From our friends at the WSJ:

As we reported recently, people whose mortgage payments are reduced through loan modifications often are still drowning in other types of debt. The loan-mod treatment can be akin to using a small Band-Aid to try to cover up a mortar-sized wound.

We may be relying too heavily on that limited loan-mod cure partly because another more holistic therapy, bankruptcy, is no longer as attractive to the patients.

A recent working paper from Wenli Li of the Federal Reserve Bank of Philadelphia and others tries to measure the degree to which the 2005 reform of U.S. bankruptcy law led to more defaults on home mortgages.

Bankruptcy has always been a way for distressed borrowers to save their homes by allowing them to shed other debts and concentrate their resources on mortgage payments. But the 2005 legislation raised the costs of filing for bankruptcy and decreased the amount of debt that is wiped out. “We argue that an unintended consequence of reform was to cause mortgage defaults to rise,” the paper says.

The paper looks at mortgage loans originated in 2004 and 2005 and concludes that the bankruptcy changes led to an additional 200,000 mortgage defaults per year. The paper doesn’t provide estimates for mortgages originated after 2005.

Of course, sloppy lending standards and crashing home prices would have led to an epidemic of mortgage defaults in any case. Nearly 8 million American households–around 15% of those with mortgages–were behind on their mortgage payments at the end of 2009, according to the Mortgage Bankers Association. But bankruptcy-law changes may have made a terrible situation even worse.

The authors of the paper suggest “rolling back” the cost of filing for bankruptcy to pre-2005 levels.

Here’s another idea: Teach your kids not to gorge on credit when it’s easy to get.

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Jim the Realtor
Jim is a long-time local realtor who comments daily here on his blog, which began in September, 2005. Stick around!

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