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Macroeconomic Effects of Bankruptcy & Foreclosure Policies

  • Kurt Mitman


    (Department of Economics, University of Pennsylvania)

Bankruptcy laws govern consumer default on unsecured credit. Foreclosure laws regulate default on secured mortgage debt. I investigate to what extent differences in foreclosure and bankruptcy laws can jointly explain variation in default rates across states. I construct a general equilibrium model where heterogeneous infinitely-lived households have access to unsecured borrowing and can finance housing purchases with mortgages. Households can default separately on both types of debt. The model is calibrated to match national foreclosure and bankruptcy rates and aggregate statistics related to household net worth and debt. The model can account for 83% of the variation in bankruptcy rates due to differences in bankruptcy and foreclosure law. I find that more generous homestead exemptions raise the cost of unsecured borrowing. Households in states with high exemptions therefore hold less unsecured and more mortgage debt compared to low exemption states, which leads to lower bankruptcy rates but higher foreclosure rates. The model also predicts recourse results in higher bankruptcy rates and a higher coincidence of foreclosure and bankruptcy. I use the model to evaluate how proposed and implemented changes to bankruptcy policy affect default rates and welfare. The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act yields large welfare gains (1% consumption equivalent variation) but results in increases in both foreclosure and bankruptcy rates. I find that implementing the optimal joint foreclosure and bankruptcy policy, which is characterized by no-recourse mortgages and a homestead exemption equal to one quarter of median income, yields modest welfare gains (0.3% consumption equivalent variation).

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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 11-015.

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Length: 58 pages
Date of creation: 01 Jun 2011
Date of revision:
Handle: RePEc:pen:papers:11-015
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  1. Anthony Pennington-Cross, 2004. "The value of foreclosed property," Working Papers 2004-022, Federal Reserve Bank of St. Louis.
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