of default or foreclosure in later quarters, as well as in the quarter when the homeowner files. To test this, we reran the same model, but redefined the bankruptcy variable to equal one if the homeowner files for bankruptcy in either the same quarter as event variables by two quarters. 30 Eit or the previous quarter and we lagged the dynamic explanatory The results are shown in table 5. Here the marginal effects and elasticities are averages over the effect of bankruptcy on whether event E it occurs in the same quarter or the next quarter. The results for the prime mortgage sample are not too far from those in table 4, with elasticities of between to in the full sample. In the sample of 30 We combine current and lagged bankruptcy filings into a single bankruptcy variable, because we do not have separate instruments for bankruptcy filings that occur in different quarters. 16

17 financially shaky prime mortgages, the elasticity of foreclosure liquidation with respect to bankruptcy increases to over 10 percent, suggesting that bankruptcy reduces the probability of foreclosure liquidation by even more in the next quarter than in the current quarter. However for the subprime sample, the results are insignificant. This suggests that for subprime mortgageholders, filing for bankruptcy mainly reduces the probability of foreclosure in the same quarter rather than the next quarter. We also reran the base case model on the subperiods of our dataset before versus after the start of the financial crisis. Our pre-crisis subperiod covers 2006 quarter 1 to 2008 quarter 2 and our post-crisis period covers 2008 quarter 3 to the end of the sample in 2010 quarter 4. We excludes 2005, so that the pre-crisis subperiod starts after the 2005 bankruptcy reform went into effect, and we use the middle of 2008 as the start of the financial crisis, since credit markets seized up around this time. Because mortgages that terminate are not replaced in our sample, our sample sizes are considerably smaller in the post-crisis than the pre-crisis period and we therefore report post-crisis results only for prime mortgages (the post-crisis subprime sample is too small). The results, shown in table 6, show that the three elasticities for the full sample of prime mortgages all increase from the pre-crisis to the post-crisis period: from around to for 90-day default, from to for the start of foreclosure, and from to for foreclosure sale (all are significant at the 1% level). These results suggest that bankruptcy became more effective in preventing default and foreclosure for prime mortgage-holders after the start of the financial crisis. For the sample of financially shaky prime mortgages, however, the results for the post-crisis sample are mainly insignificant again probably because of small sample sizes. For subprime mortgages, we can compare the results for the pre-financial crisis period to the results for the full sample, shown in table 4. They suggest that bankruptcy was about equally effective in preventing 90-day default and the start of foreclosure in the pre- versus post-crisis periods, but became less effective in preventing foreclosure sale after the start of the financial crisis. Finally, we are still working on testing whether the effect on bankruptcy on foreclosure differs for homeowners who behave strategically versus non-strategically. Preliminary results suggest that in our prime mortgage sample, filing for bankruptcy delays foreclosure sale by more for strategic homeowners than for non-strategic homeowners. But there is no significant difference for homeowners with subprime mortgages. These results suggest that mortgage lenders can 17

18 distinguish between homeowners who behave strategically versus non-strategically in the prime mortgage sample, but not in the subprime mortgage sample. Perhaps this is because nearly all homeowners with subprime mortgages behave strategically (after all, subprime mortgages were known as liar loans ). Conclusion In this paper, we examine whether bankruptcy filings by homeowners delay mortgage default and foreclosure. Our results show that bankruptcy delays both default and foreclosure for homeowners with both prime and subprime mortgages. The elasticities of default and foreclosure with respect to bankruptcy are small around -.02 for prime mortgages, but larger for subprime mortgages and for financially shaky prime mortgages. The largest effect of bankruptcy is to delay the end of the foreclosure process the elasticity of foreclosure sale with respect to bankruptcy is -.19 for financially shaky prime mortgages Overall, bankruptcy helps homeowners by reducing default and delaying the foreclosure process particularly the sale of homes in foreclosure. Delaying foreclosure may be efficiency-enhancing for a number of reasons. Because displaced homeowners sometimes become homeless, delaying the foreclosure process gives them more time to save for the costs of renting alternative housing, including paying for the move itself, the security deposit and the first month s rent. 31 Even if displaced homeowners avoid homelessness, forcing them to move is inefficient since the social cost of foreclosure exceeds lenders private cost. Among the extra costs not borne by lenders are that children of homeowners are forced to move and shift schools, causing their school performance to suffer. Also, foreclosures cause neighboring homes fall in value, resulting in loss of home equity for neighboring homeowners who therefore are more likely to default. Foreclosures homes often remain vacant and deteriorate, which causes neighborhoods to become blighted, and local governments are forced to cut public services when property values fall and property tax 31 A recent study estimates that 10% of homeless people helped by social service agencies in became homeless due to foreclosure of their homes. However some of these households previously rented rather than owned and lost their homes because their landlords stopped paying their mortgages; for these households bankruptcy would not have delayed foreclosure. See National Homelessness Advocacy Groups Release Foreclosure to Homelessness, June 27, 2009, _Homelessness/Foreclosure/prweb html and Goodman (2009). 18

19 payments decline. 32 Delaying foreclosure also increases the probability that lenders and homeowners renegotiate mortgages, rather than lenders selling the property in foreclosure. Thus to the extent that filing for bankruptcy increases homeowners probability of remaining in their homes, it increases the efficiency of the housing market. 32 See Campbell et al (forthcoming) for an estimate of the decline in value of neighboring houses when foreclosures occur. Los Angeles has recently sued Deutsche Bank for being a slumlord and causing neighborhood blight by allowing foreclosed properties to deteriorate. See Los Angeles Sues Deutsche Bank Over Foreclosure Blight, Insurance Journal, May 5,

20 References Berkowitz, Jeremy, and Richard Hynes Bankruptcy Exemptions and the Market for Mortgage Loans, J. of Law & Economics, 42: Campbell, John, Stefano Giglio, and Parag Pathak, Forced Sales and Housing Prices, Am. Economic Rev., forthcoming. Carroll, Sarah, and Wenli Li Forthcoming. The Homeownership Experience of Households in Bankruptcy, Cityscape. Demyanyk, Yulia, and Otto van Hemert. Forthcoming. Understanding the Subprime Mortgage Crisis, Review of Financial Studies. Elias, Stephen The New Bankruptcy: Will It Work for You? 1 st edition. Berkeley: Nolo Press. Elias, Stephen The Foreclosure Survival Guide, 1 st edition. Berkeley: Nolo Press. Elul, Ronel, Nicholas S. Souleles, Souphala Chomsisengphet, Dennis Glennon, and Robert Hunt What Triggers Mortgage Default? American Economic Review, 100(2): Elul, Ronel Securitization and Mortgage Default: Reputation versus Adverse Selection. Federal Reserve Bank of Philadelphia Working Paper Experian Experian Announces Strategic Defaults Remain High, PR Newswire, July 23, Foote, Christopher L., Kristopher S. Gerardi, Paul S. Willen Nagetive Equity and Foreclosure: Theory and Evidence. J. of Urban Econ., vol. 64: Ghent, Andra, and Marianna Kudlyak, 2011, Recourse and Residential Mortgage Default: Evidence from U.S. States, Federal Reserve Bank of Richmond Working paper No R. Gerardi, Kristopher, Adam Hale Shapiro, and Paul S. Willen (2007), Subprime Outcomes: Risky Mortgages, Homeownership Experiences and Foreclosures, Federal Reserve Bank of Boston Working Paper Goodman, Peter S., Foreclosures Force Ex-Homeowners to Turn to Shelters, New York Times, October 19, Jiang, Wei, Ashlyn Aiko Nelson, and Edward Vytlacil Liar s Loan? Effects of Origination Channel and Information Falsification on Mortgage Delinquency, Working paper, Columbia University. 20