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Stripping in Chapter 13

posted by Bob Lawless

We've been at this blogging thing for almost ten months now, and I'm finding the title to each blog post can be the most challenging. How about that one? Do I have your attention? We're actually not talking about that kind of stripping but lien stripping.

The concept of lien stripping is simple. A lender is owed, let's say, $150,000, but the collateral for the loan is only $130,000. Under U.S. bankruptcy law, lien stripping would reduce the lender's lien to $130,000 and leave the remaining $20,000 as unsecured debt. The idea is that outside of bankruptcy, the lender would have received the collateral worth $130,000 and be left chasing the debtor for the remaining $20,000. The bankruptcy result is thus a recontracting of the lender and debtor's relationship, consistent with the notion that the bankruptcy is a fresh start for the debtor. In other words, the bankruptcy result essentially gives the lender and debtor the terms of a new loan as if credit was extended at the moment of bankruptcy filing.

Unfortunately, the U.S. Supreme Court has issued a series of rulings that have sharply changed the concept of lien stripping that Congress laid out in 1978 when it passed the Bankruptcy Code. One of these decisions was a case called Nobelman v. American Savings Bank (1993) which interpreted language in chapter 13 that said a debtor could modify the rights of secured creditors except creditors with a claim "secured only by a security interest in real property that is the debtor's principal residence." The Court interpreted that language to mean that lien stripping was not allowed on a debtor's house.

At the hearings before the U.S. House of Representatives on Thursday, one witness (Shirley Jones Burroughs) described how she and her husband were struggling to save their house in chapter 13. To make matters worse, the bank larded up their claim against the couple with all kinds of fees and charges. Under current law, Ms. Burroughs and her husband will have to pay all these fees and charges to save their home. To make matters worse, the Burroughs are struggling to make ends meet on the reduced income that resulted from Mr. Burroughs's call to active military service in Iraq. This is not the fresh start Congress intended when it passed the 1978 Bankruptcy Code.

Both Ms. Burroughs and the next witness, Henry Sommer (president of the National Association of Consumer Bankruptcy Attorneys), proposed a simple solution -- Congress should restore the bankruptcy law to its original intent before the Supreme Court's decision in Nobelman. Although neither mentioned Nobelman by name, that was the clear result of their proposal to restore lien stripping of home mortgages in chapter 13. This proposal would merely put mortgage lenders in the same position they would occupy outside of bankruptcy court. It is not a gift to the debtor who must still pay the full value of the house over time or lose it to foreclosure. In a time of rising mortgage foreclosures, this would be a small change in the law that would provide enormous benefits.

(In his testimony, Mr. Sommer mentioned a more detailed appendix laying out the legislative proposals. That appendix did not make to the House web site. If someone has a copy and would send it along, I would be appreciative. My e-mail is rlawless-at-law-dot-uiuc-dot-edu.)

UPDATE (5/7/07): Mr. Sommer was kind enough to send me a copy of the legislative proposals and give me permission to make it available here.


Lien stripping is fine in theory, but in practice the lender does not always fare as well as you suggest. Using your example of a $150,000 loan secured by colleral worth $130,000, what happens is, first, the court finds that the collateral is worth only $115,000, then the court finds that the appropriate interest rate for a reamortized $115,000 loan is 8% when the market rate for a loan of similar terms and credit quality is 12%, leaving the lender with a loan having a market value of, say, $110,000. The lender loses $20,000 of secured value through the lien-stripping process.

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