Illustration of house, money, and documents

Mortgage Cramdowns Could Have Mitigated Foreclosure Crisis

Thursday, May 9, 2024

By Steve Henneberry


Jacelly Cespedes
Assistant Professor Jacelly Cespedes

As today’s housing market faces pressure from rising interest rates and continued short supply of available homes, a recent study of a different point in time offers a way to bring stability to the sector—and highlights a missed opportunity from the devastating 2008 financial meltdown.

That time was the early 1990s. Back then, when homeowners faced foreclosure, a legal provision known as the “mortgage cramdown” offered a lifeline. This tool allowed bankruptcy judges to reduce the principal on “underwater” home loans—i.e., mortgages exceeding the home’s value—treating the excess as unsecured debt that could be restructured. However, the U.S. Supreme Court prohibited cramdowns in 1993.

In their paper, “The Effect of Principal Reduction on Household Distress: Evidence from Mortgage Cramdown,” published in the Review of Financial Studies, the researchers looked at bankruptcy filings from that 4-year period (1989–1993).

“We focused on cases randomly assigned to judges who had the discretion to implement cramdowns, using this setup to isolate the effects of such measures,” explained Jacelly Cespedes, assistant professor at the Carlson School, who worked with co-authors Carlos Parra, PUC Chile, and Clemens Sialm, University of Texas Austin. “The results are eye-opening: mortgage cramdowns dropped the 5-year foreclosure rate by 29 percentage points. This dramatic decrease suggests that there is a way to circumvent the ripple effects of foreclosures [such as neighborhood blight and increased crime rates].”

Additionally, the authors found that when individuals can get rid of all the negative equity in their mortgage, as opposed to only small debt relief, there are significant and economically large effects on the reduction of home foreclosure. Previous research has only focused on providing liquidity to avoid foreclosure, so this points to another option.

Looking at the 2008 housing crisis, the paper posits that had cramdowns been an available tool, over half a million foreclosures could have been avoided.

“We suggest revisiting the potential of cramdowns as a policy tool to stabilize housing markets and provide a safety net for homeowners during economic downturns,” said Cespedes.

As the country grapples with ongoing economic challenges and a volatile housing market, the lessons from the early ’90s offer not just a shield against foreclosure but a step toward broader economic resilience.

This article appeared in the Spring 2024 Discovery magazine

In this issue, Carlson School faculty research addresses inequities in mental health care, the challenges that migrant workers face, inefficiencies in public-private partnerships, and more.

Spring 2024 table of contents