Liberty Street Economics

« | Main | »

February 25, 2015

The 2005 Bankruptcy Reform and the Foreclosure Crisis


Second in a two-part series

Our previous post showed that the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was associated with a sizable rise in foreclosure, in addition to a decline in bankruptcy filings and a rise in insolvency. In this post, we examine one possible explanation for the rise in foreclosure: the substitution hypothesis. Prior to the 2005 reform, individuals facing insolvency could discharge their unsecured debt via bankruptcy, thus retaining the ability to remain current on their home debts. After the reform, since bankruptcy became too expensive for many, default on home loans was the most effective way for these individuals to reduce outstanding debt. The idea that BAPCPA caused a shift from bankruptcy to foreclosure is not new; see Morgan et al. (2012) and Li, White, and Zhu (2011). In this post, we use the Federal Reserve Bank of New York’s Consumer Credit Panel (based on Equifax data, described here) to provide evidence on the mechanism through which this substitution occurred, and to precisely quantify the magnitude of its impact on foreclosures.

Transitions into Foreclosure

We estimate the frequency transition probabilities of individuals across different credit states over time. In the chart below, we first show the four-quarter-ahead transition probabilities from Delinquent (any account up to 90 days late) with no foreclosure to states with foreclosure, specifically Insolvent (at least one account 120 or more days late or charged off) with foreclosure. We restrict attention to homeowners, who in our sample correspond to the individuals who display any type of real estate debt in the last four quarters. We report estimated transitions for the overall population of homeowners (the solid blue line) and those in the bottom quintile of the credit score distribution four quarters prior (the red dashed line). The vertical line indicates the effective date of the BAPCPA in the third quarter of 2005, while the gray bars denote NBER recession dates. The chart shows a sharp rise in the transition into Insolvent with foreclosure. The rise in the transition probability to this state is more pronounced for the bottom quintile of the credit score distribution.

Estimated Transition Probabilitiess

Insolvency, Bankruptcy, and Foreclosure

To better understand the relationship between insolvency, bankruptcy, and foreclosure, we adopt an event-study approach. If the substitution hypothesis is valid, then for individuals who enter a spell of financial distress we should see lower bankruptcy rates, higher foreclosure rates, and higher rates of delinquency on home loans after the reform, relative to before.

We first study the behavior of individuals who become newly insolvent in a given quarter after two years of no insolvency, and examine their behavior for sixteen quarters around their initial insolvency. We consider their bankruptcy and foreclosure rates at various horizons before and after their new insolvency. As can be seen from the charts below, starting at the quarter of implementation of the reform, these individuals display an overall decline in bankruptcy filings at all horizons after insolvency, and a rise in foreclosure rates.

Bankruptcy Rate for Newly Insolvent Individuals

Foreclosure Rate for Newly Insolvent Individuals

We now consider bankrupt individuals. After the reform, we should see that for this group, there is a higher foreclosure rate prior to bankruptcy and a lower foreclosure rate after bankruptcy, as well as a rise in insolvent home balances prior to bankruptcy. In each quarter of our sample, we consider individuals who file for bankruptcy in a given quarter, and track them for sixteen quarters around that date. The following chart displays their foreclosure rate at various horizons before and after bankruptcy. The foreclosure rate at t-quarters from bankruptcy is normalized by the foreclosure rate at bankruptcy. We can see that foreclosure rates do not rise after bankruptcy post-reform, whereas pre-reform, foreclosure rates rise both before and after bankruptcy.

Fraction with Foreclosure for Newly Bankrupt Individuals

Cross-District Variation

In our previous post, we documented the large variation in bankruptcy filing costs associated with the reform across judicial districts. We also showed that the reform had bigger effects on bankruptcy filings and insolvency in those districts with the largest cost increases. We now exploit the cross-district variation in filing cost changes to shed light on the impact of the bankruptcy reform on bankruptcy and foreclosure.
We estimate a simple difference-in-difference regression model, where the percentage cost change interacted with a post-reform dummy is the main explanatory variable. We also include time-varying district-level economic controls, such as personal income, the unemployment rate, and an index of house prices, together with a number of state- and district-level judicial and regulatory controls.

We find a very large effect of the filing cost change on both the bankruptcy rate and the foreclosure rate. The median percentage increase in filing cost lowers the bankruptcy rate by 22 percent. Moving from the 10th to the 90th percentile of the cost change distribution increases the size of the drop in the bankruptcy rate by 33 percentage points. The median percentage rise in the filing cost increases the foreclosure rate by 20 percent. Moving from the 10th to the 90th percentile of the cost change distribution increases the rise in the foreclosure rate by 29 percentage points. The advantage of this approach is that it allows us to clean out the effect of varying economic conditions on the bankruptcy and foreclosure rates. And, indeed, economic correlates do have an impact on both bankruptcy filings and foreclosures.


The evidence presented suggests that one consequence of the 2005 bankruptcy reform is that individuals who would have filed for bankruptcy prior to the reform instead substitute into foreclosure. This change in behavior is amplified for those at the bottom of the credit score distribution, who were more affected by the rise in bankruptcy filing costs associated with the reform. Given that the reform was implemented in the third quarter of 2005, it may, through the channels we’ve described, have amplified the housing and foreclosure crisis, especially for low credit score borrowers.


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


Stefania Albanesi is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

Jaromir Nosal is an assistant professor in the Economics Department at Columbia University.


Zachary Bleemer is a senior research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group.


Matthew Ploenzke is a research associate in the Group.


Feed You can follow this conversation by subscribing to the comment feed for this post.

Last week Liberty Street did a series of blogs on student debt identifying the impact of this debt on the broader economy. Since student debt is the second largest form of consumer debt after mortgages and has always been very difficult to discharge, it would be interesting to quantify the relationship, impact, and prevalence of student debt on insolvency and the transition to foreclosures.

The comments to this entry are closed.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines


We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.