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Economists Argue 2005 Bankruptcy Reform Contributed to Mortgage Crisis

May 17, 2010

As Fontana consumer bankruptcy attorneys, we had reservations about the 2005 bankruptcy reform bill before it even passed. Now, a new paper from a team of three economists -- two in California -- argues that the Bankruptcy Abuse Prevention and Consumer Protection Act actually pushed more homeowners into default on their mortgages. By raising the cost of filing and reducing the amount of debt ultimately discharged, the paper says, bankruptcy reform limited filers' options. The paper was published this month by the National Bureau of Economic Research and written by Wenli Li of the Federal Reserve Bank of Philadelphia, Michelle J. White of the University of California at San Diego and Ning Zhu of the University of California at Davis.

Fox Business senior economist Mark Lieberman discussed the paper at length in a May 10 article. According to that piece, the reform law itself created 159,000 defaults for mortgages made in 2004 and 2005; the "means test" imposed by the law created an additional 36,000 defaults for the same time period. The means test is a standard that filers must meet to file for Chapter 7/liquidation bankruptcy; those who don't pass the test can only choose Chapter 13/payment plan bankruptcy. The authors said default rates rose by 14% among prime mortgages and 16% among subprime loans, even before the housing crisis -- suggesting that reform may have worsened the crisis. Among the changes the law made that they said contributed to the problem were the means test, a higher cost to file for bankruptcy and a new cap on the "homestead exemption" that protects the filer's home equity.

In essence, the authors wrote, that cap made bankruptcy less attractive by making it more likely that filers would have to give up their homes. The means test also hurt homeowners by forcing more into Chapter 13, and increasing the assets Chapter 13 filers were required to use to repay debts. In addition, higher filing costs discouraged some from filing at all. Reform generally reduced the amount of debt discharged in bankruptcy, the authors wrote, which had a negative effect on their ability to pay their mortgages. Even when the mortgage payment itself was not affected, they said, being obligated to pay more toward unsecured debts, such as credit card debts, took away money that could otherwise be paid toward a mortgage.

Our Orange personal bankruptcy lawyers remember some of these criticisms being made before the law passed. Of course, no one in 2005 was predicting the mortgage crisis as it currently exists, but many of our colleagues in bankruptcy law predicted that the means test would push more people into Chapter 13. In fact, this provision of the law was more or less designed to do so. The authors of this paper say the greater rate of mortgage defaults was an "unintended" consequence of the reform law, and they are probably right. But we always thought the authors of the law, who worked closely with the credit card industry to develop it, intended to make bankruptcy filing less attractive, more difficult and less financially advantageous. In that sense, financial distress among filers and likely filers is not exactly a surprise.

Howard Law PC represents clients who are considering bankruptcy as a solution to overwhelming amounts of debt, including mortgage debt as well as unsecured debts like credit cards and medical bills. Bankruptcy is not a decision most people make lightly, and our Leucadia individual bankruptcy attorneys do our best to help clients thoroughly examine whether it's the best choice in their own financial situations. But if it is, we can promise thorough counseling and representation as clients move through the bankruptcy process. We handle both of the most common types of bankruptcy for individuals and couples: Chapter 7, a fairly quick "liquidation" of their assets, and Chapter 13, in which filers make a plan to pay back debts over three to five years. Our goal is to leave you with the tools to rebuild your financial future without debts and creditors haunting you.

If you're considering filing for bankruptcy because of overwhelming debt and consistent harassment by creditors, you should talk to Howard Law. To set up a free consultation, please contact us through the Internet or call 1-800-872-5925.