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Bankruptcy Exemptions and the Market for Mortgage Loans

Personal bankruptcy is no longer an unusual phenomenon. Personal bankruptcy filings have risen over 500% in the last two decades and there were over 1 million filings in 1996 alone. Moreover, these filing statistics may in fact understate the importance of personal bankruptcy as many more debtors may implicitly use the threat of filing to evade collection efforts by their creditors; it is default and not necessarily bankruptcy which creates losses for creditors (see White and Petropolous (1996)).

The possibility that these changes in bankruptcy patterns may affect the larger market for credit is of obvious importance to economists and the general public. Yet, to date there has been surprisingly little research in this area. In one recent exception, Gropp Scholz and White (1997) used the 1983 Survey of Consumer Finance to test the question of whether differences in state bankruptcy exemption levels affect aggregate household credit.

Aggregate household credit, though, contains both secured and unsecured credit which have very different dispositions in bankruptcy. As a result, the effects of bankruptcy exemptions on aggregate credit may obscure important differences in the underlying components of household credit. In this paper, we argue that much of the conventional wisdom regarding bankruptcy does not apply to secured credit. In particular, we focus on the primary market for household credit the market for mortgage loans.

Mortgage loans are (nearly always) fully secured by a combination of collateral, downpayment and mortgage insurance. Over 97% of the secured claims of Savings and Loans and private mortgage companies on bankrupt debtors are fully secured (Sullivan, Warren and Westbrook (1989). The mortgage lender has an important legal remedy unavailable to other creditors, namely the right to foreclose on the home. The mortgage lender is senior to bankruptcy exemptions with respect to its collateral.

Bankruptcy Exemptions and the Market for Mortgage Loans