Using Bankruptcy to Reduce Foreclosures: Does Strip-Down of Mortgages Affect the Mortgage Market?

Transcription

1 Using Bankruptcy to Reduce Foreclosures: Does Strip-Down of Mortgages Affect the Mortgage Market? Wenli Li, Federal Reserve Bank of Philadelphia Ishani Tewari, Yale School of Management Michelle J. White, University of California, San Diego, and NBER Latest version: August 2015 Abstract We assess the credit market impact of mortgage strip-down reducing the principal of underwater residential mortgages to the current market value of the property for homeowners who file for bankruptcy under Chapter 7 or Chapter 13. Strip-down of residential mortgages in bankruptcy was proposed as a means of reducing foreclosures during the recent mortgage crisis, but was blocked by lenders on the grounds that it would greatly increase the cost of mortgage loans. Our goal is to test this hypothesis and determine whether the change would in fact have a large adverse impact on new mortgage applicants. Our identification is provided by a series of U.S. Court of Appeals decisions in the late 1980s and early 1990s that introduced mortgage stripdown under both bankruptcy Chapters in parts of the U.S., followed by two Supreme Court rulings that abolished strip-down all over the country. We find that neither the circuit court decisions to allow strip-down nor the Supreme Court decisions to abolish it had any significant effect on either mortgage availability or mortgage interest rates. The lack of systematic response suggests that introducing mortgage strip-down under either bankruptcy Chapter would not adversely affect mortgage loan availability and could be a useful new policy tool to reduce foreclosures when future housing bubbles burst. JEL Classifications: G14, G18, K10 Keywords: Mortgage credit, strip-down, creditor protection, bankruptcy Wenli Li: corresponding author, Research Department, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19106; wenli.li@phil.frb.org. Ishani Tewari: ishani.tewari@yale.edu. Michelle White: miwhite@mail.ucsd.edu. We thank seminar participants at the 2013 Conference on Empirical Legal Studies, Wellesley College, and Columbia Law School and particularly Avery Katz, Jonathan Fisher, Mark Scarberry, Robert Lawless, Ronald Mann, and Merritt Fox for helpful comments. The views expressed here are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. This paper is available free of charge at 1

2 I. Introduction Since the mortgage crisis began in 2008, an unprecedented 4.2 million home foreclosures have been completed in the U.S. an average of 850,000 per year compared with the 250,000 per year from 2000 to The government has tried various measures to reduce the number of foreclosures: programs under the second Bush and Obama administrations offered compensation to lenders if they modified underwater mortgages by reducing homeowners monthly payments. But these programs were largely unsuccessful because few lenders were willing to cut mortgage debt. 2 We examine an alternative approach to reducing foreclosures called mortgage strip-down, which would allow bankruptcy judges to reduce the principal owed on underwater mortgages to the current market value of the home for homeowners who file for bankruptcy. This approach has the advantage that underwater mortgages can be modified regardless of whether lenders consent, thus giving homeowners an alternative to defaulting, going through foreclosure, and moving out of their homes. The Obama administration proposed legislation in 2009 to allow strip-down of residential mortgages in Chapter 13 bankruptcy, but it was not enacted due to opposition by mortgage lenders. 3 Mortgage strip-down is attractive from an economic-efficiency perspective, since it makes homeowners better off without making lenders worse off. Lenders are not harmed because they receive as much as if they had foreclosed, and homeowners are made better off because they are not forced to move. Also, mortgage strip-down reduces an inefficiency in the mortgage market: that lenders foreclose too often because some of the costs of foreclosure are externalized. Nearby homeowners bear part of the cost, since foreclosed homes remain vacant for long periods 1 Completed foreclosures are those in which the title to the property passes to the mortgage lender, and the homeowner either moves out or becomes a tenant. Data are from CoreLogic. 2 The Bush and Obama administrations programs to reduce foreclosures were HOPE for Homeowners, Making Home Affordable, and Home Affordable Modification Program. The latter programs required participating lenders to lower homeowners monthly payments to 38% of their gross income; the government then paid the cost of lowering monthly payments to 31% of gross income. Banks typically reject most applications or never respond. See Bajaj (2008), Bernard (2009), and Morgenstern (2015). 3 The proposed bills were the Helping Families Save Their Homes Act of 2009 (H.R. 1106, 111 Congress), introduced in the House, and the Helping Families Save Their Homes in Bankruptcy Act of 2009 (S. 61, 111 Cong.), introduced in the Senate. 2

3 and fall into disrepair, causing neighborhood blight and reductions in local property values. 4 Local governments also bear part of the cost, since they lose property tax revenue and are forced to cut spending on local public goods. Another argument for allowing mortgage strip-down has been made by economists including Summers (2014) and Mian and Sufi (2014): The government s bank-oriented response to the financial crisis left households with too much debt, leading to low consumer spending levels and years of stagnation for the economy. They argue that using mortgage strip-down to reduce household indebtedness would speed up economic growth by cutting household debt and raising household spending levels. But mortgage strip-down has a drawback: it would erode creditor protection by forcing lenders to give up foreclosure, which is one of their most important contractual remedies for default, and this may cause lenders to reduce the supply and raise the cost of mortgage credit. The Mortgage Bankers Association, an advocacy group for mortgage lenders, argued that allowing mortgage strip-down would cause lenders to raise mortgage interest rates by at least 1.5 percentage points a 30% increase (Kittle 2007). In this paper, we assess the strength of the link between strip-down of mortgages in bankruptcy and the terms of mortgage loans. Drawing this causal connection is empirically challenging, since unobserved factors may affect both whether strip-down is allowed in a jurisdiction and what the local mortgage market conditions are. We are able to circumvent this identification problem by making use of a series of plausibly exogenous federal court decisions in the late 1980s to the early 1990s that separately introduced and then abolished mortgage stripdown under both Chapter 7 and Chapter 13 of the U.S. Bankruptcy Code. These decisions allowed strip-down at different time periods and in different parts of the country. Exploiting the temporal and cross-sectional variation generated by these policy shocks, we use a difference-indifference approach that compares mortgage market responses in affected versus unaffected regions following each court decision. In addition to providing empirical evidence for the effect of strip-down on credit market outcomes, our study also provides some novel insights into how markets respond to court decisions that change the law. Economists routinely study how markets respond to legal changes 4 Campbell et al. (2011) find that homes located 1/20th of a mile away from a home in foreclosure lose 1% of their value, using residential sale data from Massachusetts in the 1990s. Craig (2014) discusses zombie homes in foreclosure causing neighborhood blight. 3

4 adopted by legislatures and regulatory agencies, 5 but there are far fewer studies of how markets respond when judges change the law in the process of deciding legal disputes. 6 In addition, our study is among the first to examine whether markets respond differently to decisions of lowerlevel courts (federal bankruptcy, district, and circuit courts) relative to decisions by the U.S. Supreme Court. Markets might react differently to court decisions versus to new laws or new regulations because court decisions lack an executive-branch enforcement mechanism, and they might react differently to lower-level versus higher-level court decisions because lower-level court decisions can be reversed on appeal. Our main result is that mortgage markets did not respond significantly to either the circuit court decisions to allow mortgage strip-down or the Supreme Court decisions to abolish it under. Neither mortgage approval rates nor mortgage interest rates responded to these legal changes. Our findings suggest that introducing mortgage strip-down in bankruptcy would not have strong adverse effects on mortgage loans and could be a useful new policy tool to reduce foreclosures. The rest of the paper is organized as follows: Section II supplies some institutional background, Section III provides discusses theoretical considerations, Section IV is a brief literature review, Section V outlines the methodology and data, Section VI discusses the empirical results, and Section VII concludes and provides some discussion of related policy initiatives. II. The U.S. Court System and Consumer Bankruptcy Law Turn first to the organization of U.S. federal courts. Bankruptcy filings must be made in one of the federal bankruptcy courts; each U.S. state has one to four bankruptcy courts that cover the same geographic regions as the federal district courts. If a bankruptcy court decision is appealed, the appeal goes to the federal district court in the same region. If a federal district court decision is appealed, the appeal goes to the U.S. Court of Appeals (circuit court) that covers the relevant state; there are 11 circuit courts in the U.S., each covering at least two states. Finally, if there is 5 Examples are Neumark and Wascher (2006) and Balasubramnian and Cyree (2014). These studies examine the effect on employment of changes in Federal and state minimum wage laws and the effect on interest rates of the Dodd-Frank Wall Street Reform and Consumer Protection Act. 6 An example is Cooper and Tomlin (2008), who analyze the effect on markets of a U.S. Supreme Court decision that gave federal judges the responsibility to exclude unreliable expert testimony. 4

5 an appeal from a circuit court decision, it goes to the U.S. Supreme Court. Figure 1 shows a map of the federal district and circuit court regions. 7 When a district or bankruptcy court case is decided, the judge s decision may change the law. But since the decision applies only in the relevant district, it generates differences of law across districts within a circuit court region. These differences of law within a circuit are often resolved by the circuit court deciding appeals from lower court decisions. But since circuit court decisions apply only in the relevant circuit court region, they create differences of law across circuits. These differences of law in turn are resolved by the U.S. Supreme Court deciding appeals from circuit court decisions. Although the Supreme Court unlike the circuit courts is not obliged to accept appeals, differences of law across circuits are a major reason why it accepts them. Now turn to the two bankruptcy procedures for individual debtors, Chapters 7 and 13, and how they help homeowners in financial distress. 8 When debtors file under Chapter 7, some or all of their unsecured debts are discharged. They must use all of their assets above a fixed exemption level to repay their debts, but they are not obliged to use any of their future income to repay this gives debtors a fresh start. However mortgage loans are not changed or discharged in Chapter 7, so that the procedure does not directly help filers who are homeowners to save their homes. Nonetheless, homeowners benefit from filing for Chapter 7 bankruptcy, since discharge of unsecured debt increases their ability to pay, and if they wish to keep their homes, they can use the increase to avoid defaulting on their mortgages or to repay their mortgage arrears. 9 Homeowners who wish to save their homes benefit more directly by filing under Chapter 13. Here filers must propose a plan to repay some of their debt from future income, but they are not obliged to give up any of their assets. Repayment plans must last for three to five years. Homeowners who are in default on their mortgages must repay the arrears in full, but they can spread repayment of arrears over the length of the repayment plan, and if they complete the full schedule of payments, then their original mortgage contracts are reinstated. The plan also covers 7 Some bankruptcy court appeals go to a Bankruptcy Appellate Panel for the district before going to federal district or circuit court. Only a small minority of decisions in bankruptcy cases are appealed. 8 This discussion is based on U.S. bankruptcy law before the 2005 bankruptcy reform, since our empirical work uses pre-2005 data. See White (2005), Eggum et al. (2008), White and Zhu (2010), and Li et al. (2011) for discussion of bankruptcy law, its effects on homeowners, and the effects of the 2005 bankruptcy reform. 9 Homeowners who have lost their homes to foreclosure may also benefit from filing under Chapter 7 because deficiency judgments are discharged. See Kuchler and Stroebel (2009) for a discussion. 5

6 unsecured debt, and debtors may propose repaying as little as 1% of the amount owed. Only the bankruptcy judge must accept the repayment plan; lenders consent is not required. Thus, homeowners in financial distress can both save their homes in Chapter 13 and benefit from having some of their unsecured debts discharged. This procedure is valuable to financially distressed homeowners who have positive equity in their homes. There were two separate sets of legal decisions concerning strip-down of mortgages in Chapter 7 and Chapter 13 bankruptcy. 10 Starting in the 1980s, some bankruptcy courts and district courts began allowing residential mortgages to be stripped down in Chapter 7 bankruptcy. These decisions were appealed and three circuit courts the Seventh, Eleventh, and Third affirmed the lower court decisions and allowed mortgage strip-down under Chapter 7 within their regions. The circuit court decisions occurred between 1987 and An additional circuit the Tenth decided not to allow mortgage strip-down in The Supreme Court accepted an appeal of the Tenth Circuit Court decision, and in 1992, it abolished strip-down in Chapter 7 everywhere in the U.S. There was a similar but slightly later sequence of court decisions concerning strip-down of mortgages in Chapter 13 bankruptcy. Following lower-level court decisions to allow strip-down in Chapter 13, four circuit courts the Ninth, Third, Tenth, and Second allowed it between 1989 and An additional circuit the Fifth decided not to allow it in 1992, and the U.S. Supreme Court accepted an appeal of the Fifth circuit decision and abolished strip-down all over the U.S. in Table 1 gives the dates of all the federal court decisions on mortgage strip-down. We use these two sequences of legal decisions to test the effect of strip-down in bankruptcy on mortgage markets. III. Predictions The availability of mortgage strip-down in bankruptcy affects both the supply and demand for mortgages. On the demand side, the availability of mortgage strip-down reduces the downside risk that homeowners face because, if housing values fall by enough to make their home equity negative, they can file for bankruptcy and have some of their mortgage debt discharged. 11 If there is no strip-down of mortgages in bankruptcy, homeowners can still avoid repaying the 10 See Eggum et al. (2008), Levitin (2009), and Scarberry and Reddie (2010) for discussions of mortgage strip-down from a legal perspective. The Appendix gives a brief discussion of the legal issues. 11 This is similar to the insurance effect that bankruptcy itself has for non-mortgage debt. See White (2005) for discussion. 6

7 underwater portion of their mortgages by defaulting, going through foreclosure, and moving somewhere else. But if strip-down in bankruptcy is available, homeowners gain because they can avoid the cost of moving and because some of their other, non-mortgage debt may also be discharged in bankruptcy. 12 The cost of having underwater mortgages partially discharged thus falls when strip-down is available and, as a result, homeowners are predicted to default on their mortgages more often. In addition, the insurance against downside risk that is provided by stripdown makes borrowing more attractive to risk-averse homeowners, thus increasing mortgage demand. On the supply side, the availability of strip-down in bankruptcy is predicted to reduce lenders profits, because default rates on existing mortgages rise and because the increase in demand for mortgage debt makes new mortgage applicants more risky. However a potentially offsetting factor is the effect of strip-down on lenders costs following default. Because strip-down in bankruptcy sets the new mortgage principal equal to the current market value of the property, lenders returns should be the same in present value as the amount they would receive in an immediate foreclosure sale. But homeowners whose mortgages are stripped down may have higher re-default rates than homeowners generally, resulting in lenders incurring all the costs of foreclosure plus the extra costs of delay. Also if there were no strip-down, some homeowners in default would self-cure and repay their original mortgages in full, thus raising the opportunity cost of mortgage strip-down. If re-default and/or self-curing are common, then allowing stripdown raises lenders default costs. These considerations suggest that lenders default costs could either rise or fall when strip-down is adopted. 13 As a result, the supply of mortgage loans could either increase or decrease when strip-down is adopted, although loan supply would only increase in the unlikely case when lenders default costs fall by enough to offset the effect of higher default rates and increased riskiness of the applicant pool under strip-down. Putting these factors together, allowing strip-down of mortgage loans in bankruptcy is predicted to shift demand for mortgage loans outward and to shift the supply of mortgage loans inward in the most likely case. These changes mean that when strip-down is adopted, interest 12 See White and Zhu (2010) for discussion. 13 See Adelino et al. (2009) for a discussion of the reasons why mortgage lenders were unwilling to agree voluntarily to mortgage modifications during the mortgage crisis, some of which are also relevant to mortgage strip-down in bankruptcy. Levitin (2009) argues that lenders costs would fall if strip-down in Chapter 13 were allowed, but he does not consider the effect of strip-down on default rates. 7

8 rates on mortgage loans are predicted to rise, while approval rates for mortgage applications (our measure of supply) could change in either direction. Now turn to the question of whether allowing strip-down under Chapter 7 versus Chapter 13 is predicted to have a larger effect on mortgage markets. During the early 1990s, less than onethird of personal bankruptcy filings occurred under Chapter 13, and the costs of filing were much higher under Chapter 13 than Chapter Both of these considerations suggest that the availability of strip-down under Chapter 7 would have a larger effect on mortgage markets. On the other hand, mortgage debt is accelerated to the present in Chapter 7 bankruptcy, so that the entire amount owed on the mortgage (principal plus interest plus penalties for default) must be repaid immediately. Even with strip-down reducing the mortgage principle, most homeowners in Chapter 7 cannot afford to keep their homes in bankruptcy if doing so requires that they immediately pay off the entire mortgage. This consideration thus goes in the opposite direction and suggests that allowing strip-down in Chapter 13 is likely to have a larger effect on mortgage markets. Overall, it is an empirical question whether strip-down under Chapter 7 or Chapter 13 has a larger effect on mortgage markets. A similar question concerns whether circuit court or Supreme Court decisions have a larger impact on mortgage markets. Supreme Court decisions get much more publicity than circuit court decisions, apply all over the country, and cannot be overturned (except by the Supreme Court itself) all of which suggest that they are likely to generate larger market responses. We test whether markets respond more strongly to Supreme Court than circuit court decisions. Our empirical work uses difference-in-difference to examine how circuit court and Supreme Court decisions to allow or abolish strip-down of residential mortgages in Chapter 7 or 13 affect the terms of home mortgages in regions where court decisions change the law relative to regions where they do not change the law. We estimate separate models for each court decision to allow or abolish strip-down in bankruptcy. IV. Literature Review Our analysis ties in with research that examines the link between creditor protection and financial markets or more broadly between legal protection of contracts and the level of 14 Homeowners bankruptcy costs in the early 1990s were about $600 for Chapter 7 versus $1,600 for Chapter 13. See Flynn and Bermant (2002). 8

9 financial development. In a seminal work in law and finance, La Porta et al. (1997) show that countries with better investor and creditor protection have broader capital markets. Extending this work, Djankov et al. (2007) show that the supply of private credit depends on the strength of creditors right to force repayment, seize collateral, or take over the firm. In samples of bank loans from multiple countries, Laeven and Majnoni (2005) and Bae and Goyal (2009) find that banks respond to poor enforceability of contracts by increasing interest rates, shortening maturities, and rationing credit. In single-country studies using data from Italy and India, respectively, Jappelli et al. (2005) find higher credit availability in jurisdictions where courts act more quickly when creditors sue to enforce their default rights, and Visaria (2009) finds similar effects when new debt recovery tribunals were introduced in India to speed up the enforcement of creditors rights. In the context of U.S. consumer credit markets, several papers exploit cross-state variation in creditor protection to draw a causal link between the level of creditor protection and credit availability. Pence (2006) finds that mortgage sizes are smaller in states with defaulter-friendly foreclosure laws. Gropp et al. (1997), Lin and White (2001), and Berkowitz and White (2004) examine the effect of variable bankruptcy exemptions across U.S. states on credit availability. They find that states with higher exemption levels (which favor debtors by allowing them to keep more of their assets in bankruptcy) have higher rejection rates for home improvement loans, higher interest rates on car loans, and reduced lending to small businesses. Li et al. (2011) and Kuchler and Stroebel (2009) show that exemption levels also affect households decisions to default on their mortgages. Research focusing on the consequences of mortgage strip-down is sparse and mostly limited to qualitative discussion. Levitin (2009) was the first to consider the effects of allowing stripdown of mortgages in Chapter 13 on the terms of new mortgage loans. His article provides a detailed legal analysis. A more recent paper by Goodman and Levitin (2014, henceforth GL) uses a similar approach as ours to examine the effect of allowing strip-down on mortgage markets, but they examine mortgage strip-down only under Chapter 13 and consider only the effect on interest rates. We compare our results with theirs in greater detail below. V. Data, Specification, and Description 9

10 Data. We use two different data sources in order to get information on both mortgage approval and mortgage interest rates. The first is the Home Mortgage Disclosure Act (HMDA) data, which include nearly all home mortgage applications in the U.S. 15 For each application, we know whether the mortgage was approved; the location of the property at the census tract level; the applicant s income, race, sex, and marital status; and the type of lender. 16 To match the characteristics of the MIRS sample (see below), we keep only applications for mortgages to purchase single-family homes that were not guaranteed by the Federal Housing Administration or the U.S. Department of Veterans Affairs. 17 We also exclude observations in districts where a bankruptcy or district court decided to allow strip-down, but the relevant circuit court never allowed strip-down. We add information on whether strip-down of mortgages in bankruptcy is allowed in the court district/month where the property is located and the Chapter 7 and 13 bankruptcy filing rates in the relevant district (lagged one month). We also add a dummy variable for observations in census tract that have a minority population exceeding 30%, the average income in the metropolitan area, the unemployment rate in the county (lagged one month), and a zip code-level house price index (lagged one month). Except for the percent minority in the census tract, all these variables are updated monthly. 18 The bankruptcy filing rate is entered because network effects suggest that households are more likely to hear about and file for bankruptcy if they live in districts with higher bankruptcy filing rates During the period of our study, HMDA coverage was expanded to include loans made by independent mortgage banks. See below for discussion. 16 Lender types include banks, credit unions, thrifts, and independent mortgage banks. Indicators for lender type are included in all regressions but not reported. HMDA coverage was expanded during the period of our study to include loans made by independent mortgage banks. See below for discussion. 17 Applications for guaranteed mortgages are excluded because lenders are unlikely to vary the terms of these mortgages in response to legal rules that affect default. We also exclude applications to refinance mortgages, applications for home improvement loans, applications to purchase vacation homes and applications to purchase investment properties. The latter are excluded because they were never subject to the prohibition on strip-down in bankruptcy. We would also have liked to drop applications for mortgages on owneroccupied two- to four-family homes for the same reason, but HMDA does not distinguish between these and single-family homes. (However, the number of mortgage applications of this type is small.) We also drop observations in Hawaii and Alaska, and we drop the top and bottom 0.5% of observations based on income and loan size. Finally, to keep sample sizes manageable, we take a 20% random sample of the remaining data. 18 The average income by metropolitan area and the percent minority by census tract are constructed from HMDA data. County-level unemployment rates are from the Bureau of Labor Statistics. The house price index is from CoreLogic. Chapter 13 filing rates are from the Administrative Office of the U.S. Courts. 19 We use the Chapter 7 or Chapter 13 filing rate, depending on whether the regression explains the effect of court decisions concerning Chapter 7 or 13. See Fay et al. (2002) for empirical evidence that bankruptcy filing rates are higher when the aggregate bankruptcy filing rate in the district is higher. 10

11 The second data set is the Monthly Interest Rate Survey (MIRS), a smaller monthly sample of non-guaranteed purchase-money mortgages that originated during the last week of each month. The MIRS data include information on interest rates, whether the mortgage is adjustable rate versus fixed rate, the length of the mortgage, the property location and type of lender, but no individual borrower characteristics. We add the same regional-level variables as for the HMDA data. The MIRS survey differs from HMDA by including only accepted mortgage applications. We nonetheless examine these data because they are the only source of information on interest rates during our period. Specification. Turn first to our specification for the two Supreme Court decisions to abolish mortgage strip-down in Chapters 7 and 13. We estimate separate models for each decision, using difference-in-difference: Mortgage market outcome = α + βcircuits*post + γz + δd + λm + μt + ε. (1) To simplify the notation, we drop subscripts indicating that the observations are for individual mortgages in a given month and district court region. The mortgage market outcomes that we study are whether mortgage applications were approved (using HMDA) and interest rates on originated mortgages (using MIRS). Circuits denotes observations in circuit court regions where strip-down was allowed prior to the relevant Supreme Court decision (see Table 1) and Post denotes observations after the Supreme Court decisions to abolish strip-down, which occurred in January 1992 and June 1993 for Chapter 7 and Chapter 13 strip-down, respectively. Thus, Circuits*Post equals one for observations where the Supreme Court decision changed the law by abolishing strip-down of mortgages in the relevant bankruptcy chapter. The control group is mortgages everywhere else. Z is the set of covariates previously discussed. D denotes districtlevel fixed effects, M denotes month fixed effects, and T denotes district-level linear time trends. Because we include district- and month-level fixed effects, we do not include the variables Circuits or Post by themselves. The main coefficient of interest is β, which measures the change in mortgage market outcomes after each of the Supreme Court decisions in the circuits that previously allowed mortgage strip-down, relative to the circuits where strip-down was never adopted. As discussed above, β is predicted to be negative in the models explaining the effect of the two Supreme Court 11

12 decisions on interest rates, since strip-down was abolished under both decisions and β is predicted to be positive in the models explaining the effect of the two decisions on approval rates, although a negative sign could occur in unlikely situations. We use probit in the regressions explaining approval rates and OLS in the regressions explaining interest rates. Errors are clustered at the district level. 20 For the circuit court decisions to allow strip-down, the specification is: Mortgage market outcome = α + β Circuit*Post + γ Z + δ D + λ M + μ T + ε. (2) Here, we estimate separate regressions for each circuit court decision to allow strip-down under Chapter 7 or Chapter 13. For each regression, Circuit equals one for observations in the particular circuit affected by the circuit court decision and Post is a dummy for months after the decision. Thus, Circuit*Post equals one for observations where the circuit court decision changed the law by abolishing strip-down of mortgages in the relevant bankruptcy Chapter. The control group is mortgages outside the relevant circuit court region. 21 The major coefficient of interest is β, which is predicted to have the opposite sign as β in equation (1). The mortgage market outcomes and the controls are the same as in the previous specification. Because HMDA data are only available at the individual mortgage level starting January 1990, we can only estimate regressions explaining approval rates for circuit court decisions that occurred in 1990 or later. As a falsification test, we also estimate equation (2) for the two circuit court decisions not to allow mortgage strip-down in bankruptcy. For these regressions, the interaction terms are predicted to be zero. We use short sample periods of three months before through three months after each court decision. This is because short periods allow us to distinguish among the various court decisions we study and also because lenders have an incentive to respond quickly to court decisions if they respond at all. Also, short time periods reduce the possibility that divergent non-linear trends in treated versus control regions affect the results these are more likely to be a problem for Chapter 13 strip-down decisions because the four circuit courts that allowed strip-down under Chapter 13 are mainly on the two coasts, which often have divergent economic trends from the 20 Regressions using MIRS data are weighted to make the sample nationally representative. Regressions using HMDA data not weighted since the survey has nearly universal coverage. 21 All regressions omit observations in circuits that previously allowed strip-down, so that the control group consists of observations in which strip-down was not allowed either before or after the relevant Circuit Court decision. 12

13 middle of the country. Thus, finding that lenders respond to legal decisions using short sample periods would provide the strongest possible evidence that markets respond to these decisions. 22 One additional complication is that the legal decisions we study particularly the Supreme Court decisions are not a complete surprise to mortgage market participants. This is because the Supreme Court announces when it accepts an appeal, holds oral argument on a known date, and then announces its decision several months later. At the oral argument, the justices hear lawyers arguments for keeping or overturning the circuit court decision that is under review and the justices questions may give hints as to how they will decide the case. At that time, mortgage lenders and possibly borrowers may predict how the Supreme Court will decide and their predictions may be either right or wrong. Suppose market participants predict that the Supreme Court will abolish mortgage strip-down, thus changing the law in the treated area but not the control area. Then they might respond by adjusting mortgage market conditions in the treated area immediately, rather than waiting for the actual decision. Since their predictions turn out to be correct, they will not respond when the Supreme Court s decision is announced. In this situation, our results using the decision date will be biased toward zero. Another possibility is that market participants predict that the Supreme Court will affirm mortgage strip-down, thus changing the law in the control area but not the treated area. Then they might respond by adjusting the terms of mortgages in the control area immediately, while not changing the terms of mortgages in the treated area. When the decision is announced, market participants respond by adjusting the terms of mortgages in both the treated and control areas. This will again cause our results using the decision date to be biased toward zero. Because of the possibility of bias due to markets anticipating Supreme Court decisions, we rerun our Supreme Court regressions using the argument dates in place of the decision dates. Descriptives. Figure 2 gives monthly average mortgage approval rates and interest rates for the period three months before to three months after the two Supreme Court decisions. These figures are constructed using the raw data. The treated and control groups are constructed as discussed above. We set approval rates and interest rates for both groups equal to zero in the month before the decision December 1991 for the Chapter 7 decision and May 1993 for the 22 Because we know the month but not the day when mortgages originated, we assign observations that occurred in the month of the court decision to the post period if the decision occurred before the 15th and to the pre period if the decision occurred on or after the 15th. 13

14 Chapter 13 decision. The figures for other months are relative to the levels just before the decision. The top figures of both panels of figure 2 show approval rates before versus after the two Supreme Court decisions. Approval rates in the treated group rise relative to the control group following both decisions, although the pattern is stronger for the Chapter 13 decision than for the Chapter 7 decision. (For the Chapter 7 decision, there is a surprisingly large drop in approval rates for both groups just before the Supreme Court decision.) The figures for interest rates before versus after the two Supreme Court decisions to abolish strip-down are shown as the bottom figures of panels A and B, respectively. They do not show the expected pattern, i.e., interest rates in the treated groups do not fall relative to the control groups following the two decisions. Table 2 gives summary statistics for the two data sets used to estimate the effect of the two Supreme Court decisions to abolish mortgage strip-down. 23 VI. Results Supreme Court decisions to abolish mortgage strip-down. The benchmark regressions explaining the effect of the two Supreme Court decisions to abolish mortgage strip-down are shown in Table 3, panel A, for the Chapter 7 decision and panel B for the Chapter 13 decision. Figures shown in parentheses are p-values. In panel A, neither of the coefficients of Circuits*Post is statistically significant and neither has the expected sign. In panel B, the coefficients are larger in magnitude and have the expected signs positive for the approval rate and negative for the interest rate but neither is statistically significant. These results suggest that neither of the Supreme Court decisions to abolish mortgage strip-down had significant effects on mortgage market conditions. Among the other variables, the income and demographic variables are large and significant the results suggest that, even in the 1990 s, lenders engaged in discrimination against African- 23 Sample sizes for both the HMDA and MIRS datasets are larger for the Chapter 13 sample than the Chapter 7 sample. This is because between the two samples, both HMDA and MIRS expanded their coverage by adding mortgage lenders that were not depository institutions. Many of the added lenders were independent mortgage banks, which specialize in riskier mortgage loans. We allow for the change in the sample composition by including dummies for lender type in all regressions and, for MIRS, by using the sample weights. The HMDA web page, discusses the history of the survey. 14

15 Americans, non-whites, unmarried applicants and applicants in minority neighborhoods. 24 Not surprisingly, higher income is associated with higher approval rates and lower interest rates, ARM mortgages have much lower interest rates and longer-term mortgages have slightly higher interest rates. A doubling of the Chapter 13 bankruptcy filing rate is associated with a marginally significant reduction of 0.18 percentage points in the approval rate for mortgage applications (p-value =.06). To examine whether particular regions might have responded more strongly to the Supreme Court decisions to abolish mortgage strip-down, we reran the same two regressions but with separate interaction terms for each circuit in which the Supreme Court decision changed the law. The results for the circuit-specific interaction terms are shown in table 4. None of the coefficients in the regression explaining the Supreme Court Chapter 7 strip-down decision is significant. In the Chapter 13 strip-down regression, the only interaction term that is statistically significant is for the 3 rd circuit, where approval rates for mortgage applications rose by 2.3 percentage points (p =.046), or by 3%, in response to the Supreme Court decision. With this exception, we do not find that a strong response to the two Supreme Court strip-down decisions occurred in any of the affected regions. In Table 5, we report the results of several additional tests. The first rows of Table 5, panels A and B, repeat (for the interaction terms only) the benchmark results from table 3. In the next row, we report the results of examining whether lenders responded to the signal provided by the oral arguments before the Supreme Court, rather than to the Supreme Court decisions themselves. The oral arguments for the Chapters 7 and 13 strip-down cases occurred, respectively, three months and one month before the decision dates. The second rows show the results for the Circuits*Post coefficients of rerunning the benchmark regressions with the sample periods moved earlier by three months and one month, respectively. None of the results are significant, suggesting that either the oral arguments did not provide a strong signal or that market participants did not respond to the signals. We also examined whether the abolition of strip-down affects high-risk mortgages more strongly than mortgages in general. This is based on our hypothesis that mortgage applicants in general become more creditworthy when strip-down is eliminated and that the increase in 24 See Canner and Passmore (1994) and Avery et al. (1993) for discussion. Collection of the HMDA data was started to provide information concerning lender discrimination. 15

16 creditworthiness is greater for high-risk borrowers. The third rows of both panels in Table 5 report the coefficients of Circuits*Post when the sample is restricted to mortgage bank applications and originations, since mortgage banks specialize in lending to high-risk borrowers. Here, two of the results are statistically significant interest rates on risky mortgages fell by 23 basis points (p =.038) in response to the Supreme Court decision to abolish strip-down under Chapter 7 and approval rates fell by 3 percentage points (p =.036) in response to the Supreme Court decision to abolish strip-down in Chapter 13. But the result for approval rates has the opposite sign from what we expect and suggests that high-risk mortgage applicants strongly reduced rather than increased their demand for mortgages. We also reran the model explaining interest rates with a sample composed only of adjustable rate mortgages, since these are considered to be more risky than fixed rate mortgages. Here we find that, as predicted, interest rates fell by 56 basis points (p =.041) following the Supreme Court decision to abolish stripdown in Chapter 7. But there was no significant change in interest rates following the Supreme Court decision to abolish strip-down in Chapter 13. We also reran the regressions explaining approval rates using only mortgages/mortgage applications where borrowers have below-median income-to-loan ratios, on the grounds that these mortgages are higher-risk. The results were insignificant for both bankruptcy Chapters. Finally, we reran the models explaining approval rates using only refinance as opposed to purchase-money mortgage applications. Here we expect to find little effect of abolishing strip-down, since mortgages for refinance are considered to be less risky. But the surprising result is that approval rates rose by 1.7 percentage points following the abolition of strip-down under Chapter 13 and the result is highly significant (p <.001). This implies that lenders expect the abolition of strip-down to have larger effects on the profitability of mortgage loans to low-risk rather than high-risk borrowers. Overall, we find little support for the hypotheses that the abolition of mortgage strip-down caused approval rates to rise and interest rates to fall, even for high-risk mortgages. Finally, we also reran our benchmark model, using a longer sample period of 6 months before to 6 months after the two Supreme Court decisions to abolish strip-down. The results are shown in the last rows of Table 5, panels A and B. All of the results remain insignificant. Circuit court decisions to allow mortgage strip-down. Next, turn to our regressions explaining the effects of circuit court decisions to allow mortgage strip-down under Chapters 7 16

17 and 13. We run separate regressions for each of the seven circuit court decisions to allow stripdown and we also run regressions for the two circuit court decisions not to allow strip-down. Each regression uses a sample period of three months before to three months after the relevant decision date. Because HMDA data at the individual mortgage level are not available prior to 1990, we can only run the approval rate regressions for decisions that occurred after April The predicted signs of the Circuit*Post interaction terms for the court decisions to allow stripdown are the opposite of those for the Supreme Court regressions, while the interaction terms are predicted to be insignificant for the circuit court decisions not to allow strip-down. Results (for the interaction terms only) are shown in Table 6. The only response to adoption of strip-down that even approaches statistical significance is in the 7 th circuit following its adoption of strip-down under Chapter 7, where interest rates fell by 20 basis points (p =.092). This result has the opposite sign from our predictions. We also find that interest rates fell by 24 basis points (p =.034) following the 5 th circuit court s decision not to allow strip-down under Chapter 13, when we predicted that there would be no market response because this decision did not change the law. None of the other results for approval rates or interest rates are significant. Overall, these results suggest that lenders did not systematically respond to the circuit court decisions that introduced mortgage strip-down in bankruptcy. Comparison to Goodman-Levitin. Goodman and Levitin (2014) also examined the effect of court decisions to allow and abolish mortgage strip-down. Their approach is similar to ours in that they also use the MIRS data and a difference-in-difference specification. However, they restrict their analysis to examining the effect of strip-down under Chapter 13 (not Chapter 7), they examine only how strip-down affects mortgage interest rates (not mortgage approval), and they use much a longer sample period. In particular, their analysis of the effect of the Supreme Court s Nobelman decision on mortgage interest rates uses a sample period that extends over nearly a 5-year period, from April 1992 through December 1996, and covers 14 months before the decision and 43 months afterwards. G-L s main result is that the Supreme Court decision to abolish strip-down was associated with a statistically significant reduction in mortgage interest 17

18 rates of 15 to 22 basis points, depending on which additional control variables are included in the model. 25 G-L s results for the strip-down indicator variable which equals one for mortgages originated when strip-down was available are reproduced in row 1 of table 7. Here, the regression in column (1) controls for state and month fixed effects, the regression in column (2) adds state-level linear trends and the unemployment rate, and the regression in column (3) adds several individual mortgage characteristics and indicators for lender type. Figures in parentheses are standard errors (not p-values, as in the previous tables). Asterisks indicate statistical significance. This sample period seems too long, since the long time period makes unrelated factors likely to bias the coefficient of the strip-down indicator. Also, the asymmetry of the sample period means that the overall sample characteristics are heavily influenced by the post-period. The period of the sample was a complicated one for interest rate trends, since interest rates fell from 1992 to 1993, rose from 1993 to 1994 or 1995 and then fell again. This general pattern characterized interest rates on short- and long-term government bonds, corporate bonds and municipal bonds none of which were affected by strip-down as well as interest rates on mortgages. Without accounting for these trends, the strip-down indicator may capture the change in the direction of interest rates before versus after 1993 and therefore appear to be an important determinant of interest rates. G-L use month fixed effects and state-level linear time trends, which take account of non-linear time trends at the national level and linear trends at the state level. But these variables do not fully capture trends in mortgage interest rates if, for example, the low point occurred at different times in different states. To examine how the length of the sample period affects the results, we first replicated G-L s model as closely as possible and then reran their model using different sample periods. Row 2 of table 7 shows the results when we replicate G-L s regression as closely as possible. 26 The 25 This is G-L s post-bellamy sample, given in their Table 2, panel (E). G-L also give results for a longer, 10- year sample period which covers both the four circuit court decisions to allow strip-down under Chapter 13 and the Supreme Court s decision to abolish it, but we do not examine this sample period. 26 There are several minor differences between G-L s regressions and ours. One is that our replication uses the MIRS sample weights which make the sample nationally representative; while G-L do not say whether they use the sample weights. Also, G-L s indicator variable for strip-down is at the state level rather than the district level. This means that in states with more than one district, if one district allowed strip-down before the Supreme Court decision but three others did not, then G-L s indicator variable for strip-down would equal ¼ for all mortgages originated in the state. Our indicator variable, in contrast, is at the district level and always equals zero or one, depending on whether the mortgage originated in a district that allowed strip- 18

19 results for the strip-down variable are similar in rows 1 and 2 and the significance levels are also similar. In row 3, we shorten the post-period by truncating it one year after the Supreme Court decision this makes the pre- and the post-periods approximately equal in length and number of observations. Because the law concerning strip-down did not change during the last 18 months of the post-period, the coefficients of the strip-down indicator are not predicted to change unless the strip-down indicator is capturing something other than the Supreme Court decision. However the results show that the coefficient of the strip-down variable becomes smaller and, once we introduce state and month fixed effects, it becomes insignificant. In row 4, we further shorten the post-period by truncating it six months after the Supreme Court decision this makes the pre-period longer than the post-period rather than shorter. The result is now that the stripdown indicator is never significant and, once we introduce state and month fixed effects, its sign turns from negative to positive. Our final experiment, shown in row 5 of table 7, uses G-L s 5-year time period, but adds statelevel squared time trends to the regressions shown in columns (2) and (3). The squared time trends allow interest rates to reach their minimum level at different times in different states. In this specification, the coefficient of the strip-down indicator changes from and statistically significant when only linear time trends are included at the state level (the result in row 2, column (2)), to and insignificant when squared time trends at the state level are added (the result in row 5, column (2). When mortgage-level characteristics and lender type variables are also included in the regressions, the strip-down indicator changes from and significant (the result in row 2, column (3)) to and insignificant (the result in row 5, column (3)). These results suggest that using a long sample period over-states the importance of mortgage strip-down, because the strip-down indicator captures the effect of non-linear time trends that changed direction around the time of the Supreme Court decision. VII. Conclusion This paper examines whether allowing mortgage strip-down in bankruptcy under Chapter 7 or Chapter 13 affects the terms of mortgage loans. We make use of data from a period in the late down. Use of our more accurate district-level strip-down indicator should reduce the size of the standard errors. Third, G-L and we independently constructed lists of districts that allowed strip-down. These lists are slightly different, which means that our classifications of which mortgages are affected by strip-down are slightly different. Finally, our unemployment rate is at the county level, while theirs is at the state level. 19

20 1980s and early 1990s when seven U.S. Courts of Appeal (circuit courts) allowed mortgage strip-down under Chapter 7 or Chapter 13 of the Bankruptcy Code, and the Supreme Court in two separate decisions abolished strip-down under both Chapters. Using difference-indifference, we separately examine the effect of each of these court decisions on approval rates for mortgages and mortgage interest rates. Our main result is that mortgage lenders did not respond in a significant way to any of the court decisions to allow or abolish strip-down. While Goodman and Levitin (2014) found evidence that strip-down resulted in a small but significant increase in mortgage interest rates, we present evidence that their results may be due to their strip-down dummy capturing nonlinear time trends in interest rates, rather than the availability of strip-down itself. Our results strongly contrast with the 30% increase in interest rates that the Mortgage Bankers Association predicted would occur if Congress adopted mortgage strip-down legislation in On the contrary, our findings suggest that strip-down could be a useful new policy tool to reduce foreclosures, precisely because it has little effect on mortgage markets. Our results are also relevant to two recent initiatives for resolving the large number of residential mortgages that originated in the pre-2008 housing bubble and are still underwater. The first is a recent set of legal cases concerning discharge of second mortgages in Chapter 7 bankruptcy. The second mortgages in question are totally underwater, because the homes first mortgages exceed their market value. In this situation, first mortgage lenders are reluctant to reduce the mortgage principle to the current market value, because doing so would mainly benefit the second mortgage-holders. In a 2012 decision, the 11 th Circuit decided to allow discharge of these second mortgages in Chapter 7 bankruptcy a practice referred to as stripoff. But the Supreme Court, in a recent decision, reversed the circuit court decision and abolished strip-off of second mortgages. 27 While strip-off is no longer allowed, it could be adopted if Congress passed new legislation. Although our empirical results are for mortgages generally rather than second mortgages in particular, they suggest that allowing strip-off of totally underwater second mortgages would not harm future mortgage borrowers. 27 The Eleventh Circuit Court decision to allow mortgage strip-off was McNeal v. GMAC Mortgage (In re McNeal), 735 F.3d 1263 (11 th Cir. 2012). The Supreme Court s decision to abolish mortgage strip-off occurred June 1, 2015 and was in Bank of America, N.A. v. Caulkett, No , and Bank of America v. Toledo-Cardona, No See Levitin (2015) for arguments in favor of allowing strip-off. 20

21 The second policy consists of recent proposals by local governments to use eminent domain to purchase homes in their jurisdictions that have underwater mortgages, compensate lenders for the current market value of the homes, and finance the purchases by issuing new, smaller mortgages to homeowners at current market value. Several large lenders have threatened that if local officials proceed, they will cease making mortgage loans at all in the affected jurisdictions, which would substantially harm future borrowers in these areas. 28 We think that there is a key difference between allowing mortgage strip-down in bankruptcy versus the eminent domain proposals, which is that the eminent domain approach would simultaneously strip down all of the underwater mortgages within the local government s jurisdiction, regardless of whether homeowners would have otherwise filed for bankruptcy or even applied for strip-down. Such concerted action would harm lenders much more than allowing strip-down in bankruptcy under Chapter 7 or Chapter 13, so that their reaction is likely to be much stronger than it would be to the reintroduction of mortgage strip-down in bankruptcy. 28 See Hockett (2013) and Dewan (2013) for discussion. 21

22 Figure 1: Geographic Boundaries of United States Courts of Appeals and United States District Courts Source: United States Courts at 22