Effects of Bankruptcy Exemptions and Foreclosure Laws on Mortgage Default and Foreclosure Rates

For a discussion on higher levels of household borrowing and bankruptcy, see Dick and Lehnert (2010); for the decline in stigma and bankruptcy, see Buckley and Brinig (1998), Fay et al. (2002), and Gross and Souleles (2002).

For an excellent survey of this literature, see White (2005). In the next section, we discuss the most relevant studies.

Pence (2006) also considers the effects of both bankruptcy exemptions and foreclosure laws; however, her research focuses on mortgage originations.

When the lender purchases mortgage insurance, the insurer reimburses the lender in case of a default by the borrower. This practice is typical in risky mortgage transactions involving high LTV. According to industry estimates, about 75% of new mortgages carry either public or private mortgage insurance (US Mortgage Insurers See Jump in New Business in January, Dow Jones Newswires, 27 February 2009).

Because the insurers do not cover the entire principal amount, the lender’s gain from the default is reduced. Further, transaction costs associated with relocation give incentives to the borrowers to pay the mortgage payments, thereby further reducing the lender’s benefits from default.

Under certain extreme circumstances—below-market financing arrangements or rising interest rates combined with falling house prices, for example—insurance may stimulate lender induced defaults and foreclosures. The popularity of discounted initial interest rates in hybrid mortgages in the mid-2000s and the subsequent period of rising interest rates and falling home prices is a recent example of conditions favorable to lender induced default and foreclosure.

In a small number of states, a state official must hear evidence and approve foreclosure before a non-judicial foreclosure can occur. For further discussion of the foreclosure process, see the US Department of Housing and Urban Development (1996) or Crew-Cutts and Merrill (2008).

Crew-Cutts and Merrill (2008) reported that in the experience of Freddie Mac, the average time from the time a mortgage is sent to an attorney to begin the process of foreclosure to a finalized foreclosure sale and possession is 272 days in states that require judicial foreclosure and 149 days in states that allow non-judicial foreclosures. They also reported that foreclosure costs are greater in states that require judicial foreclosures than in states that allow non-judicial foreclosures.

See Jones (1993) and Ghent and Kudlyak (2011) for an analysis of deficiency judgments and mortgage defaults.

Also see the US Department of Housing and Urban Development (1996) or Wallace (2007). Wallace further shows that some borrowers take such actions to cure defaults even after the lender has filed for foreclosure and the foreclosure is pending.

For evidence that higher exemption levels are associated with higher bankruptcy filing rates, see Agarwal et al. (2003).

Crew-Cutts and Merrill (2008) noted that lenders’ foreclosure costs are higher the longer the foreclosure period. This consideration suggests that lenders ought to initiate foreclosure promptly to avoid higher costs of delay. However, some limited evidence suggests that the prospect of delay and higher costs might initially cause lenders to attempt non-foreclosure solutions to default. Examining data on foreclosed conventional and VA mortgages, Springer and Waller (1993) found that mortgages owed by borrowers who filed for bankruptcy remained delinquent for a longer period of time prior to starting the foreclosure than mortgages where bankruptcy was not involved.

Home improvement loans rank below first mortgages in priority or are unsecured. Home improvement lenders therefore rely more heavily on borrowers’ non-housing wealth for repayment of the loan. Thus, bankruptcy asset exemptions may have a greater effect on home improvement loans than on home purchase loans. Berkowitz and Hynes (1999) did not include home improvement loans in their analysis.

We restricted our analysis to the period before 2007, as the severe decline in house prices, sharp increases in mortgage delinquencies and foreclosures, and collapse of the subprime market (Gerardi et al. 2008) suggest that market fundamentals changed in the financial crisis and recession that followed.

The National Delinquency Survey (NDS) provides data on delinquency and foreclosures of residential mortgages based on a sample of more than 44 million mortgage loans serviced by mortgage companies, commercial banks, thrifts, credit unions, and others. The NDS provides quarterly delinquency and foreclosure statistics at national, regional, and state levels. Delinquency and foreclosure measures are broken out into loan type (prime, subprime, VA, and FHA) for fixed and adjustable rate products. For each geographic classification, the NDS reports seven measures of performance: total delinquencies, delinquency by length of delinquency (30–59 days, 60–89 days, and 90 days or more past due), new foreclosures, foreclosure inventory, and seriously delinquent (90 days or more days past due). The total number of loans serviced each quarter, as compiled through the survey, is also included in the data. See http://​www.​mbaa.​org/​ for further information. Our analysis does not consider Federal Housing Administration (FHA) and Department of Veteran Affairs (VA) loans because some foreclosure law provisions are prohibited for FHA loans and strongly discouraged for VA loans (Larsen et al. 2007).

See appendix Tables 5 and 6 for definitions and descriptive statistics of these variables.

We are grateful to an anonymous reviewer for pointing out that in a few cases, different sources disagree on whether or not state law requires judicial foreclosure. We re-ran our analyses for each of the different interpretations of the judicial foreclosure requirement (see appendix Table 7) in and found that the empirical results were similar regardless of interpretation.

Our data on deficiency judgment are from the American College of Mortgage Attorneys Inc. and the National Mortgage Law Summary, 6th Edition, 2007–2008. In our sample, only six states prohibit deficiency judgment. These are California, Minnesota, Mississippi, Montana, North Dakota, and West Virginia.

We obtained data on statutory redemption rights from Pence (2006) and the US Foreclosure Law website (www.​foreclosurelaw.​org). We also considered the length (in days) of the redemption period. We obtained the length of the redemption period from www.​foreclosurelaw.​org for Alabama, www.​realtytrac.​com for Wisconsin, and from Crew-Cutts and Merrill (2008) for other states. Of the 10 states that provide a statutory right of redemption, the length of the redemption period was 180 days for three states and 365 days for two states. The remaining five states had redemption periods less than 180 days (30, 60, 75, 90, or 120 days). We performed analyses using the length of the redemption period and obtained results similar to those using an indicator variable.

State garnishment limits were obtained from Agarwal et al. (2003).

For state-level homestead and property (non-homestead) exemptions, we collected the data manually by going over Elias et al. (2006) and its previous editions. Following Traczynski (2011), we used exemption values for an individual; and for property exemptions, we considered exemption limits for security deposits, automobile, tools of trade, and “wild card,” which can be used for protection of any of the consumer’s assets. While collecting the data, we ensured that if we had chosen the federal exemption limit of a homestead exemption for a given state in a given year, then for that state-year, we also used the federal exemption limit for the property exemption. For the states that had unlimited homestead exemptions, we assigned a value of $1,000,000. States allowing unlimited homestead exemptions were AR, FL, IA, KS, OK, SD, and TX. DC had an unlimited homestead exemption from 2002 on.

White and Zhu (2010) found that the means test made nearly a quarter of Chapter 13 filers in Delaware in 2006 ineligible for a Chapter 7 filing. Almost all of these filers were home owners, and these higher income filers were more likely than lower income Chapter 13 filers to repay their mortgages.

See White (2007), Morgan et al. (2008), and Li et al. (2009) for analyses of the effects of the BAPCPA.

The economic rationale for selecting these instruments is that (a) the prime rate reflects the opportunity cost of production of mortgage loans (b) family life-cycle considerations suggest that age influences demand for credit–older households are likely to seek larger loan amounts relative to home value and they tend to be wealthier and choose higher valued homes (c) tighter credit standards are associated with higher contract rates and greater loan-to-home value requirements, and (d) income reflects wealth and therefore influences home values and loan amount relative to home values. The data sources for the prime lending rate, borrowers’ age distribution, net tightening of mortgage credit standards for mortgage loans, and state income per capita are the St. Louis Fed FRED database, Census Bureau, Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices, and Bureau of Economic Analysis, respectively.

Several states actually changed their exemption limit after BAPCPA-2005. For example, NY increased its level of homestead exemptions from $10,000 to $50,000 in 2006. Similarly, IL doubled its level of property exemption limit to $7,900 in 2006. As discussed above, we explicitly controlled for these changes using two additional variables reflecting the effect of BAPCPA.

Estimated coefficients for the other explanatory variables are in appendix Tables 8, 9, and 10.