State Foreclosure Laws and the Incidence of Mortgage Default

This paper examines how differences in state foreclosure laws influence the incidence of default in the residential mortgage market. Specifically, we examine how judicial review requirements, lenders' recourse rights (deficiency judgments), and state assistance programs for distressed borrowers affect the likelihood of default during the recent US housing crisis. We argue that state foreclosure laws should have little effect on the likelihood of liquidity events (for example, shocks to borrowers' ability to make payments) and thus provide a good instrument for identifying the borrower's costs of default. We find that borrowers with negative home equity are significantly more likely to default in states with borrower-friendly foreclosure laws. Moreover, we find that foreclosure laws that are positively correlated with default are also negatively correlated with personal bankruptcy, which supports the view that foreclosure laws are instruments for costs of default and not merely proxies for unobserved income shocks. Finally, we examine how recent state and federal loan foreclosure prevention programs have affected the likelihood of default. Overall, we find a significant decline in the effect of judicial review requirements but not deficiency judgments on default after 2008