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Reining in Home Mortgage Creditors

posted by John Rao

Thanks to everyone at Credit Slips for this opportunity to share a few thoughts about consumer credit and bankruptcy.  True to my earlier promise, in my last post I want to come back to the topic of proposed legislative changes to chapter 13. 

Four bills are pending in Congress which seek in different ways to limit the special protection mortgage lenders have in chapter 13 cases, so that home mortgages may be modified like other secured debts.  A comparison of the four bills prepared by Mark Scarberry is available on the ABI website.  An earlier post by Bob Lawless refers to a position paper, or “call to action”, on the subject prepared by four consumer organizations (National Association of Consumer Bankruptcy Attorneys, National Consumer Law Center, Center for Responsible Lending and Consumer Federation of America).  My testimony at a House subcommittee hearing last month (and the testimony of Eric Stein of CRL) discusses reasons why the law should be changed.  In this post, however, I put forth a different justification for doing away with the anti-modification provision in section 1322(b)(2) of the Bankruptcy Code.

For those not familiar with chapter 13 bankruptcy, this may seem hard to believe.  Although the right to cure defaults on loans has been part of the Bankruptcy Code since 1978, mortgage creditors have to this day still not developed the ability to apply payments during a chapter 13 case in a manner which the law requires.  Despite incredible advances in software and payment automation systems over the past few decades, mortgage creditors still use a manual accounting system (or more accurately a manual override of their normal system) to figure out how payments should be applied in chapter 13 cases. 

Bankruptcy attorneys, trustees, and judges have known this for years but only recently have I come across a mortgage servicer willing to admit this in a court case.  The mortgage servicer in In re Nosek, 363 B.R. 643 (Bankr.D.Mass. 2007) came up with a variety of excuses for failing to properly apply the homeowner’s payments (often by diverting payments to a suspense account).  Not buying any of these excuses, the bankruptcy court said: “Even if Ameriquest must manually account for these payments . . . Ameriquest is not excused from doing it right, even if it is an administrative burden. ... Ameriquest is simply unable or unwilling to conform its accounting practices to what is required under the Bankruptcy Code, something this Court can encourage by assessing punitive damages under Section 105(a).”  The court awarded $250,000 in emotional distress damages to the debtor and $500,000 in punitive damages against Ameriquest.   

In its opening brief on appeal, Ameriquest described how most national mortgage servicers use a loan servicing program called Mortgage Servicing Platform (MSP), also known as Fidelity National Information System.  This MSP system, Ameriquest stated in its brief, is not designed to deal with chapter 13 bankruptcy.  And finally the admission we’ve been waiting for: “At present, no computer program exists that is capable of accounting for payments by Chapter 13 borrowers under the bifurcation scheme that is usually used in most Chapter 13 cases.” 

What is the “bifurcation scheme” Ameriquest was referring to?  The effect of a cure in a chapter 13 case is to nullify all consequences of the prebankruptcy default.  This means that once the debtor’s chapter 13 plan is confirmed in a case involving a long-term mortgage, the debtor's ongoing regular mortgage payments should be applied from the petition date based on the mortgage contract terms and original loan amortization as if no default exists.  All prebankruptcy arrears are paid separately under the plan as a part of the mortgage servicer's allowed claim.  The problem is that mortgage creditors continue to treat timely payments received after the bankruptcy is filed as if they were late.  This occurs based on the industry practice outside of bankruptcy of crediting payments received to the oldest outstanding installment due. 

What this means for consumer debtors is additional costs in the form of unauthorized fees.  Servicers cannot possibly override manually their automated payment processing systems every month for the three to five years of the plan.  As payments are deemed late or insufficient, these systems automatically treat payments as unapplied and divert them to suspense accounts, impose late fees and additional interest charges, and order property inspections and other default related services the cost of which is charged to the borrower.  Legal fees are imposed on debtors for groundless stay relief motions, typically without disclosure to the debtor or court approval.  This breakdown of the servicing system also results in debtors often not being notified of interest rate adjustments on adjustable rate mortgages or payment changes on escrow accounts.  It is not uncommon for debtors who successfully complete their chapter 13 plans to receive a bill for thousands of dollars of previously undisclosed improper fees once they emerge from bankruptcy.  For example in In re Dominique, 368 B.R. 913 (Bankr.S.D.Fla. 2007), the servicer failed to send escrow statements during the chapter 13 plan and just before plan completion, provided debtors with an escrow account review showing that a $6,397 escrow deficiency was owed.  See also In re Jones, 366 B.R. 584 (Bankr.E.D.La. 2007).

To make matters worse, a recent study by Katie Porter and Tara Twomey, which I am sure we will hear much more about later from Katie, raises serious questions about the accuracy of claims filed by mortgage creditors.  The study finds that some mortgage creditors fail to satisfy the requirements of Bankruptcy Rule 3001 by not including evidence of security interest perfection or an itemization of fees with proofs of claims.

Why is it that nearly 30 years after the Bankruptcy Code was enacted has the mortgage industry refused to demand that the MSP system (or any other system) be adapted to chapter 13?  How difficult can that possibly be?  Of course a system could be developed if the industry wanted it done.  My theory is that this arrogance is caused by the special protection from modification home mortgage lenders have under the Code.  These creditors have attempted to transform this provision into a blanket grant of immunity.  Attorneys who attempt to challenge servicer practices know that the first defense raised by mortgage creditors is that the Code allows them to do whatever they like because their contract rights cannot be modified.  For example, when the debtors in In re Padilla, 2007 WL 2264714 (Bankr.S.D.Tex. Aug 03, 2007) contended the mortgage creditor who had sent them a bill for fees after they completed their plans had never disclosed the fees during bankruptcy, the creditor argued that requiring it to file fee applications under Bankruptcy Rule 2016 like other creditors would be an improper modification of its mortgage.  The creditor in In re Sanchez, 372 B.R. 289 (Bankr.S.D.Tex. Jul 24, 2007) made the same argument that “§ 1322(b)(2) renders the contractual language sacrosanct, and neither § 506(b) and Rule 2016 may be given effect.” 

Recently in case after case in which consumer debtors have attempted to force compliance through plan provisions specifying payment application so as to obtain relief after discharge under new section 524(i), mortgage creditors have objected claiming that that plan provisions modify their rights under section 1322(b)(2).  For example, see In re Collins, 2007 WL 2116416 (Bankr.E.D.Tenn. Jul 19, 2007).

It is time to take away this “super-creditor” status from home mortgage creditors.  Maybe then they will finally fix this enormous problem.   


Bravo! This is a stunningly clear, complete, and concise (as is possible to maintain the other two!) explanation of the problem and how it plays out in the real world. I admit I agreed with you before I read this, but I feel that you have made a very strong case for the legal remedy under consideration.

It is true that the servicers are handicapped by automated systems that do not handle this contingency, and that it is an enormous undertaking to change these sorts of systems. At the same time in 30 years new systems that came into use could have integrated these rules in the design, and old systems certainly went through revisions to deal with new products and practices.

The industry comes out looking pretty bad when they cry out that they are helpless having tied their own hands.

I work for a small mortgage company in Michigan, and I'm going to look/ask if our systems are setup like MSP tomorrow(afaik we use a fairly small vendor). Anyway, I can't believe I fell on this article by chance, this is very informative thank you!!

As to the Padilla decision, I think it important to note that the principle reason for limiting 506(b)'s application to home mortgage lenders in chapter 13 was section 1327. That court noted that section 506 in toto applies only the treatment of a secured creditor's allowed claim, as of filing, as augmented up to confirmation. Past confirmation, said the court, 506 simply could no longer apply to further charges assessed post-confirmation.

Thus, the real need may be to adjust the language of the Code, so as to make something like 506(b)'s test apply to charges asserted post-confirmation but pre-discharge. I understand that there is legislation now pending in Congress that would do just that.

Sacrosanct contracts can only arise from the premise of contract-capable parties. Upon bankruptcy, the bankrupt person cannot be considered a contracting party since he/she is effectively dead on arrival as of the filing of bankruptcy.

To allow servicers to continue as if the bankrupt person was alive having control over finances is a legal fiction since, for purposes of contractibility, he isn't.

Servicers who continue to levy after notice of financial death can only be said to be leveraging upon the corpus of a once viable financial transactor. It's much like tomb raiding, and can only be considered as price gouging or scalping the victim.

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