Using bankruptcy to reduce foreclosures: does strip-down of mortgages affect the supply of mortgage credit?

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 in Chapter 7 or Chapter 13 bankruptcy. Strip-down of mortgages in bankruptcy was proposed as a means of reducing foreclosures during the recent mortgage crisis but was blocked by lenders. Our goal is to determine whether allowing bankruptcy judges to modify mortgages would have a large adverse impact on new mortgage applicants. Our identification is provided by a series of U.S. Court of Appeals decisions during 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 it throughout the U.S. We find that the Supreme Court decision to abolish mortgage strip-down under Chapter 13 led to a reduction of 3% in mortgage interest rates and an increase of 1% in mortgage approval rates, while the Supreme Court decision to abolish strip-down under Chapter 7 led to a reduction of 2% in approval rates and no change in interest rates. We also find that markets react less to circuit court decisions than to Supreme Court decisions. Overall, our results suggest that lenders respond to forced renegotiation of contracts in bankruptcy, but their responses are small and not always in the predicted direction. The lack of systematic patterns evident in our results suggests that introducing mortgage strip-down under either bankruptcy chapter would not have strong adverse effects on mortgage loan terms and could be a useful new policy tool to reduce foreclosures when future housing bubbles burst.