Fenaba Addo, UW-Madison

J Michael Collins, UW-Madison

For more than thirty years American families have experienced significant changes in federal and state bankruptcy laws, expanding credit markets, and sharp declines in insolvency-associated stigma. Despite these transformations, having the right and exercising the option to start over has remained foundation of the bankruptcy system in the U.S.. The decision to file for bankruptcy varies significantly across households by demographic characteristics and geographic location. Given the depth of the housing and labor market recession in recent years, the role of bankruptcy may be particularly salient as households recover financially. Research on the role and effects of bankruptcy policy on households has been limited, however.

This study examines the behavior of households with subprime loans during the peak of the housing boom and subsequent bust. Specifically, we examine the influence of bankruptcy on the probability of mortgage default and foreclosure.  Does bankruptcy offer households time to reconfigure non-housing debt and offer the opportunity to keep up with mortgage payments and retain their home? Or, does bankruptcy simply signal economic distress and just extend the inevitable foreclosure and loss of the home? Are homeowning households that file for bankruptcy systematically different from those who do not, and is this difference associated with the likelihood of default and foreclosure? Using a monthly panel dataset of about 200,000 private label subprime mortgages originated between 2004 and 2006 and tracked through January 2013, we show the demographic, socioeconomic, and local geographic factors predicting the probability that a household files for bankruptcy.  We then estimate whether filing for bankruptcy is causally associated with the likelihood of mortgage default or foreclosure. Because bankruptcy is associated with these outcomes in unobserved ways, we also test state variations in bankruptcy provisions and the monthly intensity of MSA level advertisements for bankruptcy attorneys as instruments to predict  filing for foreclosures.

The results of this analysis can help policymakers to understand which households file for bankruptcy, which fail to file despite potential benefits, and how filing is related to home foreclosure and the stability of the mortgage market. The analysis can inform policy and legal scholars with a shared interest in the how existing legal structures may either contribute to or mitigate wealth building, retaining of assets, and economic disparities with our society.