Redemption (of the 722 variety) for Struggling Homeowners

Homeowners continue to struggle, foreclosures continue to climb, and loan modification efforts continue to lag. A persistent problem, pointedly described in these letters (July 10, 2009 and March 4, 2010) from Rep. Barney Frank to the large banks, is that the banks that hold second mortgages are not modifying those loans. (Yep, these are the same banks that took TARP money). The reluctance of the second lienholders to agree to a modification gums up the process for trying to get a modification on first, and usually much larger, mortgages. The investors in the first loan somewhat sensibly resist modifications, particularly those with principal write-downs, pointing out that it doesn't seem right that they should take a haircut, while junior lienholders refuse to modify their loans. And while the Administration announced new initiatives with HAMP and FHA to help with the second lien problem, I remain skeptical. After all back in April 2009--a year ago, they also made an announcement that they were revising their loan modification programs to deal with second liens. Hhmm . . . Deja vu? Why wait another year while servicers build a platform and train personnel, and Treasury writes regulations, etc.

Here's a legislative solution to the second lienholder hold-out problem. Congress should amend section 722 to permit chapter 7 bankruptcy filers to be able to redeem any junior loan on a debtor's principal residence. Current bankruptcy law permits debtors in chapter 7 bankruptcy to redeem personal property, such as cars, by paying the lienholder the value of the collateral. This redemption right exists regardless of the terms of the loan contract. The effect of the redemption is to remove the lien from the collateral. To redeem, a debtor must pay the secured party the amount of the allowed secured claim that is secured by such lien in full at the time of the redemption. If a secured party is completely underwater because the value of the first mortgage exceeds the house's value, the debtor would file a motion to redeem under 722 and pay nothing (that's the amount of the allowed secured claim!))  I think this legislation would provide some real leverage to get banks to agree to write down second loans.

If enacted, redemption for junior mortgage loans could give homeowners a credible threat to force the banks to negotiate loan modifications of second mortgages.  This seems to be a much better solution than trying to use (or threatening to use) chapter 13 to deal with second mortgages. The advantages: 1) redemption could easily work for partially-secured loans whereas lien-stripping in chapter 13 is limited to wholly undersecured loans because of a Supreme Court case called Nobelman that interprets chapter 13’s anti-modification rule for mortgages (1322(b)(2)));  2) chapter 7 actually provides fast relief, usually in about 90 days, rather than forcing everyone into a wait-and-see position during a three- to five-year repayment plan. This proposal is not "cramdown." It leaves the sacred anti-modification rule for chapter 13 in place. And it avoids the administrative complications of cramdown in chapter 13, where there were concerns about how to handle property appreciation during the repayment plan, and about the fact that only 1 in 3 chapter 13 debtors complete their repayment plans and make permanet the cramdown.

Implementation could be fast and cheap. Families could be helped within days of enacting such a reform, without the costs and expense and delay of chapter 13, HAMP, or Barney Frank sending more letters that fall on deaf ears. The amendment itself would be simple. Section 722 could be changed to read:

An individual debtor . . . may redeem tangible personal property intended primarily for personal, family, or household use, from a lien securing a dischargeable consumer debt, and may redeem real property that is the debtor’s principal residence from any lien that is junior to another secured obligation on the same property, if such property is exempted under section 522 of this title or has been abandoned under section 554 of this title, by paying the holder of such lien the amount of the allowed secured claim of such holder that is secured by such lien in full at the time of the redemption.

Comments

[AMC]

Wholly unsecured second mortgages are, of course, already strippable in almost every district in the United States - using Chapter 13:

In re Tanner, 217 F.3d 1357 (11th Cir.2000); In re Dickerson, 222 F.3d 924 (11th Cir. 2000)(following Tanner, somewhat reluctantly); In re Bartee, 212 F.3d 277 (5th Cir. 2000); In re McDonald, 205 F.3d 606 (3d Cir. 2000); In re Pond, 252 F.3d 122 (2nd Cir.2001); In re Lane, 280 F.3d 663 (6th Cir. 2002); In re Zimmer, 313 F.3d 1220 (9th Cir. 2003).

Other appellate decisions allowing totally unsecured mortgages to be stripped include: In re Mann, 249 B.R. 831, 835-37 (1st Cir. BAP 2000)(cited with approval in dicta in by In re LaFata, 483 F.3d 13 (1st Cir. 2007)); Johnson v. Asset Management Group, LLC, 226 B.R. 364 (D. Md. 1998).

The structural problem with your proposed change in the law is that it makes Chapter 7 more attractive than Chapter 13. Although Congress has done a terrible job of making Chapter 13 more beneficial than Chapter 7, the goal of BAPCPA was to put more debtors into Chapter 13s. Your proposal would have the opposite effect, making Chapter 7 the preferred vehicle for relief for a substantial number of debtors - those with second mortgages that are not wholly underwater. For that reason, as real legislation, I think your suggestion would be DOA.

In addition, you would get the same "moral hazard" response from financial institutions that Chapter 13 mortgage cramdown legislation received. And as we know, no bankruptcy legislation can be passed in this country unless it is supported by main street banks and credit unions. It appears to be some kind of a rule.

[Patches]

The sunset provision in the proposal for Cramdown Mortgages I thought was a good preventative for that "moral hazard" but oh well....:(

I think going into 7 for that kind of mortgage relief would be detrimental in that most people with those types of mortgage problems have pushed the pain down the line a bit. Getting a discharge in 7 most likely will prevent them from seeking 13 protection for other things in the near term (property taxes,vehicles..etc.) Don't get me wrong, its good out of the box thinking but I don't think redeeming on the second mortgage will get Servicers on the ball more than they are off the ball right now.

Almost everyone who has come in to file with Mortgage arrears has run into dead ends with the Servicers and Mortgage modifications. (Some with decent incomes and only one mortgage) I think I would faint if I actually saw one that worked out. I might be permanently in a coma if I saw a write down of principal...OMG! The sky would fall. Maybe though the people who have received Mortgage mods wont necessarily come here for help.

[Adam Levitin]

Katie, we've discussed the limitations in using 722--my concern is its impact wouldn't be broad enough--but maybe you have further thoughts on the issue.

First, the means test might be a big obstacle to widespread impact. Presumably a lot of the people who would be helped by 722 have higher incomes than typical bankruptcy filers. That might mean means test problems, although high secured debt payments would help. This should be possible to at least model with stylized debtors.

Second, these higher income filers might also be higher asset, and not want to surrender non-exempt assets as part of a 7. The choice isn't the house or their junk, but a shot at the house or their junk.

Third, is it worth filing for bankruptcy to get rid of a second lien on the cheap, if the first lien is still a problem? Getting rid of the second will reduce monthly mortgage payments and will make a workout of the first easier, but hardly guaranteed. And a debtor can probably just stop paying on the second irrespective because it won't do the second any good to foreclose, so the real benefit is the easier, but non-guaranteed workout of the first. Let's say it costs $1000 to file for 7. That's an expensive lottery ticket.

Finally, I wonder how much negotiating leverage 722 would really provide. Against a perfectly rational party, it works. But add in the dysfunction in some servicing operations, and that may not matter.

Again, this is not to in any way object to the proposal, but I don't see it having a major impact in and of itself. It would help, but I'm not sure it would help a lot of people. (I'm hoping you can convince me otherwise).

Also, I suspect that any amendment of the Bankruptcy Code, no matter how small, would require significant political capital. Amending 722 might be less costly politically than amending 1322, but I'd be surprised if the Administration is willing to spend its political capital on this. I'm afraid we're in a McGyver situation where the Administration has $70 billion, a rubberband, and a paper clip to fix the housing crisis, but not a realistic option of legislation.

[Katie Porter]

I think it is a benefit of this proposal that people would achieve some mortgage relief in chapter 7, and not chapter 13 (where to get lasting relief from stripdown they have to be the 1 in 3 that completes a repayment plan). Those odds are better than a loan modification, but still low. Chapter 7 is much cheaper, much faster, and has a very high rate of discharge. The lottery ticket as to stripping off their second is guaranteed payout, whereas in cramdown, it took completing the plan--a 1 in 3 payout lottery ticket. Because I think permitting redemption as I outline would actually remove 100% of totally underwater second liens in every chapter 7 case with such a mortgage, I think it would exert considerably more negotiating leverage than cramdown in ch 13. I also think the moral hazard is much less because the time period is shorter--part of the concern in chapter 13 about moral hazard was about debtors whose homes appreciate considerably during the 5-year plans but are still able to strip it off entirely by continuing to pay. Finally, Adam, your point about dysfunction in servicing operations has been my point about HAMP all along. But doesn't that just mean that the Administration's new proposals are doomed even more so than a 722 redemption. In the latter case, if the leverage fails, the debtor can force the stripoff of the second. With the Administration, if the program doesn't work as hoped, homeowners have no option but to wait another year for yet another announcement of "we have a solution to the second lien problem."

[Patches]

Thought I saw something the other day in my westlaw updates. Something like a debtor delaying discharge in a 7 to negotiate a Mortgage Mod via reaffirmation...? Those two concepts if worked together might do the trick..? We still are using up our "get out of jail free" card with 13 but I see the point on the time frame and discharge rates.

[Arnie Wuhrman]

Sounds like a wonderful idea, but I agree with AMC that it will be DOA legislatively. I'm a consumer BK lawyer representing debtors 95-99% of the time, and I'm struck, in talking to the general population, how many non-bankrupts believe that cram down of any kind is a "free ride" for the debtor, while "I still have to pay all of my bills." There's just not enough of a constituency out there for this sort of change.

NOTE TO PATCHES: Still recovering from the shock, but I've now seen TWO principal reductions in some 100 mortgage mods -- both by Wachovia. Neither one CAME CLOSE to matching market value, but they still wrote off some 20% of the loan. Would love to tell you I knew the secret to getting these, but I had nothing to do with them. The debtors sent in the paperwork, and the numbers came back that way.

[Patches]

lol!!! That's funny! They do exist!!! I thought they were like the tooth fairy or the Easter Bunny!

[Ken Doran]

While it is widely assumed that stripping wholly unsecured mortgages is unavailable in Chapter 7, there is actually a split of authority on the issue, with no decisions in many jurisdictions. Attorney Daniel Press of McLean, Virginia has been in the forefront of developing this issue.

[Austin Bankruptcy Attorney Alex Wathen]

While it may help many in other parts of the country, in Texas I do not see that many second mortgages and do not see that many that are under water by a huge amount. It would only be moderately useful. What is really needed is full mortgage modification on primary residences.

[Laura Morton]

There must be some incentive for the second lien holder. He should be paid a fee and also allowed to register a silent second after the modification. This would allow him to recoup some money when the house is sold.