Bankruptcy Changes Led to Subprime Crisis

Around two years before the housing market crashed during the subprime crisis, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2005.

BAPCPA, or sometimes informally referred to as the bankruptcy abuse reform act (BAR), was passed to limit the abuse of bankruptcy by implementing a means test to determine who could file, generally limiting the ability for non-secured debt to be discharged, like credit card debt not connected to assets like real estate.

It was intended to prevent people from intentionally running up debt that they could pay off, knowing that they could eventually discharge it in bankruptcy.

While there was a small spike in filings before the bill was passed, the changes in BAPCPA would lead to almost a third fewer filings in 2006 from the year before based on data from the U.S. Courts.

Chapter 7 personal bankruptcies dropped from 1.6 million in 2005 to 349,012 in 2006. Chapter 13 personal bankruptcies went from 407,322 to 248,430.

The largest changes came in California’s Central district (Los Angeles), Ohio’s Northern district (Cleveland), Illinois’ Northern district (Chicago), and Florida’s middle district (Orlando).

Subprime Foreclosures Followed Bankruptcy

A paper from the New York Fed details how subprime foreclosures were significantly higher in states with higher home equity exemptions—where the residential home is immune from a forced sale to pay off debt. States like Texas and Florida have 100 percent immunity, while others like California have partial—where it is protected up to a certain limit.

The changes in BAPCPA/BAR made foreclosing on a subprime loan more attractive for someone using it to pay off debt.

Put bluntly, BAR increases the incentives of some cash-flow-constrained mortgagors to quit paying their mortgage—rather than quit paying some other debts and use the cash flow freed up to stay current on their mortgage instead.

Knowing that unsecured debt would not be discharged, debtors might have turned to subprime loans to cover their credit card debt, knowing that they would not lose their homes if they couldn’t make monthly payments. Loans were being foreclosed, but people were not necessarily losing their house.

Investigative Economics previously detailed how subprime lending was not necessarily connected to a large number of home foreclosures as most beneficiaries of Troubled Asset Relief Program (TARP) funds did not appear to be subprime borrowers, and the largest majority of recipients came from North Carolina—not a center of the subprime crisis and nowhere as large as California. There are also questions as to whether subprime loan foreclosures caused the bulk of the housing crisis.

BAPCPA’s Effect on Business Bankruptcy During the Crisis

The other type of bankruptcy, business bankruptcies, did not see the same drop-off in filings after BAPCPA was passed, but the law had a wholly different effect on investment banks at the time.

A 2008 Financial Times story gets into how the law encouraged the collapse of Bear Stearns, Lehman Brothers, and American Insurance Group (AIG) by exempting derivatives and other financial transactions during bankruptcy.

Previously those transactions would be frozen until a bankruptcy court decided which creditors might receive them. But the 2005 changes exempted those derivative trades from being frozen.

Without those trades being frozen, investors could demand their money back, exacerbating the liquidity crunch of the time and hastening their demise.