Bankruptcy Laws of 2005 Are Being Blamed for Foreclosure Meltdown

September 9th, 2009

As the economic crisis worsens there is a scramble to pin the blame on various causes. The latest culprit is the bankruptcy reform Act of 2005. It was strongly advocated by the credit card lobby.

Three researches of Federal Reserve Bank of New York are of this opinion. They argue that the law transferred the risk from credit-card lenders to mortgage-holders. This led to the swelling of foreclosure numbers.

Previous to the passing of this (Bankruptcy Abuse Prevention and Consumer Protection Act of 2005) the borrowers could cancel their unsecured debt by the filing of Chapter 7 liquidation. Distressed house owners could use their freed income to make necessary mortgage payment. As a consequence those who were better off seeking bankruptcy protection filed Chapter 13. It meant that the house owners would have to continue paying their unsecured lenders. This ultimately meant that financially beleaguered house owners who had a chance to save their homes by filing Chapter 7 became much more exposed and vulnerable to the risk of foreclosures.

These findings made the researchers pose the question, “Is it just coincidence that the surge in sub-prime foreclosures that has rocked financial markets came right after the bankruptcy reform in 2005? Is that surge just about falling home prices, bad mortgage decisions and weak economic conditions?” The answer is an emphatic, “No”.

The lead personality behind the research work is Donald P. Morgan. In an interview over the phone he said that he was “99% confident” that this act of 2005 related to bankruptcy was one of the main reasons behind the foreclosure catastrophe and the falling real estate market – something that has affected each house owner across the country. Morgan added, “Before the reform, over-indebted households might file bankruptcy and get rid of their credit card debt, and that would free up income to pay the mortgage. The new law blocks that escape route and forces better-off households to continue paying credit card debt, which makes it harder than before to continue paying the mortgage.”

Even before the findings of Morgan and his colleagues others too had opined along similar lines saying that the stricter conditions of the new law has led to the increase in defaults in mortgages. Many have started walking away from their houses seeing the futility of bankruptcy protection.

David Bernstein commented that it is an irony of fate that the increase in dollar value of assets has weakened financial institutions.