Bankruptcy

What Happens to Homeowners in Bankruptcy?

By Katie Porter

Amending bankruptcy law to permit judges to modify home loans for chapter 13 debtors does not seem to be gaining traction in Congress, despite the fiasco with the bailout vote and pressure to incorporate more "Main Street" provisions. For many reasons, I remain convinced that any bailout should attempt to limit losses at the family-level, rather than addressing only the end consequences for major financial institutions. That said, does filing bankruptcy improve a family's chances of saving its home?

A new paper, The Homeownership Experience of Households in Bankruptcy, by economists Sarah Carroll and Wenli Li provides a tenative answer to this question. Before summarizing the findings, let me emphasize a few key points. The paper's sample comes from Delaware. Yup, that's it. That limits my confidence, and to their credit, the authors' confidence, about extrapolating these findings to the whole nation. Another difficulty is that the housing market has changed so rapidly that despite the authors' quick production of this study, the mortgages of today's families may look very different from those of families that filed bankruptcy in 2002. Keeping those qualifications in mind, what do Carroll & Li report on how many homeowners that file bankruptcy avoid foreclosure.

In short, five to six years after their bankruptcy filing, 72.1% of families still owned their homes. The remaining 27.9% lost their houses. I read this as cause for optimism about bankruptcy's potential as a home-saving device, although Carroll & Li find that among homeowners who entered the foreclosure process and did not file bankruptcy, even 57% of this group owned their homes and avoided foreclosure.

Carroll & Li conclude that "bankruptcy does not help homeowners", but I think their data show the opposite effect. Bankruptcy does help, but perhaps more modestly than some would have anticipated. Also ultimately retaining the home may not be the only positive outcome of bankruptcy for a homeowner.  Carroll & Li find that for those bankruptcies ending in a foreclosure sale, the bankruptcy adds about ten months to the process. This delay may be desirable if it mitigates some of the related costs of foreclosure by permitting families to locate alternate housing, even though it could reduce lenders' recoveries.

I disagree with Carroll & Li's effort to use their paper as evidence that modifying mortgages in bankruptcy would not be a substantial help for families. To me, the paper suggests the opposite, which is that bankruptcy's efficacy as a home-saving device could be improved if bankruptcy judges could, in appropriate situations, give families additional relief from their mortgage debt, such as by freezing an interest rate. Regardless of the interpretation, I think the authors would echo my hope that their paper stimulates more research on bankruptcy outcomes for homeowners.

Full post as published by Credit Slips on October 01, 2008 (boomark / email).