Using Bankruptcy to Reduce Foreclosures: Does Strip-Down of Mortgages Affect the Mortgage Market?

We assess the credit market impact of mortgage “strip-down” -- reducing the principal of underwater residential mortgages to the current market value of the property for homeowners who file for bankruptcy under Chapter 7 or Chapter 13. Strip-down of residential mortgages in bankruptcy was proposed in 2009 as a means of reducing foreclosures during the Great Recession but was blocked by lenders on the grounds that it would greatly increase the cost of mortgage loans. Our goal is to test this hypothesis and determine whether the change would in fact have a large adverse impact on mortgage availability. Our identification is provided by a series of U.S. Court of Appeals decisions in the late 1980s and early 1990s that introduced mortgage strip-down under both bankruptcy Chapters in parts of the U.S., followed by two Supreme Court rulings that abolished mortgage strip-down all over the country. We find that neither the circuit court decisions to allow strip-down nor the Supreme Court decisions to abolish it had any significant effect on either mortgage availability or mortgage interest rates. The lack of systematic response suggests that, at least during normal economic times when bankruptcy and foreclosure rates are low, introducing mortgage strip-down under bankruptcy would not adversely affect mortgage loan availability and could be a useful new policy tool to reduce foreclosures.