Mortgages in Bankruptcy 101

A few weeks ago, Katie Porter discussed how the Wall Street Journal mischaracterized U.S. bankruptcy law while its editorial page criticized bills that would give relief to beleaguered homeowners. Yesterday, the New York Times mischaracterized U.S. bankruptcy law while its editorial page supported bills that would give relief to beleaguered homeowners. Sorry New York Times, but it is not true that "Under current law, mortgages on primary homes are the only type of secured debt that is ineligible for bankruptcy protection." Mortgage debt is part of the bankruptcy case--it is just treated differently from other debt in chapter 13. And, after the 2005 law, some other debt in chapter 13 does get similar treatment. Long sigh.

At the least, we can say that the mischaracterizations are now equal on both sides of the political fence. I doubt either the WSJ or the NYT set out to deliberately mislead. What's the quote? "Never blame malice or ill-will where sloth or ignorance can explain." The complexity is pretty high here. A number of reporters have asked me for an explanation of how bankruptcy law currently treats home mortgages. With these bills pending in Congress, it is not just the reporters who are interested, so I've posted what I hope is a clear explanation below the fold. Bankruptcy jocks and other legal eagles should avert their eyes lest they be exposed to overgeneralization and blinding statements of the obvious (to them).

A creditor holding collateral for a debt is known as a "secured creditor." Creditors not holding collateral, like credit card companies, are unsecured creditors. In bankruptcy, a secured creditor can be undersecured (i.e., the value of the debt is more than the value of the collateral) or oversecured (i.e., the value of the collateral is more than the value of the debt). We've all talked about and understood people being "upside down" on their mortgage or car loan. The bankruptcy world just uses the terms "undersecured" and "oversecured" to describe this simple concept.

An undersecured creditor really has two claims in a bankruptcy case--a secured claim up to the value of the collateral and an unsecured claim for the excess of the debt over the value of the collateral. United States bankruptcy law protects the full value of the secured claim. In contrast, the unsecured claim only receives a proportional share of the debtor's remaining assets (again, like the credit card companies).

The bankruptcy law thus aims to put the undersecured creditors--like all creditors, really--in the same position they would be outside of bankruptcy court. Without a bankruptcy proceeding, an undersecured creditor could seize the collateral, recognize the collateral's value in a sale, and then get paid a proportional share of the debtor's remaining assets for the balance of the debt. (By definition, an insolvent debtor cannot pay all of his or her obligations, meaning payment is always partial.) Because the filing of a bankruptcy case halts all legal actions against a debtor, bankruptcy law substitutes its own rules to recreate these out-of-bankruptcy rights.

Because the current legislative proposals deal with home mortgages in a chapter 13 case, I will limit the discussion to how these principles play out in that chapter. Under U.S. bankruptcy law, a chapter 13 debtor must pay all secured claims in full, with interest, and must devote all remaining disposable income for the next three or five years to payment of the unsecured claims. There are rules to determine whether it must be three or five years, but we can ignore those rules for purposes of this discussion. If disposable income is sufficient to pay the unsecured claims in full, the debtor typically would not be in bankruptcy, and thus unsecured claims are usually not paid in full through a chapter 13 plan.

Let's put some numbers on it. Suppose a secured creditor is owed $300,000 and has a claim against collateral with a value of $200,000. Under the general principles just outlined, a chapter 13 plan would have to pay the secured creditor the full value of $200,000 including interest. The judge would determine the appropriate interest rate, which would be based on current market rates and not necessarily the rate in the loan agreement. The remaining $100,000 would be lumped with the other unsecured claims, and receive a proportional share, without interest, of the debtor's disposable income over the three or five-year life of the chapter 13 plan. These are general rules that apply to most unsecured claims.

Home mortgages always have been an exception to this treatment. Home lenders successfully persuaded Congress that they needed special protections chapter 13 does not give to other lenders. Thus, the U.S. Bankruptcy Code says that a chapter 13 plan cannot modify secured claims on a debtor's principal residence. The U.S. Supreme Court  has interpreted this provision to mean that a chapter 13 plan must pay the full value of the secured creditor's claim, i.e. the full $300,000 in the example above. In bankruptcy talk, we say that a chapter 13 debtor cannot "strip down" the mortgage to equal the value of the residence. The 2005 changes to the bankruptcy law extended the chapter 13 anti-"strip down" rules to car loans made within two-and-a-half years of bankruptcy and all loans with one year of bankruptcy that fund the purchase of the asset serving as collateral for the loan (called a "purchase money security interest").

Also, bankruptcy judges cannot change the interest rates on home mortgages even if the current interest rate is much higher or lower than the interest rate at the time the loan was made. Thus, the New York Times was partially right. Loans on a principal residence get all sorts of special treatment that loans on a vacation home do not. It does not seem like sensible housing policy.

There are four bills pending in Congress that would end all of these special rules for home mortgages. That's all these bills would do. Each bill would end the rule in a slightly different way. Some would be more than others. I think the Durbin bill is probably the best alternative. Why I think that and how it is different than the other bills is a topic for a different post. For now, I hope the above explanation of what the current law will be helpful to some.

Comments

[Bob]

Very clear exposition - Thanks

[Holden Lewis]

Bob,
Is a stripdown the same as a cramdown?

[Nathalie Martin]

Holden, for many of us, this is the same, stripdown and cramdown. Some pursits think it is best to only use 'stripdown' for this concept because cramdown has a different meaning in Chapter 11, but lawyers don't keep it distinct, nor do the courts....so for me at least, the answer is YES. Theya re the same.