Foreclosure and Bankruptcy--Policy Conclusions from the Current Crisis

The recent episode of rising consumer bankruptcy and increasing foreclosure rates has sparked a lively debate about how to best tackle the crisis in the U.S. housing market. This paper contributes to the debate by providing an explicit model of the interactions of households' decisions to declare Chapter 7 bankruptcy, and to enter into foreclosure. We construct a model to show that the interaction of bankruptcy exemption limits and mortgage regulation has an impact on the prevalence of bankruptcy and foreclosure. We use state-level data to show empirically that our model predictions are plausible. We argue that policy proposals that focus solely on one aspect of the twin-crisis are likely to be misguided. In particular, we show that in the short-run a switch from non-recourse mortgages to recourse mortgages may have little effect on foreclosures, but could dramatically increase the number of bankruptcies.