Bankruptcy For Debtors - Advantages and Disadvantages

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1 Saving Your Home in Bankruptcy Michelle J. White UC San Diego and NBER and Ning Zhu UC Davis February 2008 Preliminary draft please give us comments, but do not quote! 1

2 I. Introduction The subprime mortgage debacle is causing a crisis in US housing markets and a possible recession in the US economy as a whole. With falling housing prices, many homeowners have mortgages that exceed the value of their homes. Several million households also have mortgages with low teaser interest rates that are scheduled to increase, but with a drastically reduced supply of mortgage loans they cannot refinance. Housing pundits have estimated that 2 million households will lose their homes to foreclosure, including 1 out of every five holders of subprime mortgages made in 2005 and Congress and the Bush Administration have searched for solutions to the crisis, including several that involve allowing bankruptcy judges to rewrite the terms of mortgages. These reforms would give bankruptcy judges the power to modify the terms of debtors mortgages by reducing the mortgage principle to the current market value of the home, lowering the interest rate, and/or limiting fees and penalties charged by mortgage lenders. 2 The goal of this paper is to examine how bankruptcy law helps homeowners to save their homes. We do this, first, by developing a combined model of debtors decisions to default on their mortgages and to file for bankruptcy. Second, we evaluate the model s predictions using data on actual bankruptcy filings in Third, we examine the effects of the 2005 bankruptcy reform known as BAPCPA ( Bankruptcy Abuse Prevention and Consumer Protection Act ) on whether debtors keep their homes in bankruptcy and we also examine the effects of additional bankruptcy reforms that have been proposed recently to address the subprime mortgage crisis. II. Treatment of homeowners in bankruptcy current law and proposed reforms 1 See Testimony by Eric Stein (2007). For discussion of the treatment of homeowners in bankruptcy prior to 2005, see White (1998), Lin and White (2001) and Baichieva et al (2005). For discussion of the subprime mortgage crisis, see Gramlich and Reichauer (2007). Scarberry (2007) gives a comparison of mortgage reform bills currently pending in Congress. 2 Scarberry (2007) gives a comparison of mortgage reform bills currently pending in Congress. 2

3 How does filing for bankruptcy help homeowners who are in financial distress to save their homes? Filing for bankruptcy does not help homeowners directly, since they must repay their mortgages in full regardless of whether they file or not. 3 However bankruptcy helps homeowners indirectly in two ways. First, some of their unsecured debt is discharged (forgiven) in bankruptcy, which makes it easier for them to pay their mortgages. There are two separate bankruptcy procedures, known as Chapters 7 and 13, and, in both, some or all unsecured debt is discharged. The two Chapters differ in that debtors who file under Chapter 7 are obliged to repay debt only from their assets above an exemption level, while debtors who file under Chapter 13 are obliged to repay debt only from their future income above an exemption level. Second, homeowners who file for bankruptcy under Chapter 13 are allowed to stop mortgage lenders from foreclosing and to repay arrears on their mortgages (interest, principle, and penalty payments that were due in the past) over a 3 or 5 year repayment period. 4 5 In contrast, homeowners who file for bankruptcy under Chapter 7 receive little help in saving their homes, because they are obliged to repay the entire amount owed on the mortgage immediately in order to prevent foreclosure. A type of debtor that clearly benefits from filing under Chapter 13 is one who owns a house, is in arrears on the mortgage, has positive home equity, and has income below the median family income level in the state. These debtors are not obliged to repay any of their unsecured debt in Chapter 13 (see the discussion below) and they can prevent foreclosure by repaying the arrears as part of a 3- to 5-year repayment plan. Debtors whose incomes are above the median level in their states receive the same treatment, but may have to repay part of their unsecured debt as well as their mortgage arrears in Chapter 13 and they must have 5-year repayment plans. 3 Prior to 1993, bankruptcy judges sometimes stripped-down mortgage loans. The prohibition on stripdown of mortgages in bankruptcy is based on the Supreme Court s decision in Nobleman v. American Savings Bank, 508 US 324 (1993) U.S.C. 1322(c)(1) allows debtors to cure defaults on their mortgages in Chapter 13, as long as the residence has not been sold in foreclosure. But 11 U.S.C. 1322(b)(2) prevents bankruptcy judges from discharging any of the mortgage debt on a primary residence, even if the value of the house is below the principle of the mortgage. See Bourguignon (2007) and Jacoby (2008). 5 Debtors can similarly use Chapter 13 bankruptcy to save their cars from repossession or to save their vacation homes or investment properties from foreclosure, since they can reinstate the terms of the original loan by repaying arrears under a repayment plan. Unlike mortgages on a primary residence, the principle owed on a car, a vacation home or an investment property can also be reduced in bankruptcy see below for discussion. 3

4 These rules imply that debtors who wish to save their homes are likely to file for bankruptcy under Chapter 13, while debtors who do not own homes or who do not wish to save them are likely to file under Chapter 7. 6 Norberg and Velkey found that 54% of a sample of debtors who filed under Chapter 13 in 1994 were homeowners and Eraslan, Li and Sarte (2007) found that 87% of a sample of debtors who filed under Chapter 13 in were homeowners. In contrast, homeowning is much less important to Chapter 7 bankruptcy filers. Using a sample of debtors who filed under Chapters 7 and 13 in 2003, Zhu (2007) found that the median Chapter 7 filer had no mortgage debt, while the median Chapter 13 filer had $91,000 in mortgage debt. These studies were conducted prior to the adoption of BAPCPA in 2005, but recent evidence suggests that Chapter 13 remains important to homeowners who wish to save their homes. We collected a sample of bankruptcy filings in 2006 (see below for discussion) and found that 77% of Chapter 13 filers had mortgages and the median mortgage debt was $108, Congress is currently considering various proposals to make bankruptcy more favorable to homeowners. S. 2136, introduced in the U.S. Senate in October 2007, would give bankruptcy judges the power to modify the terms of residential mortgages by reducing the principle, converting variable rate mortgages to 30-year fixed interest-rate loans, and/or by disallowing prepayment penalties specified in the mortgage ( Another bill pending in the Senate, S. 2133, would allow judges to modify mortgage terms, but only if the mortgage-holder consents (thomas.loc.gov/cgi-bin/query/z?c110:s.2133:). A similar bill, H.R. 3609, was passed by the House of Representatives in late 2007 ( We examine the effects of these proposed changes below. III. Model 6 Some states allow debtors to prevent foreclosure outside of bankruptcy by curing defaults on their mortgages, but these programs usually require repayment of arrears more quickly than in Chapter 13. See Jacoby (2008). 7 Eraslan et al s (2007) study and Zhu s (2007) study both examined bankruptcy filings in Delaware, while the Norberg and Velkey sample was of filers in five eastern states. 4

5 In this section, we develop a model of debtors decisions to file for bankruptcy and to default on their mortgages under current bankruptcy law. We then modify the model to examine how debtors incentives differed prior to the adoption of BAPCPA in 2005 and how they would differ if the proposed bankruptcy reforms were adopted. Suppose in period 0, debtors borrow an amount P in unsecured (credit card) debt, obtain a mortgage of amount M, and borrow A to purchase a car. In period 1, debtors owe P > P on the unsecured debt, where P includes the principle, interest, late fees and penalties. Assume that P is large. 8 of amount M in period 0. In period 1, they owe Debtors are also assumed to obtain a mortgage M > M to the mortgage-lender, where M equals the present value of all payments owed on the mortgage until the end of the mortgage term, including the principle, interest, late fees, penalties, arrears (payments due in the past that were not paid), interest on the arrears, and additional interest owed because the mortgage had a low teaser rate for the first two or three years, but a higher rate thereafter. Finally, debtors obtain a car loan of amount A in period 0 and, in period 1, they owe A > A on their car loans, where A equals the present value of all payments owed, including the principle, interest, late fees, penalties, arrears, and interest on the arrears. 9 Both housing value and debtors incomes are assumed to be uncertain. At the beginning of period 2, the value of the house v is drawn from a distribution f (v) and debtors incomes y are drawn from a different distribution g (y). The realized value of the house is denoted V and debtors realized income per year is denoted Y. To keep the model simple, the values of V and Y in period 2 are assumed to remain constant in subsequent periods. Car value, in contrast, is known in advance and is assumed to be in period 2. After learning V and Y, debtors make two decisions: whether to give up their homes and move to rental housing and whether to file for bankruptcy. Although most debtors are already behind on their mortgage payments at the time they file for bankruptcy, we use the term default to refer to debtors decisions to give up their homes and move to 8 More specifically, assume that P > V M X v C f + Cb (see the discussion below). 9 Debtors must pay interest on mortgage and car loan arrears, but not on unsecured debt arrears. V A 5

6 rental housing. If debtors default but do not file for bankruptcy, then mortgage lenders are assumed to foreclose and debtors relocate to rental housing. Assume that debtors relocation cost is L and that rental housing costs R per year. Lenders cost of foreclosure is denoted C. Mortgages are assumed to be non-recourse, so that if the foreclosed house f sells for less than the amount owed on the mortgage, the mortgage lender has no claim on the debtor for the residual. 10 If debtors default on the mortgage and file for bankruptcy under Chapter 13, mortgage lenders cannot foreclose during the bankruptcy procedure and debtors are allowed to repay the arrears as part of their repayment plans. Because the focus of the model is on debtors default decisions, we assume that they always repay their car loans in full. 11 Now suppose debtors file for bankruptcy under Chapter 13. Under Chapter 13, they can reinstate the original terms of their mortgages by following a five-year repayment plan under which they use part of their post-bankruptcy income to repay the arrears on the mortgage, plus interest. They may also be required to repay part of their unsecured debt. Repayment plans in Chapter 13 thus require that debtors make four types of payments: mortgage payments, car loan payments, payments on unsecured debt, and costs of bankruptcy. We examine separately how each of these payments is determined. Consider the mortgage first and suppose the amount owed, M, is divided into two parts. The first part consists of arrears and interest on arrears, plus normal interest and principle payments owed during the next five years. These are denoted M. 1 The second part consists of normal interest and principle payments owed during years 6 through the end of the mortgage, denoted M 2. Assume that the discount rate is zero, so that M = M 1 + M 2. Also assume that the remaining term of the mortgage at the end of the 5-year repayment plan is N years. The debtor therefore owes M / 5 per year during the repayment plan and positive, M 5 > M / N. 1 / 2 M 2 / N per year during the remaining years. When arrears are As an example, suppose the debtor s normal mortgage payments are $750 per month or $9,000 per year, but she owes arrears equal to four months of payments, or 1 10 See Pence (2003) for a list of states that allow mortgage lenders an unsecured claim against the debtor for the residual. 11 However the model could be reinterpreted as a model of debtors decisions to default on their car loans. 6

7 $3,000, plus late fees and penalties of $1,000. Adding one-fifth of the arrears to the normal payment during each year of the plan makes the payment $9,800 per year. In addition, interest must be paid on the arrears. If the interest rate is 6%, then the payments during the plan increase to $9,848 per year, so that M / 5 9, 948. After completion of 1 = the plan, the debtor s payments fall back to $9,000 per year, so that M / N 9, = Debtors car payments under the repayment plan are the normal payments of A / 5 per year because there are no arrears. Now turn to debtors obligation to repay their unsecured debt P. Since the adoption of BAPCPA in 2005, debtors have been subject to a means test that determines their obligation to repay. Debtors compute an income exemption, denoted X y, which is the amount of income they are allowed to keep for their living expenses. If debtors income is below the median income level in their state of residence (adjusted for family size), then X equals the median income level in their state and y debtors are not obliged to repay anything to unsecured creditors. (Nonetheless they still may gain from filing under Chapter 13 and following a repayment plan in order to keep their homes.) If debtors income is above the median income level in their state, then X y is determined by adding several allowances for living expenses. There is an allowance for rent that depends on average housing costs where the debtor lives, an allowance for transportation that depends on the number of cars the debtor owns (up to two), and an allowance for personal expenditures that depends on the debtor s family size and income. There are also additional allowances for debtors expenditures on taxes, mandatory payroll contributions, insurance, telecommunications, childcare, child support, children s educational expenses, care of elderly or disabled relatives, and security costs. Finally, debtors are also allowed to add their secured debt obligations during the period of the plan to the income exemption. Thus if debtors have a car loan, their income exemption increases by the amount A / 5 and, if they have a mortgage, their income exemption increases by M / 5. Debtors are obliged to use all of their income above the 1 exemption for five years to repay unsecured debt, so that their total obligation to repay if 7

8 their income is above the state median level is min[ P,5( Y X )]. The increase in debtors income exemption due to the mortgage is referred to as the mortgage subsidy. 12 Finally, debtors cost of filing for bankruptcy is assumed to be C b, which includes debtors lawyers fees and bankruptcy filing fees. C b is assumed to be less than min[ P, X y ]. Assume that C b must be paid in full during the first year of the repayment plan. 13 Debtors who wish to save their homes thus gain in several ways from filing for bankruptcy under Chapter 13. First, they can reinstate the original mortgage payment schedule by repaying arrears during the five years of the repayment plan, rather than being forced to repay the entire mortgage debt immediately. Second, part or all of their unsecured debt is discharged. Third, debtors receive a mortgage subsidy which increases their income exe mption by up to M / 5 if they keep their homes in bankruptcy. The 1 discharge of unsecured debt and the mortgage subsidy increase debtors ability to pay, which makes it easier for them to keep their homes. 14 Now consider how debtors make their bankruptcy and mortgage default decisions in period 1. Debtors are assumed to make these decisions so as to maximize their wealth. We also assume that debtors define their wealth to include their income and expenditures up to N + 5 years in the future, i.e., until the end of the mortgage. Wealth therefore equals debtors income evaluated over the next N + 5 years minus the cost of repaying their car loans, unsecured loans, housing costs, and bankruptcy costs. Debtors housing costs equal the cost of repaying the mortgage minus the value of the house if they do not default or the cost of relocating plus paying rent over the next N + 5 years if they default. They are assumed to have no financial wealth other than their home equity. Because of y 12 The means test is based on Internal Revenue Service procedures for collecting from delinquent taxpayers, but is more generous to debtors. See White (2007) for further discussion. 13 In practice, debtors usually pay part of the lawyer s fee in advance and pay the remainder under the repayment plan. This discussion ignores a 10% fee that bankruptcy trustees levy on payments made under the plan. Because of this fee, debtors often try to make their normal mortgage and car payments outside of the repayment plan. 14 Berkowitz and Hynes (1999) first suggested that filing for bankruptcy might increase debtors ability to repay their mortgages by reducing their unsecured debt obligations. 8

9 low wealth, debtors may be subject to binding liquidity constraints that prevent them from making wealth-maximizing choices. 15 Because debtors bankruptcy and default decisions may interact, they have four possible choices: default on the mortgage/file for bankruptcy, default/no bankruptcy, no default/bankruptcy, and no default/no bankruptcy. I discuss debtors decisions separately for different ranges of values of Y and V. Debtors decisions under current law are considered in section IIIA. Then we modify the model to consider their decisions under bankruptcy law prior to the adoption of BAPCPA in section IIIB. Finally the original model is modified to consider proposed bankruptcy reforms in section IIIC. A. Default and Bankruptcy Decisions Under Current Law Case (A): V < M ( L + ( N + 5) ). Here L + (N + 5)R is debtors cost of relocating to 2 R alternative housing and paying rent for the next N+5 years. Housing value in case (A) is so low that debtors cost of alternate housing is less than their cost of owning, even if they do not have to make mortgage payments during the repayment period. First consider the choices of debtors whose incomes are below the state median income level. These debtors keep all of their incomes in bankruptcy, so that they receive no subsidy in bankruptcy for keeping their homes. They therefore prefer to default on the mortgage, regardless of whether they file for bankruptcy. Now consider their bankruptcy decisions. If they file, their wealth will be ( N + 5) Y + V A C ( L + ( N 5) R) ; A b + while if they do not file, their wealth will be ( N + 5) Y + VA A P ( L + ( N + 5) R). Because P > Cb, they prefer bankruptcy. Now consider the choices of debtors whose incomes are above the state median level. If they file for bankruptcy, they gain from not defaulting on the mortgage because they receive the mortgage subsidy which reduces their cost of housing from low as M V to as M 2 V. However even with this subsidy, they are better off defaulting on the mortgage because the cost of renting is lower than the cost of owning, i.e., 15 The assumption that debtors maximize their wealth in making their default and bankruptcy decisions implies that they may use all of their resources to repay the mortgage, if doing so maximizes wealth. However if debtors were instead assumed to spend some minimum amount on non-housing consumption, the model would not change in any substantive way. 9

10 L ( N + 5) R < M V. They therefore choose between default/bankruptcy and + 2 default/no bankruptcy. Their wealth if they choose default/bankruptcy is NY + [ 5X + A ] + V A C ( L + ( N 5) R) and their wealth if they choose y A b + default/no bankruptcy is ( N + 5) Y + VA A P ( L + ( N + 5) R). (Here the term in square brackets is the income exemption in bankruptcy, including the subsidy for secured debt payments.) We use Y ~ generally to denote the income level where debtors are indifferent between filing/not filing for bankruptcy under Chapter 13. In case (A), this ~ income level is Y = X + ( A + P C ) / 5. Here, debtors net gain from having their A y b unsecured debt discharged in bankruptcy, P Cb, is just offset by the income they must ~ give up in bankruptcy, 5Y [5X + A ]. Debtors file if their income is below Y ~ A and not otherwise. A y Figure 1 shows debtors period 2 income Y on the horizontal axis and their period 2 housing value V on the vertical axis. Case (A) is the lowest horizontal band. In this region, debtors always default on the mortgage, but they file for bankruptcy if income is below Y ~ A and do not file otherwise. The default/bankruptcy subregion is labeled D/B denotes, while the default/no bankruptcy subregion is labeled D/NB. Case (B): M ( L + ( N + 5) R) < V < M ( L + ( N + 5) ). Here, the value of housing 2 R is higher. In this range of values, debtors may prefer not to default if they receive the mortgage subsidy in bankruptcy, but they still default otherwise. Debtors whose incomes are below the state median level face the same choice as in case (A) and they still default and file for bankruptcy. However those whose incomes are above the median level receive a subsidy on their mortgages if they keep their homes in bankruptcy and they receive a subsidy on their car loans if they keep their cars in bankruptcy. Thus the income that debtors keep during the repayment period is min[ Y, X y + ( A + M 1 ) /5]. Consider their choice whether to default, assuming that they always keep their cars. Their wealth if they choose default/bankruptcy is NY + min[ 5Y,5X y + A ] + VA A ( L + ( N + 5) R) Cb ; while their wealth if they 10

11 choose no default/bankruptcy is NY + min[ 5Y,5X + A + M 1 ] + V A + V M C. y A b When income is X y + A / 5 or less, debtors default and when income is X y + ( M 1 + A ) / 5, they keep their homes. We use Yˆ to denote the income level where debtors are indifferent between defaulting and not defaulting. In case (B), this income level is Yˆ B = X y + ( A + M V ( L + ( N + 5) R) / Now consider debtors choice when their incomes exceed X ( 1 ) y + A + M / 5. At a sufficiently high income level, debtors prefer not to file for bankruptcy. But when they do not file, they receive no mortgage subsidy and this means that they are better off defaulting on their mortgages rather than keeping their homes. Therefore high-income debtors choose between the alternatives of default/no-bankruptcy and nodefault/bankruptcy. Their wealth in the former situation is ( N + 5) Y + VA A P ( L + ( N + 5) R) ; while their wealth in the latter is NY + [ 5X + M1 + A ] + V A + V M C. Debtors are indifferent between these y A b alternatives at the income level Y ~ B that satisfies ~ 5Y [5X + M1 + A ] + ( M V ) ( L + ( N + 5) R) = P C. Here, debtors net gain B y from filing from debt discharge in bankruptcy (the right-hand side) is just offset by the cost of giving up their non-exempt income during the repayment period plus the extra cost of keeping their homes rather than renting (the left- hand side). They choose nodefault/bankruptcy if their incomes are below Y ~ B and they choose default/no-bankruptcy otherwise. Note that Y ~ B increases as V rises, because debtors gain more from keeping their homes when home value is higher and this gain causes them to file for bankruptcy at ~ ~ higher income levels. At the boundary between cases (A) and (B), Y B = Y. The second-lowest horizontal bar in Figure 1 shows the results in case (B). Here debtors in the highest and lowest income regions default, but there is an intermediate income region in which they keep their homes because they receive the mortgage subsidy. Thus the bankruptcy procedure adopted under BAPCPA that allows debtors in b A C < X. 16 Note that the liquidity constraint is not binding in case (B) as long as b y 11

12 bankruptcy to add their mortgage payments to the income exemption has the effect of reducing default. Case (C). housing M ( L + ( N + 5) R) < V < M + X h + C. In case (C), the cost of owned M V is less than the cost of rental housing L + ( N + 5) R, so that debtors prefer to keep their homes. Consider debtors whose incomes are below the state median level first. While they prefer to keep their homes, they may be liquidity-constrained and forced to default if they cannot pay the cost of the repayment plan during the first year. Debtors are liquidity constrained if their incomes are below a level denoted Yˆ C, where Yˆ C = Cb + ( M 1 + A )/ 5. They default if Y < Yˆ C but not otherwise. Liquidity-constrained debtors also file for bankruptcy since P > Cb. 17 Next consider debtors decisions if they are not liquidity-constrained but still have incomes below the state median level. They still prefer to file for bankruptcy, so consider whether they default. Their wealth if they choose default/bankruptcy is ( N + 5) Y + V A ( L + ( N + 5) R) ; while their wealth if they choose nodefault/bankruptcy V > M ( L + ( N + 5) R). A C b A f ( N + 5) Y + V A + V M C. They prefer not to default since Finally consider debtors bankruptcy decisions when their incomes are above the median level. Since they do not default, their wealth if they choose nodefault/bankruptcy is if they choose no-default/no-bankruptcy is y A b NY + [ 5X + M1 + A ] + V A + V M C ; while their wealth ( N + 5) Y + VA A + V M P. They are indifferent between the two choices at the income level Y ~ ~ ~ C, where YC = YA + M 1 / 5. ~ They file for bankruptcy if Y Y and do not file otherwise. 18 C b 17 Debtors who are liquidity constrained may file under Chapter 13, but not propose a repayment plan because they decide that the payments would be unaffordable. Alternately, they may just default on the mortgage and file under Chapter Note that B ~ ~ Y C = Y at the boundary between cases (B) and (C). 12

13 Figure 1 shows the results for case (C) in the third-from-the-bottom horizontal band. Debtors with the lowest incomes default because they are liquidity-constrained even though they file for bankruptcy. Debtors in the middle income region default and file for bankruptcy, so that they receive the mortgage subsidy. Finally debtors in the highest income region neither default nor file for bankruptcy. Compared to case (B), fewer debtors default but more file for bankruptcy. Case (D). M + X + C < V M + X + C + P C. In case (D), home equity v f h f b V M is positive and it exceeds the cost of foreclosure C f plus the homestead exemption for equity in owner-occupied homes, denoted X v. 19 Therefore in a foreclosure, the proceeds of selling the house would be sufficient to pay the foreclosure costs, to repay the mortgage in full, and to give the debtor an amount equal to the state s homestead exemption X v. After all these expenses are paid, there would still be a positive amount V M X v C available to pay unsecured creditors. This means that f for debtors to keep their homes in Chapter 13, they must not only repay the mortgage arrears, but they must also pay unsecured creditors V M X v C f. And since they are also obliged to use their non-exempt income during the repayment period to repay unsecured debt, their total obligation to unsecured creditors is the maximum of V M X v C f or non-exempt income during the 5-year repayment period, whichever is higher. 20 Case (D) is unlikely to occur in states that have high homestead exemptions and cannot occur in the seven US states that have unlimited exemptions. However it can exist and may occur frequently in states with low or zero homestead exemptions, including Delaware. Consider debtors whose incomes are below the state median level. Because the value of their homes is high, they must pay unsecured creditors V M X v C in order to f 19 Seven states in the U.S. have unlimited homestead exemptions and several others have large homestead exemptions. In these states, cases (D) and (E) either never apply or only rarely apply. 20 This is because the best interest of creditors test requires that unsecured creditors receive at least what they would get if the debtor filed for bankruptcy under Chapter 7, where debtors must use their non-exempt home equity to repay their unsecured debt. Reference? 13

14 keep their homes. And, because they have no wealth other than their home equity, they must pay this amount from income even though their incomes are exempt. Debtors are therefore liquidity-constrained and forced to default if they cannot pay the cost of the repayment plan during the first year, or if their incomes are below Yˆ D, where Yˆ D = C + ( M + A + ( V M X C )) / 5. These debtors both default and file for b 1 v f bankruptcy. Now consider the choice of debtors who are not liquidity-constrained. They do not default, so consider their bankruptcy decisions. Their wealth if they do not file is ( N + 5) Y + VA + V M A P. Their wealth if they file is either ( N + 5) Y + V A + V M ( V M X C ) C if their incomes are below the state median level or A y v A f b NY + [ 5X + M1 + A ] + V A + V M C if their incomes are above the state median level. In the former case, debtors prefer to file for bankruptcy since b v f P C > V M X C. In the latter case, debtors are indifferent between no- ~ ~ default/bankruptcy and no-default/no-bankruptcy at an income level Y D = YC. 21 They file if their incomes are below Y ~ D and they avoid bankruptcy otherwise. Figure 1 shows debtors choices in case (D) as the second-from-the-highest horizontal band. A surprising result is that debtors in case (D) are more likely to liquidity-constrained than those in case (C), because debtors in part (D) must pay part of their home equity to unsecured creditors. Otherwise, the results are similar to case (C). b Case (E). V > M + X + C + P C. In case (E), the value of the house is so high v f b that selling it would generate enough to pay the costs of foreclosure, repay the mortgageholder in full, return the full amount of the homestead exemption to the debtor, and repay unsecured creditors at least P Cb. This means that most debtors in case (E) do not gain from filing for bankruptcy because the amount of debt that is discharged in bankruptcy is less than the cost of filing. Debtors also do not gain from receiving the mortgage subsidy in bankruptcy, since they still must repay their unsecured debt in full. 21 This applies when debtors non-exempt income is la rger than their non-exempt home equity. 14

15 This means that the only reason for debtors in case (E) to default on their mortgages and file for bankruptcy is that they are liquidity constrained, which occurs if income is below the level Yˆ = C + ( M + A + )/ 5. These debtors choose default/bankruptcy. E b 1 P Above this income level, debtors choose no-default/no-bankruptcy. The top horizontal bar in figure 1 shows the results in case (E). Overall, the results in figure 1 imply that debtors default on their mortgages when their housing value is low, regardless of their income levels. But debtors in the middle region of case (B) keep their homes rather than defaulting, because the mortgage subsidy in bankruptcy makes doing so worthwhile. The mortgage subsidy was probably an unintended consequence of the 2005 bankruptcy reform, but it has the effect of encouraging debtors some debtors to keep their homes in bankruptcy when they would otherwise default. Low-income debtors also default because of liquidity constraints, even when their housing value is high. B. Default and Bankruptcy Decisions Prior to BAPCPA The 2005 bankruptcy reform has been criticized for making the subprime mortgage crisis worse by reducing the level of debt relief to debtor-homeowners in bankruptcy. 22 To evaluate this claim, consider how BAPCPA changed the treatment of homeowners in bankruptcy. Both before and after the adoption of BAPCPA, debtors who wished to prevent mortgage creditors from foreclosing on their homes had to file under Chapter 13 rather than Chapter 7 and they were obliged to repay all their mortgage arrears, plus interest, as part of their Chapter 13 repayment plans. But BAPCPA changed bankruptcy law by adopting a statutory formula for determining how much debtors in bankruptcy were obliged to repay unsecured creditors. Prior to BAPCPA, debtors proposed their own repayment plans and the only requirement was that they had to repay an amount at least equal to the value of their non-exempt assets. Because most debtors either had no non-exempt assets or could convert their assets from non-exempt to exempt before filing, they often proposed plans that involved only token repayment of unsecured debt. Thus most debtors could prevent mortgage lenders from foreclosing in bankruptcy without 22 For example, see Birnbaum (2007). 15

16 incurring any obligation to repay unsecured debt. 23 Another important difference is that, prior to BAPCPA, debtors cost of filing for bankruptcy was much lower. This is because BAPCPA increased the amount of information that debtors must provide to the bankruptcy court, instituted a requirement that debtors take a credit counseling course before filing, and made bankruptcy lawyers liable for penalties when debtors provide false or inaccurate financial information. Lawyers responded by increasing their fees. How do these differences change the results in figure 1? The most important change is that, under pre-bapcpa bankruptcy law, all debtors in cases (A) and (B) had an incentive to default and file for bankruptcy. All debtors had an incentive to file for bankruptcy because they were not required to repay their any of their unsecured debt, even if they had high incomes. And debtors in the middle income region of case (B) who do not default in figure 1 because of the mortgage subsidy had an incentive to default prior to BAPCPA because there was no mortgage subsidy. Figure 2 shows that, prior to BAPCPA, more debtors in cases (A) and (B) had an incentive to file for bankruptcy and more debtors in case (B) had an incentive to default. 24 Now consider debtors in cases (C) through (E). Prior to BAPCPA, some debtors in these cases defaulted on their mortgages because they were liquidity-constrained. While the liquidity constraints Yˆ C, Yˆ D and Yˆ E remained the same before versus after the adoption of BAPCPA, they were less binding prior to BAPCPA because bankruptcy costs C b were lower. As a result, fewer debtors prior to BAPCPA had an incentive to default. But more debtors in cases (C) and (D) filed for bankruptcy prior to BAPCPA, because their obligation to repay unsecured debt in bankruptcy was lower. Figure 2 shows debtors gains from defaulting and filing for bankruptcy prior to BAPCPA. Comparing figures 1 versus 2, the differences are striking. Many more debtors gained from filing for bankruptcy prior to BAPCPA which was the reason that unsecured lenders lobbied heavily for bankruptcy reform. But the adoption of BAPCPA 23 Homeowners also could avoid repaying their unsecured debt by first filing a Chapter 7 bankruptcy and having their unsecured debt discharged and then filing a Chapter 13 bankruptcy and proposing a plan to repay their mortgages. This strategy was called filing a Chapter 20. Since the adoption of BAPCPA, this strategy is no longer allowed. 24 See White (1998) for discussion of the fact that prior to the adoption of BAPCPA, many debtors had an incentive to file for bankruptcy even if they had high incomes. Although not all debtors who could gain from filing for bankruptcy actually filed, Fay et al (2002) show empirically that debtors are more likely to file when their financial gain from bankruptcy is higher. 16

17 had an ambiguous effect on the level of default, because more case (B) debtors but fewer case (C), (D) and (E) debtors had an incentive to default prior to BAPCPA. C. Default and Bankruptcy Decisions with Strip-down Finally, consider how the bankruptcy reforms that have been proposed recently to address the subprime mortgage crisis would affect homeowners incentives to default and file for bankruptcy. All of the bankruptcy reform bills pending in Congress would allow bankruptcy judges to strip-down debtors home mortgage obligations in bankruptcy under certain conditions. Strip-down may take various forms, including reducing the mortgage principle to the current market value of the house, lowering the interest rate so that the initial teaser rate continues for the full term of the mortgage, and eliminating prepayment fees and other types of mortgage penalties. 25 Suppose the amount owed under the stripped-down mortgage is denoted S, where S is divided into an amount S1 owed during the repayment period and an amount S 2 owed after the end of the repayment period. Assume that S 1 < M1 and S 2 < M 2. All other aspects of bankruptcy law are assumed to remain the same as under BAPCPA. The analysis of debtors default and bankruptcy decisions under strip-down remains mainly the same as the analysis of current law as shown in figure 1, except that S1 and S 2 are substituted for M 1 and M 2. Figure 3 shows debtors default and bankruptcy decisions under strip-down. Because S 2 < M 2 and S < M, debtors are more likely to be in case (E) and less likely to be in cases (A) through (D) under stripdown. As a result, fewer debtors gain from filing for bankruptcy or defaulting on their mortgages. Now consider the changes for debtors who are still in cases (A) through (D). For these debtors, the liquidity constraints Yˆ C, Ŷ D and Yˆ E shift to the left and become 25 The Durbin bill, S. 2136, would allow strip-down only if the debtor has insufficient current income to make mortgage payments after deducting the income exemption, while the Specter bill, S. 2133, and the Chabot bill, H.R. 2778, allow strip-down only if the mortgage lender agrees. The Durbin bill and the Miller bill, H.R. 3609, also allow bankruptcy judges to lower the interest rate or extend the term of the mortgage, regardless of the debtor s income. See Scarberry (2007). Note that, under current law, bankruptcy judges can also strip-down debtors mortgages on their vacation homes and rental properties in bankruptcy, but the stripped-down principle must be repaid in full during the repayment plan. Because most mortgages have longer terms than a five-year repayment plan, this means that debtors rarely ask for strip -down. Bankruptcy judges can also strip down car loans if the car was purchased more than 2 ½ years prior to the bankruptcy filing.. 17

18 less binding (assuming that the reduction in debtors first year mortgage repayment obligation is greater than the increase in bankruptcy costs). This means that fewer debtors in cases (A) through (D) default because they are liquidity-constrained. However these debtors are more likely to file for bankruptcy, because their gain from filing increases by the amount of mortgage debt discharged. These changes suggest that, if strip-down were adopted, there would be less default, but the number of bankruptcy filings might either increase or decrease. Thus introducing strip-down would allow more debtors to keep their homes, but possibly at the cost of additional bankruptcy filings. An important issue concerning strip-down is how it would affect the supply of mortgage credit. In the short-run, the proposed reforms would probably benefit lenders as well as borrowers. This is because, when lenders foreclose on a house, transactions costs C f are high (Pence, 2003) and therefore mortgage lenders incur large losses. Because most debtors would prefer to keep their homes, both sides would often gain if they could avoid foreclosure by renegotiating the mortgage terms. But in practice, mortgages are unlikely to be renegotiated, because the packaging and resale of mortgages on the secondary market fragments their ownership among multiple bond issues. There also are often conflicts of interest between the owners of first versus second mortgages and between mortgage-holders and mortgage servicers the latter because mortgage servicers are compensated for the costs of foreclosing, but not for the costs of renegotiating. 26 Allowing bankruptcy judges to strip-down mortgages as part of a Chapter 13 bankruptcy thus potentially imposes a solution that makes both sides better off, but which they could not agree to on their own. But allowing mortgage strip-down in bankruptcy is likely to be bad for future borrowers because it increases default. This will make mortgage lending less attractive, thus reducing credit supply and increasing interest rates. Future homeowners are 26 Evidence on whether mortgages are renegotiated privately is wildly divergent. The Mortgage Bankers Association claims that many mortgages are renegotiated and most non-renegotiated foreclosures are of investor-owned properties where the owner is uninterested in renegotiation or properties for which the owner does not respond to repeated attempts to renegotiate. See Brinkman (2008). This organization has argued against the proposed bankruptcy reforms. But a recent Moody s report claims that only 1% of subprime loans that have resetting interest rates were modified in See Drucker and Fricke (2007). Morgenstern (2007) discusses how mortgage servicers often make a pretence of renegotiating mortgages, but in fact use the renegotiation as an excuse to add large fees to the mortgage principle. 18

19 therefore likely to pay higher interest rates and to need higher down payments. Allowing mortgage strip-down will also reduce the supply of unsecured credit because more bankruptcy filings will occur. Overall the proposed reforms would help existing homeowners, but at the cost of making it more difficult and expensive for future homebuyers to obtain mortgages and for future debtors to borrow on their credit cards. IV. Data and Empirical Tests We tested the model by collecting a new dataset of all debtors who filed for Chapter 13 bankruptcy in Delaware in 2006 there were 586 filings in total. The information was collected from both the bankruptcy filing forms and debtors repayment plans. 27 We used bankruptcy filings in Delaware because the Delaware bankruptcy court has been a leader in making bankruptcy filings available to researchers and because Delaware filers are representative of bankruptcy filers nationally. The importance of Chapter 13 for debtors who wish to save their homes is demonstrated by the fact that 77% of filers in our sample have mortgages the average level of mortgage debt (including first and second mortgages) for those who own homes is $153,000. An additional 8% of debtors who do not have mortgages have automobile loans the average level of automobile debt for those who have car loans is $18,500. Overall, 86% of Chapter 13 filers have either mortgages or car loans and therefore are likely to be in Chapter 13 to save their homes or their cars. In addition, 82% of Chapter 13 filers pass the means test and therefore would be allowed to file under Chapter 7. These debtors presumably file under Chapter 13 only because they wish to save their homes or their cars. In other words, few debtors file under Chapter 13 for reasons other than to save their homes or cars. Now turn to the estimation of the model in figure 1. From the forms that debtors file with the bankruptcy court, we obtained information concerning the variables Y, V, M, M1, M, P, VA, A, and C b. Table 1 gives summary statistics for these, X y 2 27 See Zhu (2007) for discussion of how Delaware filers are representative of bankruptcy filers nationally. For bankruptcy forms, see Is the repayment plan form posted on the web? 19

20 variables and the appendix gives details concerning how we constructed them. Note that the results discussed here are very preliminary! Table 2, column (1), gives results for the base case, which corresponds to the model in section IIIA and figure 1. Few debtors are in the low-housing-value cases 13% are in case (A) and 14% in case (B). This is not surprising since most debtors in these cases are better off defaulting on their mortgages and, if they default, they are likely to file for bankruptcy under Chapter 7. Less than 2% of all debtors are in middle region of case (B), where the mortgage subsidy in bankruptcy gives them an incentive to keep their homes rather than defaulting. The proportion of debtors who default because they are liquidity-constrained (meaning that they are in cases (C), (D) or (E) and their incomes are below Yˆ C, Yˆ D, or Yˆ E, respectively) is 20%. Overall, 45% of Chapter 13 filers gain from defaulting on their homes and 89% gain from filing for bankruptcy. 28 Now turn to bankruptcy law pre-bapcpa, which corresponds to the model in IIIB and figure 2. The results are given in column (2). Here the main change is that, prior to the adoption of BAPCPA, 97% of debtors gained from filing for bankruptcy compared to 87% under current bankruptcy law. This difference is not surprising since a central goal of BAPCPA was to make filing for bankruptcy less attractive to higher-income debtors. But the proportion of debtors in bankruptcy who would gain from defaulting on their mortgages was not much different 46% prior to the adoption of BAPCPA compared to 45% under current law. Thus the adoption of BAPCPA caused an increase of about 2% in the probability that debtors in bankruptcy keep their homes. This result suggests that the mortgage subsidy under BAPCPA, which increases debtors incentive to keep their homes, more than offset the higher cost of filing under BAPCPA, which increases default because more debtors are liquidity-constrained. 29 Now turn to strip-down, which corresponds to the model in IIIC and figure 3. We examine two separate versions of strip-down. The first is a generalized strip-down in 28 A number of debtors are observed in the sample even though our model predicts that they should not file for bankruptcy under Chapter 13. Presumably they file either because of other reasons (such as priority debts or student loans that can be repaid under the repayment plan) or because our calculations are distorted by missing or erroneous data. 29 The simulations of bankruptcy reform assume that debtors do not change their bankruptcy filing behavior. In reality, reform might cause changes in the number of debtors who file under Chapter

21 which all homeowners who file under Chapter 13 have their mortgage payments reduced by 20% both during and after the repayment plan, i.e., S 1 =. 80M1 and S 2 =. 80M 2. Column (3) of table 2 shows the results in this case. The proportion of debtors who gain from defaulting falls from.45 in the base case to.36 under strip-down, so that strip-down in bankruptcy increases debtors probability of keeping their homes by about 20%. But the proportion of debtors who gain from filing for bankruptcy falls from.89 in the base case to.74 under generalized strip-down. This is mainly because the bankruptcy thresholds Y ~ C and Y ~ D fall when strip-down is introduced, so that fewer debtors have incomes low enough to gain from bankruptcy. Another important change is that the proportion of debtors who keep their homes because of the mortgage subsidy in bankruptcy falls from.018 in the base case to.012 under strip-down. The second version of strip-down is more targeted it reduces debtors mortgages only if the mortgage principle exceeds the current market value of the house. 30 debtors, we multiply the mortgage payments M 1 and M 2 by the value of the house divided by the principle amount of the mortgage. The results of this version of strip-down are shown in column (4) of table 2. For these Surprisingly, only about 12% of debtors benefit from targeted strip-down and, of those affected, the average mortgage payment is reduced by only 17.5%. The debtors who benefit from strip-down have average income of $52,000, which is far higher than the average income level of $38,000. Thus the average beneficiary of strip-down is relatively well-off. Because few debtors benefit from strip-down, the results are quite similar to those in the base case. The proportion of Chapter 13 debtors who gain from default is.445 compared to.45 in the base case. And the proportion of debtors who gain from filing for bankruptcy is.88, compared to.89 in the base case. Thus, a targeted form of strip-down does little in terms of helping debtors in bankruptcy to save their homes. However because our sample of bankruptcy filers was collected in 2006, housing values were higher than they would be in 2008 and this means that additional debtors would gain from targeted strip-down. 30 Most of the bills currently pending in Congress target strip-down. For example, the Specter bill (S. 2133) limits strip-down to debtors who have income less than 150% of the state median level. Try this? 21

22 V. Conclusion In this paper, we model how Chapter 13 bankruptcy treats homeowners and the extent to which it helps them keep their homes. One perhaps unintended result of the adoption of BAPCPA in 2005 is that it gives debtors a stronger incentive to keep their homes in Chapter 13, because their income exemption in bankruptcy increases by up to the amount of their mortgage payments. As a result, our simulations suggest that the proportion of debtors in Chapter 13 who gain from defaulting falls by nearly 2%. But an offsetting effect is that bankruptcy costs are higher under BAPCPA and this means that more debtors are forced to default because they are liquidity-constrained and cannot afford to make the payments under their repayment plan. We also examine two bankruptcy reform proposals. The first is a generalized stripdown proposal under which bankruptcy judges reduce the mortgage payments of all Chapter 13 filers by 20% if they keep their homes. Under this reform, the number of Chapter 13 filers who default falls by 20%. The second reform is a more targeted stripdown which reduces the mortgage payments of Chapter 13 filers according to how much the mortgage principle exceeds the current market value of the house. Because our sample of debtors filed for bankruptcy in 2006 before the subprime mortgage crisis began, the targeted reform benefits only 12% of debtors in our sample. This proposal causes default rates in Chapter 13 fall by only 1%. 22