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Policies to allow mortgage modifications for struggling homeowners may raise the cost of credit for the riskiest borrowers, but not nearly as much as the banking industry has claimed. That is one finding in a new Harvard Kennedy School Working Paper titled "Bankruptcy Law and The Cost of Credit: The Impact of Cramdown on Mortgage Interest Rates" co-authored by Assistant Professor Joshua Goodman.
The paper examines the impact of so-called "cramdown" policies, which force banks to reduce the principal owed by homeowners facing bankruptcy.
In order to ascertain the relationship between principle reductions and the cost of credit, Goodman and co-author Adam Levitin, Bruce W. Nichols Visiting Professor of Law at Harvard Law School, examined mortgage and interest rate data from October 1979 until June 1993, during which time there were numerous federal court rulings affecting cramdown practices.
"The legal variation between judicial districts and over time allows us to test cramdown’s impact on mortgage interest rates and other characteristics using a difference-in-difference strategy," Goodman and Levitin write.
"We find evidence that home loans closed during the time when cramdown was allowed had interest rates 10-20 basis points higher than loans closed in the same state when cramdown was not allowed, which translates to a roughly 1-2 percent increase in monthly payments," the authors report. "Consistent with the theory that lenders are pricing in the risk of principal modification, interest rate increases are higher for the riskiest borrowers and zero for the least risky, as well as higher in states where Chapter 13 filing is more common."
Goodman and Levitin contend that their paper is the first to provide clear empirical evidence about the impact of cramdowns on credit markets. They say it also the first "to use judicial rulings as a source of exogenous variation in the state of bankruptcy law and is the first to show differential impacts of bankruptcy law by the risk to the lender of a given loan ending up in bankruptcy."
Joshua Goodman is assistant professor of public policy at Harvard Kennedy School. He teaches empirical methods and the economics of education, and his research interests include labor and public economics, with a particular focus on education policy.
Joshua Goodman, assistant professor in public policy
"We find evidence that home loans closed during the time when cramdown was allowed had interest rates 10-20 basis points higher than loans closed in the same state when cramdown was not allowed, which translates to a roughly 1-2 percent increase in monthly payments," the authors report.