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Macroeconomic Effects of Bankruptcy and Foreclosure Policies

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  • Kurt Mitman

    (University of Pennsylvania)

Abstract

Bankruptcy laws govern consumer default on unsecured credit. Foreclosure laws regulate default on secured mortgage debt. In this paper I use a structural model to argue that bankruptcy and foreclosure are inter-related. This interaction is important for understanding the cross-state variation in bankruptcy rates and evaluating reforms to default policies. To study this interaction, I construct a general-equilibrium model where heterogeneous households have access to unsecured borrowing and can finance housing purchases with mortgages. Households can default separately on both types of debt. The calibrated model is quantitatively consistent with the observed cross-state correlation between policies and default rates. In particular, the model correctly predicts that bankruptcy rates are lower in states with more generous homestead exemptions (the amount of home equity that may be retained after filing for bankruptcy), despite the decreased penalty of declaring bankruptcy. In equilibrium, that lower penalty of going bankrupt in high exemption states raises the price of unsecured credit. Households respond to the higher price by taking on more highly leveraged mortgages and less unsecured credit. As a result, bankruptcy rates are lower in high exemption states than in low exemption states, but foreclosure rates are higher. I use the model to evaluate the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act which made it more difficult for high income households to declare bankruptcy. Despite being intended to reduce bankruptcy rates, I find that the reform substantially increases them. In addition, the reform has the unintended consequence of considerably increasing foreclosure rates. Nevertheless, the reform yields large welfare gains.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 563.

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Date of creation: 2012
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Handle: RePEc:red:sed012:563

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Cited by:
  1. Leonardo Martinez & Juan Carlos Hatchondo & Juan M. Sanchez, 2012. "Mortgage Defaults," IMF Working Papers 12/26, International Monetary Fund.
  2. John Y. Campbell & João F. Cocco, 2011. "A Model of Mortgage Default," NBER Working Papers 17516, National Bureau of Economic Research, Inc.
  3. John Y. Campbell, 2013. "Mortgage Market Design," Review of Finance, European Finance Association, vol. 17(1), pages 1-33.
  4. Dean Corbae & Erwan Quintin, 2013. "Leverage and the Foreclosure Crisis," NBER Working Papers 19323, National Bureau of Economic Research, Inc.

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