Research

High foreclosures but low bankruptcies: Why the disconnect?

Foreclosure rates have increased dramatically in the last year. Yet bankruptcy filings are much lower than they were before the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) went into effect. Experts at the W. P. Carey School of Business examine various factors that may be contributing to the gap and discuss possible policy responses.

2007-09-12

It's not news that foreclosure rates have skyrocketed. In the first half of this year, home foreclosure filings were up 128 percent in Arizona and 56 percent nationwide, compared to the first half of 2006, according to RealtyTrac. Yet bankruptcy filings are dramatically lower this year than in 2004 (the most recent comparable year, before the new bankruptcy law took effect).

According to the U.S. Bankruptcy Court in the District of Arizona and the American Bankruptcy Institute, bankruptcy filings this year will be down 70 percent in Arizona and 50 percent nationwide, compared to 2004. If foreclosures are up so dramatically compared to previous years, then why are bankruptcy numbers relatively low?

"That is the question to find out," said Terry Miller, Clerk for the U.S. Bankruptcy Court in the District of Arizona. "It used to be that people would file for bankruptcy to stave off foreclosure, but we're just not seeing that now," he added.

Are more stringent bankruptcy laws the culprit?

On October 17, 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) went into effect. But it's not that the new law has changed how homeowners would go about saving their home through bankruptcy.

"The basic rules about what to do to keep the house are the same under the new law," said Randy Haines, who is an adjunct professor at the Sandra Day O'Connor College of Law and a judge for the U.S. Bankruptcy Court in the District of Arizona.

But the new law, designed to counter perceived abuses of the bankruptcy system, has made filing for bankruptcy more complex, Miller said. "Under the new law, there are more requirements for individual filers," he said. Specifically, there are three new requirements:

1. Before filing, the individual must complete a consumer credit counseling program, within a relatively short period of time.
2. The individual must pass a means test to determine if his income, assets, and debts qualify him for Chapter 13 (restructuring) or Chapter 7 (liquidation). But Haines said that the number of individual filers who are disqualified by the means test is very small.
3. Once the individual has filed for bankruptcy, he must complete a financial management program before discharge.

In addition, filing for bankruptcy has become more expensive. "In Arizona, filing fees for Chapter 7 have increased from $209 to $299 and filing fees for Chapter 13 have increased from $194 to $274," Miller said. And because filing is now more complicated and time-intensive (especially because of the means test requirement), attorneys' fees are also now more expensive.

Or does the new bankruptcy law just seem too daunting?

The combination of greater complexity and greater expense may make bankruptcy seem too daunting for many would-be filers, Miller suggested. But perhaps that is a misperception. "When looking at the amount of debt that can potentially be discharged (many thousands of dollars), the outcome would seem to still be worth the expense of filing for bankruptcy for many people in serious financial distress," Miller said.

And, he added, "BAPCPA may not actually preclude people from successfully going through a bankruptcy."

Nevertheless, "there is a perception that bankruptcy is no longer a viable option for many people." Haines thinks that perception comes, in part, from the heavy advertising that many bankruptcy attorneys did before the new law took effect. "The heavy file-now advertising that many bankruptcy attorneys did in 2005 may have convinced people that bankruptcy is no longer available. You don't see as many attorneys advertising today that bankruptcy is still an option."

Declining values and upwardly adjusting rates are other suspects

It's no secret that a large percentage of the nation's mortgage woes are caused by declining home values and upwardly adjusting interest rates — especially on subprime loans. According to Anthony Sanders, a professor of finance and real estate at the W. P. Carey School, almost 37 percent of seriously delinquent loans (including loans 90 or more days past due and those in foreclosure) in the second quarter of 2007 are subprime adjustable rate mortgages (ARMs) — even though they make up only 7 percent of all loans.

"Some subprime borrowers speculated on the market in 2005 — they took out too much debt — and their gamble turned out wrong," Sanders said. Now that those borrowers' adjustable rate mortgages are resetting to much higher interest rates, many borrowers are finding that they can no longer afford their homes.

One option, available to many borrowers during the boom, was to refinance the loan at a lower rate. But now that home values have declined many borrowers have too little equity to refinance. "The recent cooldown in housing prices, coupled with ARM resets, have caused problems, particularly in the housing types populated by subprime borrowers (including starter homes on the urban/rural fringe and condominiums)," Sanders said.

Homeowners in that situation may not be helped by bankruptcy, said Haines. "A person could file for bankruptcy to stop a foreclosure if they wanted to hold on to the house and had the ability to pay the mortgage," he said. In a Chapter 13 bankruptcy, for example, a homeowner would have the ability to pay back already-late payments over a period of three years but would have to keep current on all future mortgage payments as they were defined in the original mortgage agreement.

In Chapter 7, Haines said, the individual would still have to stay current on his regular mortgage payments, but wouldn't have the option of paying down already-late payments over three years. Either way, Haines said, bankruptcy would only save a person from foreclosure if the individual could still afford the mortgage payment. In the case of dramatically increasing mortgage payments due to ARM resets, that may often not be the case.

Or could it be the investors?

Because of low interest rates, creative financing (zero-down, interest-only, and adjustable-rate mortgages), and rapidly rising home values in many areas, the last few years of the housing market have been characterized by heavy investment.

W. P. Carey School Research Economist Dawn McLaren said that in the bubble areas, where housing appreciation — and, now, depreciation and foreclosures — was highest, 20 to 30 percent of homes were owned by investors.

And now, a lot of the homes that are being foreclosed on are owned by investors, said Haines. Investors, he said, are more likely to cut their losses — simply walk away from a home (and let it fall into foreclosure) — than an individual who lives there. And, most investors see the loss as they would any other investment loss and aren't inclined to file for bankruptcy over it.

Many homeowners, in contrast, will file for bankruptcy to keep the home because it's the roof over their heads. McLaren agrees that investors behave differently when the market turns — perhaps turning to foreclosure more easily than homeowners inclined to try to save their home. She said it's because investors have different decision criteria than other homeowners. The different motivations are even greater for foreign investors, McLaren said.

And according to a report released by the National Association of Realtors in July 2007, 32 percent of realtors report having had at least one international client between April 2006 and April 2007. More than two-thirds of those foreign buyers used mortgage financing to purchase their U.S. home. Yet the combination of stagnating (or declining) home values and the weakening value of the dollar make the U.S. a less attractive place for foreigners' investments, McLaren said.

"The foreign investor has the exchange rate to think about. With the weak value of the dollar relative to other currencies, investments here in the U.S. are worth less than when the dollar was strong." Many foreign investors may decide to cut their losses and walk away from their U.S. property investments — sending them into foreclosure — in order to invest their money where it's more profitable.

Bridging the disconnect

The policy prescription for bridging the gap between the high number of foreclosures and relatively low number of bankruptcies depends in large part on which factor caused the gap. Where the disconnect is attributable to more complex and expensive bankruptcy filing requirements or a misperception that bankruptcy is no longer an available option, public education to help homeowners facing foreclosure understand their options available under the current bankruptcy law is probably the answer.

McLaren said that the key is to correct asymmetric information — cases where actual reality is different than perceived reality. According to Miller, the U.S. Bankruptcy Court in the District of Arizona is trying to do just that, through activities that include public education programs, presentations to local Fresh Start women's groups, and outreach to local high school students.

Where the disconnect is caused by declining home values and rising interest rates that make people's mortgages simply unaffordable, the solution may be in new legislation that would modify the current bankruptcy law to help more homeowners who are facing foreclosure.

In April, the National Association of Consumer Bankruptcy Attorneys (NACBA), in partnership with a number of other consumer organizations, proposed to Congress a series of bankruptcy reforms, including expanding Chapter 13 to allow debtors to write down mortgage loan amounts to the current fair market value of their home and restructure the mortgage debt based on a fixed interest rate.

Senator Richard Durbin of Illinois reportedly plans to introduce an amendment, called the Helping Families Avoid Foreclosure Act, with provisions akin to the NACBA's proposal. A better public understanding of the law as it stands would also help. In Arizona, the Phoenix and Tucson Bankruptcy Courts in partnership with local attorneys created educational materials on the bankruptcy process.

The courts also established self-help centers, and a "live chat" service from the court's revamped website assists self-represented debtors and creditors. The court has also reached out to he far flung communities of Prescott Valley, Florence and Bullhead City, and is looking to continue this effort.

As for foreclosures on homes owned by investors — foreign or domestic — the most realistic policy prescription is to do nothing; investors, more than anyone, should have calculated their risk when entering the booming housing market.

Bottom Line:

• Foreclosure rates — nationwide and in Arizona — have increased dramatically in the last year. Yet bankruptcy filings are much lower than they were before the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) went into effect.
• Homeowners used to file for bankruptcy to stave off foreclosure, but they're not anymore — at least not at comparable rates. There are four possible explanations:
  1. BAPCPA makes filing for bankruptcy more complex and more expensive than before — perhaps too complex and expensive for some homeowners in financial distress.
  2. There is a general misperception that BAPCPA means bankruptcy is no longer an option for individuals in financial crisis.
  3. Declining home values and rising interest rates may make people's mortgages unaffordable, and current bankruptcy laws don't allow homeowners to change their monthly mortgage obligations.
  4. The housing market boom was characterized by heavy investment — both foreign and domestic. Investors account for a large percentage of homeowners in default, but investors are less likely to file for bankruptcy in an attempt to keep the investment property.
• The best response to the disconnect between foreclosures and bankruptcies depends on which explanation is at work, and may include public education and/or legislation to revise the bankruptcy laws.

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