Bankruptcy "Reform" and the Financial Crisis

http://www.futureofcapitalism.com/2010/05/bankruptcy-reform-and-the-financial-crisis

Of the culprits blamed for the financial crisis, the politicians in Congress who passed a 2005 bankruptcy "reform" law haven't gotten much attention. But a new working paper from three economists -- Wenli Li of the Federal Reserve Bank of Philadelphia, Michelle White of the University of California San Diego, and Ning Zhu of the University of California, Davis -- argues "the U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession." The abstract summarizes their findings as follows:

When debtors file for bankruptcy, credit card debt and other types of debt are discharged—thus loosening debtors' budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise.

... Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. ...bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.

Whether it's health care, financial regulations, or bankruptcy, just because the word "reform" is applied to legislation doesn't necessarily mean the legislation will be good for the country.

by Ira Stoll  |  May 10, 2010 at 9:07 am Related Topics:  Banking, Capital Markets Regulation, Housing receive the latest by email: subscribe to the free futureofcapitalism.com mailing list