On Tuesday the Supreme Court heard a case, Bank of America vs. Caulkett, that could have huge implications for the mortgage market. At stake is whether or not a judge can forgive mortgage debt completely in a Chapter 7 bankruptcy if a home is underwater. The practice is often referred to as “lien stripping.”
In a Chapter 7 bankruptcy, almost all unsecured debt is completely forgiven. For example, credit card debt is typically written off completely, providing a fresh start for borrowers and an immediate credit loss for banks. Mortgages, however, have been kept out of Chapter 7 completely. Even if your house is underwater, most states treat your mortgage as secured debt and exclude it from the filing. Because the bank has a lien on your home, the mortgage debt remains after the bankruptcy.
However, three states (Florida, Georgia and Alabama) allow second mortgages that are completely underwater to be considered unsecured and have the debt eliminated in bankruptcy.
Imagine a home is worth $100,000.
There is a first mortgage for $100,000 and a second mortgage for $50,000. The second mortgage is completely underwater because the home is only worth $100,000.
In Florida, Georgia, and Alabama you could have the second mortgage lien stripped, which means the second mortgage would no longer be attached to the property. The debt would then be treated like any other form of unsecured debt in the Chapter 7 bankruptcy, and would be completely forgiven.
Outside of these three states, the only way to reduce your second mortgage debt is through a different kind of bankruptcy called Chapter 13.
In Chapter 13, the court determines how much you can afford to pay towards your debt, and creates a repayment plan. The repayment plan lasts three years (if your income is below the median) or five years. At the end of the repayment plan, any remaining debt is forgiven.
Clearly, second mortgage lenders much prefer Chapter 13 bankruptcy, where the borrower must pay back a portion of the loan based upon affordability. In Chapter 7, the entire balance is wiped out, leaving a lender with nothing.
Details Of The Case
The case focuses on the travails of David Caulkett, a Florida homeowner who used the equity in his home to borrow. By the time of the foreclosure, Mr. Caulkett had a first mortgage balance of $183,000 and a second mortgage balance of $47,855.
Although the home had been worth $300,000 at its peak, the price had dropped dramatically and the home was only worth about $98,000 at the time of the foreclosure.
Mr. Caulkett wanted to avoid foreclosure and stay in his home. He decided to file for Chapter 7 bankruptcy.
And in his case, the judge stripped the lien from the second mortgage and treated the debt as fully unsecured. The full $47,855 second mortgage was written off in the bankruptcy.
Bank of America was not happy with the outcome, and sued.
They used a 1992 case (Dewsnup) to make their case. In Dewsnup, it was ruled that judges are not permitted to reduce the principal of first mortgage balances to the current value of the home. The ruling implied that mortgages are protected up to the contract value, not the market value of the property.
Underwater homeowners could get more relief
After the 2008 mortgage crisis, property prices declined dramatically and many homeowners are still underwater on their mortgages. If Chapter 7 bankruptcy becomes an option for homeowners with large underwater second mortgage balances, banks fear a rapid increase in the filings would follow.
Chapter 7 would provide an easy way for consumers to eliminate second mortgage debt completely and quickly, while remaining in their homes.
There are really only two ways to eliminate second mortgage debt completely (outside of Florida, Georgia and Alabama).
One way is to agree a short sale with the lender.
Alternatively, the borrower can go through the foreclosure process and then file Chapter 7 bankruptcy after the foreclosure is complete. The deficiency balance (the remaining balance after a foreclosure is complete) would be treated as unsecured debt in a future Chapter 7 filing. Both of these require a significant amount of time, and result in a foreclosure.
Banks argue that easier lien stripping would restrict access to credit and drive up the cost of borrowing.
However, the lawyers arguing for Mr. Caulkett pointed out that mortgage borrowing is not more expensive in the three states that allow the lien stripping practice.
The entire argument comes down to a relatively simple question.
Are mortgages immune to bankruptcy up to the contract (mortgage) value, or the market value of the property?
The decision, which will be made later in the year, will have massive implications for anyone who is underwater on their property today. If it is upheld many more people will be able to more quickly escape an underwater home and leave a bad mortgage behind.
And it could also have big implications for anyone who wants to take out a mortgage in the future if banks decide to tighten lending criteria.
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