One of the key questions about H.R. 3609 is whether its provision permitting the modification of mortgages in bankruptcy will drive up mortgage interest rates, as the mortgage industry claims. Currently, the Bankruptcy Code bars the modification of mortgages on single-unit primary homes. This is a special protection that no other type of creditor receives; all other debts may be modified in bankruptcy.

The policy assumption behind the bar on mortgage modification is simple enough. Prohibiting modification will reduce mortgage lenders’ losses in bankruptcy. Lenders will then pass these savings on to all consumers in the form of lower mortgage interest rates, which will encourage homeownership.

This economic rational sounds convincing at first blush. The Wall Street Journal (subscription required) certainly bought into it in their lead editorial last Thursday, claiming that “High levels of homeownership have been the result [of the modification bar]. To repeal this policy and make lenders wonder whether mortgage loans will be secured or unsecured can have only one result—more expensive mortgage loans.” The only problem is the empirical evidence does not support it.

I have been testing the policy assumption behind the anti-modification provision empirically. Between 1981 and 1993, many federal judicial districts allowed for stripdown, the most drastic form of mortgage modification, in which the secured claim on an underwater mortgage was reduced to the value of the house. The split in the law among judicial districts allowed us to compare the historical mortgage rates in districts permitting stripdown with those that did not. I have not found any statistically significant effect on mortgage rates.

There’s other evidence suggesting that modification is unlikely to impact mortgage interest rates. First, Freddie Mac and Fannie Mae, the two largest purchasers of home mortgages on the secondary market, do not charge a risk premium for mortgages on certain types of properties that can currently be modified in bankruptcy. Second, historically, at least, only a small percentage of mortgages are underwater, and then only by an average of about $9,000. While today’s market is very different, in part because of aggressive lending practices requiring little or no down payment, the historical data suggests that most mortgages would not be subject to stripdown, much less by more than a lender would lose in a foreclosure. Finally, H.R. 3609 allows only limited modification of interest rates—lenders are guaranteed an interest rate of at least the most recent national average 30-year mortgage fixed rate. It appears that the impact on lenders from modification will be quite limited. But for families struggling to keep their homes, however, these changes can make a real difference.