2005 Bankruptcy Law Linked to Mortgage Crisis

Debate continues on efforts to give Federal bankruptcy judges the power to modify mortgage loans. Heralded as a way to deliver relief directly to distressed homeowners, new academic studies are cautioning hasty bankruptcy reform.

The Federal Reserve Bank of New York says the last time bankruptcy law was reformed it triggered the mortgage meltdown. Linking the 2005 bankruptcy reform to thesubprime mortgage implosion, the New York Fed claims this reform shifted risk from credit card to mortgage lenders.

Prior to Congress passing the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, debt burdened homeowners could file Chapter 7 bankruptcy. This allowed them to clear unsecured credit card and free cash flow to pay their mortgage. However, after this bankruptcy reform forced better-off household to declare Chapter 13--requiring continued payments to credit card companies.

The conclusion of this research was two-fold. First, many homeowners that would have filed Chapter 7 bankruptcy are now facing foreclosure. Second, the authors of this Fed research are "99 percent confident" that this 2005 bankruptcy reform sent the mortgage market into foreclosure crisis and sent housing prices plummeting.

Most are still looking for culprits for the mortgage meltdown, but the real cautionary tale is be careful of the unintended consequence of reform.