In this paper we examine the relationship between homeowners’ bankruptcy decisions and their mortgage default decisions and the relationship between homeowners’ bankruptcy decisions and lenders’ decisions to foreclose. In theory, both relationships could be either substitutes or complements. Bankruptcy and default tend to be substitutes because homeowners’ budgets are limited and, if they spend less on payments to unsecured lenders, then they have more money to pay their mortgages. But bankruptcy and default may also be complements if homeowners use bankruptcy to reduce the cost of defaulting on their mortgages. Bankruptcy and foreclosure similarly may be either substitutes or complements. In fact we show that both relationships are complementary, although homeowners reacted to the 2005 bankruptcy reform by treating them as substitutes. We also show that bankruptcies, defaults and foreclosures all tend to spread, i.e., higher bankruptcy rates in the neighborhood raise homeowners’ probability of filing, higher default rates raise homeowners’ probability of defaulting, and higher foreclosure rates raise homeowners’ probability of foreclosure. We provide estimates of the size of these effects. The paper argues that these relationships have important public policy implications. In particular, foreclosures have very high social costs, and some of these costs are external to both borrowers and lenders. As a result, there is a social gain from discouraging bankruptcies, since fewer bankruptcies mean fewer defaults and foreclosures. We show that these considerations shift optimal bankruptcy law in a pro-creditor direction, because pro-creditor bankruptcy policies reduce the number of filings and therefore reduce foreclosures. But the same considerations shift other policies that affect bankruptcy in a pro-debtor direction. This is because pro-debtor shifts in, for example, wage garnishment policy reduce the number of bankruptcy filings and therefore reduce foreclosures.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
15472.
Length: Date of creation: Nov 2009 Date of revision: Handle: RePEc:nbr:nberwo:15472
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Find related papers by JEL classification: G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation G2 - Financial Economics - - Financial Institutions and Services K35 - Law and Economics - - Other Substantive Areas of Law - - - Personal Bankruptcy Law R21 - Urban, Rural, and Regional Economics - - Household Analysis - - - Housing Demand R28 - Urban, Rural, and Regional Economics - - Household Analysis - - - Government Policy R31 - Urban, Rural, and Regional Economics - - Production Analysis and Firm Location - - - Housing Supply and Markets R51 - Urban, Rural, and Regional Economics - - Regional Government Analysis - - - Finance in Urban and Rural Economies
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