Using Bankruptcy to Reduce Foreclosures: Does Strip-down of Mortgages Affect the Supply of Mortgage Credit?

We assess the credit market impact of allowing mortgage "strip-down"--that is, reducing the principal of underwater residential mortgages to the current market value of the property for homeowners in Chapter 13 bankruptcy. Our identification is provided by a series of U.S. Circuit Court of Appeals decisions in the early 1990's that introduced mortgage strip-down in parts of the U.S., followed by a 1993 Supreme Court ruling that abolished it all over the U.S. We find that the Supreme Court decision led to a short-term reduction of 3% in mortgage interest rates and a short-term increase of 1% in mortgage approval rates, but only the approval rate effect persists in longer sample periods. In contrast, the circuit court decisions to allow strip-down did not have consistent effects on mortgage terms. We also show that strip-down had little effect on default rates by homeowners with existing mortgages. Taken together, these results suggest that mortgage lenders responded weakly to both the adoption and abolition of strip-down because strip-down had little effect on their profits from mortgage lending. According to these findings, re-introducing strip-down of mortgages in bankruptcy as a foreclosure-prevention program would have only small and transient effects on the supply of mortgage loans.