The US subprime crisis erupted because US households had borrowed too much, and had invested too much in housing. In the aftermath of the crisis, the US financial system is being revamped to prevent a recurrence of too much risky borrowing – for instance, by adopting tougher capital adequacy standards for banks. Little is being done, however, to correct the other side of the problem, namely the tendency of US households to invest too much in housing.
Currently, the US tax system and legal system conspire to make housing investment attractive. Interest paid on mortgages continues to be tax deductible, providing an incentive to borrow heavily and buy an expensive home. At the same time, the legal system favours homeowners who experience financial difficulties by making investments in home equity partially exempt from personal bankruptcy. Households that file for bankruptcy according to Chapter 7 of the US bankruptcy code can retain the equity in their home up to a certain amount, determined at the US state level. This preferential treatment of home equity in bankruptcy spurs investment in additional home equity, especially by households with fragile finances that face bankruptcy risk. The resulting bias in household portfolios exposes households to a lot of housing-related risk. In the aggregate, an overinvestment in home equity can increase macroeconomic instability as well, as private consumption and potentially investment become very sensitive to house prices. Reform of US bankruptcy law ending the preferential treatment of housing is needed to reduce household and macroeconomic risk.
The US bankruptcy exemption for home equity, or homestead exemption, ranges from $0 in Maryland to an unlimited amount in eight US states, including Florida and Texas, in 2006. Personal bankruptcy is quite common in the US, with about one million Chapter 7 filings in 2009, and homestead exemptions therefore frequently apply. With a home ownership rate of about 67% in the US in 2009, the homestead exemption greatly affects the financial position of households that emerge from personal bankruptcy, especially in high exemption states.
Homestead exemptions can be seen as partial wealth insurance against the risk of personal bankruptcy. The possibility of declaring bankruptcy itself, and the retention of some wealth in bankruptcy, can be rationalised as welcome insurance against financial distress, and as such can increase household welfare. Using a simulation model, Li and Sarte (2006) offer evidence that a general wealth exemption against bankruptcy can be welfare improving.
The current US homestead exemption, however, may not be the best way to insure household wealth against personal bankruptcy. A major disadvantage of the homestead exemption is that it biases credit supply as well as household investment towards housing. Berkowitz and Hynes (1999) show that homestead exemptions reduce the probability of being denied a mortgage. This shows that the homestead exemption increases the supply of housing credit.
In a recent paper (Corradin et al. 2010), we find that the homestead exemption also biases household investments towards home equity. The homestead exemption is found to have a positive effect on a household’s home equity share in net worth. A one standard deviation increase in the homestead exemption level of $354,303 starting from a level of zero, specifically, is estimated to increase the share of home equity in total wealth by 22%, or about half a standard deviation of this home equity share. Thus, the bias towards home equity investment caused by the homestead exemption is economically significant. Our estimation uses household-level data from the Survey of Income and Program Participation of the US Census Bureau over the years 1996-2006. This data source provides information on wealth allocation for approximately 30,000 households in any given year.
The positive relationship between the home equity share and the exemption level is estimated to be stronger for households with low net worth, as these households may face a higher bankruptcy risk. The home equity share is also more strongly related to the homestead exemption for households that report poor health, as this could trigger bankruptcy through income loss or major medical expenses. Indeed, Jacoby et al. (2002) show that illness or injury are implicated in about half of personal bankruptcies in the US.
Furthermore, households with some mortgage finance, shorter house tenure, and a younger household head tend to have home equity shares that are more strongly affected by the homestead exemption level. This could reflect that these households also have somewhat uncertain financial prospects.
The bias in household portfolios towards home equity triggered by its special bankruptcy protection suggests that these portfolios are not efficient, as they expose the household to too much real estate risk in the absence of a bankruptcy. Wealth protection against personal bankruptcy may be desirable, but its provision through an exemption for home equity unduly distorts household portfolio choice.
The homestead exemption could be rationalised if it were to promote home ownership, and if in addition home ownership produced positive externalities on neighbourhood stability, as claimed by a substantial literature. Glaeser and Sacerdote (1999), for instance, find a negative relation between home ownership and crime. In our study, however, we do not find robust evidence that homestead exemptions affect home ownership. Thus, the costs of homestead exemptions in biasing household portfolios towards home equity are clear, while there are no obvious counterbalancing benefits of singling out housing for special bankruptcy protection. At the macroeconomic level, homestead exemptions potentially lead to important biases as well, including higher price prices and additional housing construction. Legal reform ending the special bankruptcy protection of housing is warranted to eliminate household portfolio and any macroeconomic biases.
The views expressed here are entirely those of the authors. They should not be attributed to the European Central Bank or the International Monetary Fund.
Berkowitz, Jeremy and Richard Hynes (1999), “Bankruptcy exemptions and the market for mortgage loans”, Journal of Law and Economics, 42:809-830.
Corradin, Stefano, Reint Gropp, Harry Huizinga, and Luc Laeven (2010), “Who invests in home equity to exempt wealth from bankruptcy?”, CEPR Discussion Paper No. 8097.
Glaeser, E and B Sacerdote (1999), “Why is there more crime in cities?”, Journal of Political Economy, 107:s225-s258.
Jacoby, Melissa B, Teresa A Sullivan, and Elizabeth Warren (2002), “Medical problems and bankruptcy”, Norton’s Bankruptcy Advisor.
Li, Wenli, and Pierre-Daniel Sarte (2006), “US consumer bankruptcy choice: The importance of general equilibrium effects”, Journal of Monetary Economics, 53:613-631.