By Christopher Farrell Score one for the law of unintended consequences.
In past periods of economic turbulence, American households were able to escape mountains of bad debt—and keep their homes—by declaring bankruptcy. During the weak growth years from 2001 to 2003, for example, nonbusiness bankruptcy petitions averaged roughly 1.5 million per year. Lenders complained bitterly that bankruptcy was too easy, but because financially stressed Americans could write off their credit card and other consumer debt, they had more money available to pay their mortgages.
But today's growing problem in the housing market is different—foreclosures are soaring, while bankruptcies, though clearly on the upswing, are running roughly at half the 2001-2003 pace. The reason: A new bankruptcy law, approved by Congress in 2005 after years of debate, makes it much harder for households to get out from under their consumer debt. The result: More people being forced to walk away from their homes, leaving lenders holding the bag. Perversely, a law intended to help the financial industry may be damaging the housing sector, creditors and borrowers alike. "It doesn't matter what you think of the purpose of the new bankruptcy law. The timing is bad," says Susan M. Wachter, professor of real estate at the Wharton School of Business.
The old bankruptcy law, in effect since 1978, was considered extremely housing-friendly. Most distressed borrowers favored filing under Chapter 7, essentially cheap, quick debt liquidation. In practice, most got to keep their homes, while the rest of their property and assets were sold off to pay a portion of unsecured debts such as credit-card and medical bills. When the assets ran out, the remaining loans were cancelled—although some debts were off limits, like student loans and child support. Future paychecks could go to mortgage payments.
By contrast, the new law was designed to protect creditors. For one thing, only low-income borrowers can file for Chapter 7, which wipes out debts. The amended law pushes more people into Chapter 13, which forces households to accept 3-5 year repayment plans on all debts—secured and unsecured. In other words, they're still trying to make payments on car, credit card, medical, and other bills that used to be discharged in Chapter 7. That makes meeting the mortgage more onerous. Filing for Chapter 13 temporarily halts foreclosure proceedings, but the protection only lasts as long as the borrower is making mortgage payments.
But even low-income subprime borrowers aren't escaping the new law. In theory, Chapter 7 is still available, but the new law hiked the cost of going bankrupt in order to discourage the practice. Under the old law, the average cost of filing for Chapter 7 was about $800 to $1,400 in attorney and other fees, according to Henry J. Sommer, president of the National Association of Consumer Bankruptcy Attorneys. He estimates that the cost is now up to roughly $1,400 to $2,400. That's a hefty price tag.
Another problem: Under current law, bankruptcy courts don't have the option of reducing the payments on the mortgage for a primary residence. That means anyone who took out a subprime loan is stuck, unless they want to walk away. "If you file for bankruptcy, you don't get relief on the mortgage," says Michelle J. White, an economist at the University of California at San Diego.
Recent bills introduced in the House and Senate would allow judges to adjust unaffordable mortgages downward. That change—if Congress wants to reopen the 2005 law—could transform bankruptcy into a more practical option when dealing with mortgage lenders.
But at least for now, the impact of the 2005 law is to make the housing slump worse. And that means it could take a lot longer than many expect for the economy to regain its footing.
Farrell is contributing economics editor for BusinessWeek