Hobson's Choice

In my last post this week I wanted to thank everyone at Credit Slips for giving me the opportunity to “speak my mind.” It has been a full week when it comes to bankruptcy and foreclosure. The Senate Banking Committee held its hearing to examine the crisis in the subprime mortgage market, Judge Steen in Texas heard hours of testimony in the hearing to determine the appropriate sanctions for Countrywide’s counsel Barrett Burke, and the Bankruptcy Appellate Panel for the Eighth Circuit decided the case of In re Zahn, 2007 WL 817510 (B.A.P 8th Cir. Mar. 20, 2007). The Zahn case, while little noticed, shines a spotlight on the way chapter 13 debtors fighting to save their homes, must often battle the “system” first.

You see when creditors or trustees object to confirmation of a chapter 13 plan and lose, they may appeal immediately as of right. By contrast, when debtors lose and a plan is rejected, the order in most circuits is considered interlocutory. Debtors must request leave to appeal the interlocutory order and, at least in the Eighth Circuit, leave is rarely if ever granted. As a result debtors are left with two choices: 1) file an amended plan that contains provisions the debtor does not believe are required by the Code, or 2) elect not to file an amended plan and have the case dismissed. The dismissal results in a final appealable order, but also terminates the automatic stay. In addition, under BAPCPA dismissal now has significant consequences if the debtor must later refile.

Not wanting to suffer the consequences of dismissal, the debtor in Zahn tried a different approach—she filed an amended plan and objected to it. This procedure was referred to favorably in dicta from other Eighth Circuit cases. Unfortunately for the debtor, the BAP held that she had no standing to appeal confirmation of her own plan. According to the court, the debtor was not an “aggrieved party.” Despite the court's conclusion, the debtor was effectively left without a way to challenge the original denial of confirmation. With so many chapter 13 issues under BAPCPA unresolved many more debtors are likely to find themselves in this same situation.

Until the Courts of Appeals reconsider their position on this issue (as suggested by Judge Mahoney in concurrence) debtors will have to choose between submitting less favorable plans or having their cases dismissed. Sometimes a choice is no choice at all.

The Case of the Upside-Down Trade-In

The more times I read section 1325(a), the more I am convinced that not even Leroy “Encyclopedia” Brown, the wonder boy detective, could solve the mysteries of the “hanging paragraph.” The latest chapter, in what is sure to be a very long series, involves the case of the upside-down trade-in.

An upside-down car is one in which in which the value of the car is less than the amount owed on it. It is not unusual for owners with longer-term loans, low or no down payments, and/or cars that are depreciating rapidly to be “upside-down.” According to J.D. Power and Associates, more than one-third of U.S. car buyers who traded in for a new car in 2005 were upside-down. When an owner of an upside-down car goes to buy a new car, not only must he pay the purchase price of the new car, he must also payoff the negative equity on the old car. Is a loan that includes refinancing of negative equity a purchase money loan, in whole or in part? Does the “hanging paragraph” cover claims in which only a portion of the debt is purchase money? These were the puzzlers faced by the court in the recent case of In re Price, 2007 WL 664534 (Bankr. E.D.N.C. Mar. 6, 2007).

One-Way ARMs: Stacking the Deck.

The Senate Banking Committee has invited representatives from the top five subprime lending companies to “explain their lending practices in the subprime mortgage market” at a hearing scheduled for tomorrow, March 22. With all the recent focus on teaser rates and no document loans, the one-way adjustable rate mortgage (ARM) probably won’t get much attention. An analysis of the actual terms of recent ARM loans, however, shows that one-way ARMs are yet another example of how subprime lenders stack the deck against borrowers.

In its simplest form an adjustable rate mortgage is one in which the interest rate for the loan is pegged to an “index” and for which the interest rate is adjusted at set intervals (e.g., 6 months, 1 year, etc.). If the index increases, the borrower’s interest rate increases, if the index declines, the borrower’s interest rate goes down. The floating rate structure of the ARM allows lenders and borrowers to share the interest rate risk. In exchange for assuming some of this risk, borrowers generally receive lower initial interest rates. This economic reward for risk-sharing is the justification for ARM loans--at least in theory.

In practice, the one-way ARM, which is ubiquitous in the subprime market, only adjusts upwards from the initial rate. By the terms of the note the interest rate can never drop below the initial rate even if the index goes down. As a result, borrowers, not Wall Street, bear the brunt of any interest rate volatility.

Preliminary data from an empirical project (funded by the National Conference of Bankruptcy Judge’s Endowment for Education) that I am currently working on with Professor Katie Porter confirms the widespread use of one-way ARMs among homeowners in bankrutpcy. As part of the project, which looks at the intersection of bankruptcy and homeownership, we coded information about debtors’ notes and mortgages when such loan information was available. Among ARM loans in the sample-to-date, more than 85% of these loans put no risk of interest rate change on the lender because the initial interest rate and the floor interest rate (the lowest rate permitted by the note) were identicial.

Some have likened ARMs to a gamble: the borrower wins if interest rates go down and loses if the interest rates go up. The realities of recent subprime lending practices show that Wall Street is like every winning gambling house—it is has effectively stacked the deck so that the house always wins. With one-way ARMs, consumers don’t get a fair deal, no matter how you cut the deck.

Subprime Servicing Getting Worse?

Wall Street is watching closely to see what, if any, “ripple effect” the problems in the subprime market will have on other credit markets. It is also watching to see what effect the market meltdown will have on subprime servicing. Financial troubles, staff layoffs and potentially higher servicing costs on defaulting loans have led to concerns that servicing quality may decline.

SUBPRIME SERVICING QUALITY MAY DECLINE!! This is really bad news for homeowners in bankruptcy where mortgage loan servicing is already abysmal. Of course, according to servicers and their attorneys it’s not really their fault. It’s those darn pesky computers that keep giving them incorrect information.

Super Trustees?

Faster than speeding bullets, more powerful than locomotives and able to liquidate fully exempt property with a single motion—they’re super trustees! Taking their cue from a Superman comic book, trustees around the country are attempting to exert their self-proclaimed super trustee powers by filing motions to liquidate exempt property, particularly homesteads, to pay domestic support obligations. According to these trustees their superpowers derive, not from some Kryptonian heritage, but rather BAPCPA’s amendment to section 507(a)(1)(A).

In 2005, Congress made several changes to the bankruptcy code to benefit payees of domestic support obligations. Significantly absent from these extensive amendments was any mention of the power to liquidate exempt property. Despite the lack of express authorization for such power, trustees have argued that the amended language in section 507 gives them “implied authority” to liquidate all of the debtor’s assets, whether exempt or not, to pay domestic support obligations. The amended language of section 507(a)(1)(C) states that: “If a trustee is appointed…the administrative expenses of the trustee…shall be paid before payments of [DSO claims], to the extent that the trustee administers assets that are otherwise available for the payment of [DSO claims].” The trustees argue that Congress, in adding the trustee compensation provision and using the term “assets” instead of “property of the estate,” impliedly bestowed upon them this superpower. Given the additional fees that the trustees would generate for themselves by liquidating exempt assets (admittedly a less than altruistic motive), no one can blame them for wanting these superpowers, but here’s why this one won’t fly.

Introduction

Thanks to Credit Slips for having me "on" this week. Between BAPCPA and foreclosures there is certainly no shortage of things to talk about. This week I will share some thoughts on both and hopefully in the process highlight some lesser known, but important issues. I welcome and look forward to your comments.