This article reviews the 2005 bankruptcy reform, examines statistical evidence of the effects the reform had on mortgage default rates, and discusses the need for a repeal of bankruptcy reform to build a more stable mortgage and real estate market. 

Lenders led the bankruptcy onslaught

High numbers of mortgage defaults were in the works even before the 2008 financial crisis began to show its effects on California’s real estate market. The Bankruptcy Abuse Prevention and Consumer Protection Act of October 2005 (bankruptcy reform) completed construction of the bars which would condemn so many homeowners to their current negative equity prisons.

Spun as a cure for the allegedly rampant fraud perpetrated by individual debtors (read: non-corporate America), the 2005 bankruptcy reform made it tougher for individuals to get out from under unsustainable debt and regain their financial footing. Riding high on the wave of lender dominance, the rentier class ushered in higher filing fees, more restrictive qualifying criteria and a curb on the judicial authority to grant cramdowns to negative equity homeowners seeking bankruptcy relief to keep their homes. With bankruptcy reform, mortgage lenders forced homeowners to bear the entirety of the risk of property devaluation — this after lenders had rubber-stamped approvals for the same bloated home values during the Millennium Boom. [For more information about the struggle between the debtors and the rentiers, see the September 2011 first tuesday article, Rentiers and debtors: why can’t they get along? ]

Lenders and Wall Street (collectively, the rentiers) reveled in their purported victory, oblivious and (worse) indifferent to how their actions would impact the economy beyond the confines of their own balance sheets, by then replete with distended mortgage assets. The financial crisis would show their celebration was not without cause: bankruptcy reform was one of the saving graces of Wall Street mortgage bankers during the onslaught of the housing crisis since their solvency was no longer imperiled by bankruptcy judges’ cramdown authority or proper mark-to-market accounting standards, both protections having been removed by bankruptcy reform and congressional fiat.

Stricter bankruptcy requirements

To understand how bankruptcy affected a change in mortgage defaults, a brief review of the 2005 bankruptcy reform is instructive.

There are two main types of bankruptcy available to individuals: Chapter 7 and Chapter 13. In Chapter 7 bankruptcy, a homeowner’s home is sold to satisfy his unsecured debts (e.g., credit card debt, medical bills).

In Chapter 13 bankruptcy, a homeowner who has a positive equity beyond their homestead amount can keep their home by arranging a payment plan for any delinquent mortgage payments and other debts. [For more information about the relief available under each respective type of bankruptcy, see the first tuesday Market Chart, Bankruptcy’s often overlooked tie to homeownership.]

The single most important change homeowners experienced under bankruptcy reform was the removal of the judicial authority to grant cramdowns on principal residence mortgage debt to individuals filing a Chapter 13 bankruptcy petition with the intention of keeping their homes. (Remember, under Chapter 7 the home is sold, not retained.)

Bankruptcy reform also made both types of bankruptcy more expensive. Attorney filing requirements (and thus, attorney fees paid by clients) were increased, credit counseling was mandated and bankruptcy petitioners were required to complete a course in debt management while the bankruptcy was in process. Previously, the average cost for Chapter 7 bankruptcy was $900; post-reform, the average cost increased to $1,500. For Chapter 13 bankruptcies, average costs rose from $3,700 to $5,700. None of this helps a negative equity homeowner keep his home, as was the case prior to the 2005 bankruptcy reform. 

The single most important change homeowners experienced under bankruptcy reform was the removal of the judicial authority to grant cramdowns.

Editor’s note — While credit counseling and debt management courses are theoretically sound measures for those facing bankruptcy, the increased “cost of entry” into bankruptcy produced by reform effectively nullifies the good intent. The very same people who would benefit most from counseling and debt management do not have access to it simply due to the high fees required to file.

Under 2005 bankruptcy reform, homeowners who file for bankruptcy must pass one of two means tests to determine:

  • which type of bankruptcy they may file under; and
  • how much they must repay when they file bankruptcy.

The two means tests are the income-only means test and the income-asset means test, so dubbed by the economists. [For the full text of the study, see the November 2011 American Economic Journal: Economic Policy paper, Did Bankruptcy Reform Cause Mortgage Defaults to Rise?]  

Editor’s note — For simplification purposes, in the discussion that follows, the home is the only asset considered, but of course assets can include other properties owned, vehicles, jewelry, etc.

The income-only means test

The income-only means test applies when a homeowner’s home equity is:

  • nonexistent, as is the case with over two million negative-equity California homeowners; or
  • positive, but entirely exempt as less than the amount of the state’s (California’s) homestead exemption. [For California’s current homestead exemption limits, see the December 2009 first tuesday Legislative Watch, Homestead exemption increases affecting future judgment liens.]

If no home equity exists, the homeowner filing for bankruptcy must annualize his average family income during the six months prior to the bankruptcy filing, then compare that annualized average family income with the median income within the state.

Editor’s note — As of November 1, 2011, California’s median family income amounts are:

  • Single-earner: $47,683;
  • Two earners: $61,539;
  • Three earners: $66,050; and
  • Four earners: $74,806.

If the annualized family income is less than the state median income, the homeowner may file for bankruptcy under Chapter 7. But the home cannot then be retained and must be sold or foreclosed upon.

If the annualized family income is greater than the state median income, the homeowner must calculate their non-exempt income to determine whether they file under Chapter 7 or Chapter 13.

To calculate the non-exempt income, they must first calculate what is called their individual income exemption. This is the total of their exemptions set by a list of pre-determined allowances, including:

The amount of the individual income exemption is then subtracted from the homeowner’s actual income to arrive at the non-exempt income. If a homeowner’s non-exempt income is less than or equal to $2,000, they may choose to file under Chapter 7. If it is greater than $2,000, they must file under Chapter 13.  As a result, in Chapter 13 they must use all of their non-exempt income for five years to repay their debts. Thus, the family’s standard of living will deteriorate during that five-year period.

The income/asset means test

The income/asset means test applies when a homeowner has excess home equity remaining after deducting the amount of the state’s homestead exemption, called non-exempt assets (again, in this discussion, these assets consist entirely of that remaining excess home equity). [For current homestead exemption amounts, see the December 2009 first tuesday Legislative Watch, Homestead exemption increases affecting future judgment liens.]

Editor’s note — Bankruptcy reform also capped homestead exemptions at $125,000 for homeowners who have owned their homes for less than 3 1/3 years. In California, this only impacts one of the three tiers of homestead exemptions, that of the aged or disabled, which is currently set at $175,000.

A homeowner with non-exempt assets (a noted rarity in California’s current real estate market) who files for bankruptcy is obliged to repay the greater of their:

  • non-exempt assets under Chapter 7; or
  • five years’ worth of non-exempt income under Chapter 13 (see above calculation to determine non-exempt income amount).

Since individuals have to pay more for less protection under bankruptcy reform, researchers predicted that defaults would increase across all types of loans. This is especially logical for homeowners, who now pay more to file for Chapter 13 bankruptcy, have to pay more back under their bankruptcy repayment plans and receive no relief on their negative equity position.

More specifically, homeowners whose income exceeded the thresholds set under the income-only means test or the income/asset means test were expected to experience the greatest increase in percentage of mortgage defaults.  As you will see, they did.

Reform in, defaults up; de jure, de facto basis

The data used to determine bankruptcy reform’s impact consisted of 663,412 first-lien 30-year mortgages originated in purchase or refinance transactions between January 2004 and December 2005. Loans were separated according to whether they were prime loans (353,225) or subprime loans (310,187), and monitored from a period lasting from three months prior to bankruptcy reform through three months after bankruptcy reform.

Editor’s note — Important to note is that the end of the sample period is still well before the wave of defaults caused by the financial crisis and ensuing housing bust. Also, the homestead cap referenced above also played a role in whether a homeowner was more likely to default on his mortgage after bankruptcy reform, but due to its limited effects in California, it is not thoroughly digested here.

Post-reform mortgage defaults rates were compared to pre-reform default rates. The results followed the expectations: in prime loans, mortgage defaults rose 23% after bankruptcy reform. For homeowners with subprime mortgages, mortgage defaults rose 14%.

Breaking the results down further, 27% more prime mortgage homeowners subject to the income-only means test defaulted on their mortgages after bankruptcy reform. In contrast, 5% more subprime mortgage homeowners defaulted after bankruptcy reform.

With the income/asset means test, prime mortgage homeowners defaulted 11% more post-reform; subprime mortgage homeowners subject to the same means test defaulted 11% less than their pre-reform counterparts.

To explain the decrease in mortgage defaults for subprime mortgage homeowners subject to the income/asset means test, researchers indicated that the rate of mortgage defaults for subprime mortgage homeowners increased through the entire sample period, however the rate of increase slowed post-reform.

Subprime mortgage homeowners are least likely to have a firm understanding of their financial situation, and thus are more reliant on others (say, bankruptcy judges) to make their decisions. They are also most likely to be irrationally bound to the family home and most likely to respond to the dogma of moral obligation to pay one’s legal debts, to believe in their self-defeating efforts to pay their mortgages and accept the decrees of their bankruptcies, come hell or high water. [For more information on financial illiteracy and homeownership, see the May 2011 first tuesday article, Financially illiterate homebuyers in distress — agents to the rescue!]

While mortgage defaults were up overall in subprime mortgage homeowners, as a group (likely first-time homebuyers) with generally fewer assets and generally less income, they are more likely to “pass” the means tests and qualify to file for the cheaper and less financially burdensome Chapter 7 bankruptcy. Thus, the barrier posed by bankruptcy reform is lower, and mortgage defaults are thus less pronounced than in the prime mortgage homeowner category. 

By the same logic, prime mortgage homeowners have more to lose (generally more income, generally more assets) when filing for bankruptcy — they are more likely to “fail” the means tests and be forced to file under the more expensive Chapter 13 bankruptcy. And with cramdowns off the table, what impetus does a negative equity homeowner with money have to pour five years of their non-exempt earnings into paying down a black hole asset?  So, they take the rational strategic default, as dictated by the 2005 bankruptcy reform. Then their future income is theirs.

Undewater homeowners find buoyancy in strategic default

The researchers chose a sample period which began and ended prior to the onslaught of mortgage defaults precipitated by the financial crisis.  Thus, they could more accurately track the impact of bankruptcy reform alone.

Consider their findings in relation to California’s current landscape. The Great Recession’s brutal housing price adjustment and the current ongoing jobless Lesser Depression have created a population of financially insolvent California homeowners who have a decreased ability to support their families, and pay for housing. For homeowners whose finances are stretched thin by unemployment and mounting debts, bankruptcy proceedings still offer debt relief for unsecured debt (e.g., credit card and medical debt) and buy time to remain in the home while making no payments, generating net savings after paying all bankruptcy costs.  

And during these hard times, bankruptcy filings have accordingly soared – and will continue to rise for several more years. [For more information about the automatic stay provision, see the first tuesday Market Chart, Bankruptcy’s often overlooked tie to homeownership.]

In prime loans, mortgage defaults rose 23% after bankruptcy reform. For homeowners with subprime mortgages, mortgage defaults rose 14%.

However, as the researchers revealed and is painfully apparent to anyone who keeps tabs on the real estate market, post-reform bankruptcy is powerless to provide long-term relief for the largest and most devastating type of homeowner debt — the mortgage on a negative equity home. For an underwater homeowner, the automatic stay is just an extension of the inevitable; a variation of the extend-and-pretend loan modification game, just from a different source (the court stay, rather than lender forbearance).

The cramdown prohibition, increased fees and more restrictive filing rubric stifle the ability of homeowners, and by extension the housing market, to recover from this financial crisis. Without cramdowns, the majority of homeowners who file for bankruptcy will lose their homes, take a major hit to their credit (and their future economic opportunities) and add yet another property to a saturated multiple listing service (MLS) market already struggling to find willing and able buyers.

Whether or not they intended it, Wall Street and collaborating mortgage lenders created the perfect trap for homeowners when they rallied together to pass bankruptcy reform: homeowners have no source of assistance to help them with their negative equity other than a DRE-licensed real estate gatekeeper who can tell them, calmly and rationally, to check their family balance sheet to determine if it makes sense to strategically default, sound financial advice any investment counselor can provide for a fee. [For more information about determining whether it makes financial sense for a buyer to strategically default, see the October 2010 first tuesday article, The LTV tipping point: when negative equity owners strategically default; for more information on this divide between the two classes of debtors, see the January 2012 first tuesday article, The morality of strategic default: businesses vs. homeowners.]

Reform the reform!

first tuesday will be the first to agree with readers: strategic default is not the ideal solution. But we do not live in ideal times. For homeowners, it has become the only rational decision to make under the circumstances they must live with – it’s either walk away or stay chained to a black hole asset. Otherwise stated, it’s the application of the laws of antideficiency or those of bankruptcy.  The antideficiency walkaway has prevailed among those who take charge of their future. [Stay tuned for our upcoming digest of California’s antideficiency laws!]

It’s clear from numerous policy declarations that the government entities are not taking the homeowners’ side against lenders on this cramdown debate — even though they had no problem doing so for businesses, for which cramdown authority still exists. The conflict lies in the government ownership of two thirds of the mortgage paper in this country, a situation which will exist for years.  [For more information on Fannie Mae and Freddie Mac’s stance on cramdowns, see the November 2011 first tuesday article, Surprise: Frannie says “no thank you” to cramdowns.]

Like it or not, strategic default is the future to which we commit the housing market in California if we do not address the flaws in our government’s treatment of homeowner debt. Each time the housing market takes a dip and jobs are lost, we throw the majority of homeowners — the 99% — to the mercy of lenders, unwilling to change their improper societal behavior at the risk of losing profits, and to Congress and the administration, unwilling to legislate against lenders at the risk of losing their personal funding. There must, in any democracy, be a third and independent party – the courts – who can step in and break the social stalemate. After years of deregulation and lender missteps leading directly into the financial crisis, a reform of the reform would be a critical step in the right direction.

Want to know more about bankruptcy’s ties to real estate? Stay tuned for our upcoming article on bankruptcy and single purpose entities (SPEs) holding and operating real estate.