Recent proposals to address housing market troubles through principal modification raise the possibility that such policies could increase the cost of credit in the mortgage market. We explore this using historical variation in federal judicial rulings regarding whether Chapter 13 bankruptcy filers could reduce the principal owed on a home loan to the home’s market value. The practice, known as cramdown, was definitively prohibited by the Supreme Court in 1993. 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. 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, Joshua, and Levitin, Adam. "Bankruptcy Law and The Cost of Credit: The Impact of Cramdown on Mortgage Interest Rates." HKS Faculty Research Working Paper Series RWP12-037, August 2012.