For those readers not familiar with the Bankruptcy Abuse Prevention and Consumer Protection Act (”BAPCA”), prior to October of 2005, unsecured debt (credit cards, for example) could be discharged under a Chapter 7 bankruptcy (liquidation) therefore allowing the debtor to use that money to make their mortgage payments. However, the 2005 reform act imposed a means test. This test states that if the debtors “average income over the last 6 months exceeds the median for his state, and if his leftover income less IRS recognized living expenses exceeds $166.67 per month, Chapter 7 is not an option”. Debtors who do not qualify for a Chapter 7, then file a Chapter 13 (an individual reorganization) which requires that unsecured lenders are paid out of the same pool as secured lenders, i.e. mortgage companies. If the debtor defaults on his Chapter 13 plan payments, the bankruptcy protection that stayed the foreclosure of his home is withdrawn and his bankruptcy case is typically dismissed. In essence, the 2005 amendments made it worse for individual debtors who are trying to save their homes.

In November of last year three researchers for the Federal Reserve Bank of New York authored a paper that has identified a new scapegoat for the mortgage crisis. The lead author, Donald P. Morgan, stated that he was “99 percent confident” that the bankruptcy reform law had a major role to play in the current mortgage crisis that has crippled the nation. The paper asked, “[i]s it coincidence that the surge in subprime foreclosures that has rocked financial markets came right after the bankruptcy reform in 2005? Is that surge just about falling home prices, bad mortgage decisions and weak economic conditions?” Their answers to these questions are, “no and no”. “Before the reform, over indebted households might file bankruptcy and get rid of their credit card debt, and that would free up income to pay the mortgage. The new law blocks that escape route and forces better-off household to continue paying credit card debt, which makes it harder than before to continue paying the mortgage”.

The paper includes charts and graphs that bring to light the relationship between the home equity exemption rates by state and the amount of foreclosures from the second quarter of 1998 through the second quarter of 2007. It is interesting to note that those states with higher exemption rates had more foreclosures. Whereas, those states (like Texas) that have possibly an unlimited exemption were not affected as hard as other states. In fact, Texas is in the top five of those states in the best shape; unlike Tennessee, Nevada, Georgia, Alabama, and Indiana who are the top five states hardest-hit per capita ratios on foreclosures.

See Morgan, Donald P., Iverson, Benjamin Charles and Botsch, Matthew,Seismic Effects of the Bankruptcy Reform(November 2008). FRB of New York Staff Report No. 358. Available at SSRN: http://ssrn.com/abstract=1310304

You can also read a news article from the Kansas City Star that summarizes the paper at: http://www.kansascity.com/business/v-print/story/976039.html

Chandra