Home Foreclosure Crisis: Will Proposed Amendments to the Bankruptcy Code Be Helpful or Hurtful?
December 10, 2007
Alvin Fletcher Benton - Orlando
James L. "Jim" Fly- Orlando
A residential foreclosure crisis exists at an unprecedented level in many parts of the United States. Prompted by the enormous number of families losing their homes to foreclosure, several members of Congress have introduced legislation which would amend the present treatment of mortgages on primary residences in chapter 13 bankruptcy cases.
Primary Residence Mortgage Loans Protection Under Current Chapter 13
Chapter 13 affords an individual with regular income, whose secured and unsecured debts do not exceed the statutory maximums, an opportunity to pay debts, in whole or in part, over a period of time. Unlike chapter 11 reorganization cases in which creditors get to vote on plans, creditors do not vote on chapter 13 plans, although they may object to the terms of a plan.
Subject to certain exceptions, the allowable amount of a secured claim in a bankruptcy case is determined pursuant to 11 U.S.C. § 506(a)(1).1 This section basically states that the claim of a creditor secured by a lien (mortgage) on property is a secured claim only to the extent of the value of such property; the balance of the claim is an unsecured claim. Under this provision, a claim of $100,000 secured by property with a current value of $75,000 is to be treated as a secured claim for $75,000 and an unsecured claim for $25,000. Some of the exceptions are stated in §1322.
One of the exceptions is contained in §1322(b)(2), which states that a plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence … .”
Although this language would appear to exclude the applicability of §506(a)(1) to the treatment of primary residence secured claims in chapter 13 cases, based on grammatical interpretations of the section, not all courts adopted this interpretation. The dispute was resolved by the U.S. Supreme Court’s determination that as to primary residence mortgages, §1322(b)(2) prevailed over §506(a)(1).2
The effect of §1322(b)(2) is that if a chapter 13 debtor owes $200,000 on a primary residence valued at $175,000, the plan must provide for the treatment of the claim as a $200,000 secured claim and the payment terms may not be modified. Additionally, a plan may provide for a debtor delinquent in his mortgage payments to cure the defaults during the term of the plan.
Statutory History
Section 1322(b)(2) has been in the Bankruptcy Code since its enactment in 1978, although the adoption of this section was not without dispute. In 1970, Congress created the Commission on the Bankruptcy Laws of the United States, which in 1973 issued a report containing its finding and recommendations and a draft of a bill to implement them.
The Commission’s bill made no provision for modifications of real property mortgage debt in chapter 13 cases. The House proposed to allow modifications of secured and unsecured debt. The Senate proposed to exclude from modification claims “wholly secured by mortgages on real property.” The compromise, as stated in §1322(b)(2), was that §506(b)(2) would not apply to mortgages on primary residences. This limited non-modification position “was apparently in response to perceptions, or to suggestions advanced in the legislative hearings … that, home-mortgagor lenders, performing a valuable social service through their loans, needed special protection against modification thereof (i.e., reducing installment payments, secured valuations, etc.).”3
Proposed Changes
Senate Bill S. 2136, titled the “Helping Families Save Their Homes in Bankruptcy Act of 2007” was introduced by Senator Richard J. Durbin of Illinois and is similar to the House bill introduced by Representative Brad Miller of North Carolina, H.R. 3609, titled the “Emergency Home Ownership and Mortgage Equity Protection Act of 2007,” the Senate bill introduced by Senator Arlen Specter of Pennsylvania, S. 2133, and the House bill introduced by Representative Steve Chabot of Ohio, H.R. 3778, titled the “Homeowners’ Mortgage and Equity Savings Act.”
In general, these bills seek to limit or delete §1322(b)(2)’s prohibition on modification of mortgages on a debtor’s principal residence. These bills would allow a bankruptcy judge to “strip down” a mortgage loan on a primary residence to the home’s current value rather than the indebtedness on the home.
One variation in the bills is whether the “strip down” would be applicable in all chapter 13 cases or would be subject to a debtor’s income level. The ability of a plan or a bankruptcy court to adjust the mortgage interest rate and/or the term of the mortgage loan are other variations.
Notwithstanding the variations, the import of all of the bills is that treatment of primary residence mortgages debts would no longer be immune from modification.
Policy Questions and Consequences
Sponsors of the proposed legislation to permit modification of primary residence mortgage loans under the Bankruptcy Code anticipate enactment will result in many homeowners avoiding foreclosure of their homes. The proposed legislation begs the question, however, whether such a change would be consistent in the long run with the federal government’s long standing policy of encouraging home ownership. Congress allows a tax deduction for payment of home mortgage interest while protecting lenders with the anti-modification provision in the Bankruptcy Code. Is it wise to remove the anti-modification governmental incentive that encourages the lender side of the transaction at a time when other factors, such as depressed home values, have already chilled the market? A recent publication of the American Bankruptcy Institute states, “The Mortgage Banker Association contends that the proposed amendment would give bankruptcy courts too much leeway to rewrite loans without legal or economic restraints. MBA also contends that the change would cause risk premiums charged on mortgages to increase as much as 2 percent – saying lenders would be unsure about profits from the loan, since the terms could be changed at a judge’s discretion and thus could scare away potential investors in the secondary market.”4
Several other questions are raised by the proposed amendments: Will the legislation solve the problem for existing homeowners? What about the large percentage of chapter 13 cases that historically are not successfully completed? What about debtors in chapter 7 liquidation cases who would like to emerge from bankruptcy with at least their home?
Conclusion
The proposed amendments would allow chapter 13 debtors to have their principal residence mortgage indebtedness reduced to the value of the residence, with the balance of the indebtedness becoming an unsecured claim. Assuming a debtor had other unsecured indebtedness, the modification would increase the total amount of unsecured indebtedness and, in all likelihood, reduce the percentage distribution to each of the other unsecured creditors.
If the value of the residence is not substantially less than the mortgage indebtedness, the strip down may not be significant enough to enable a debtor to retain the residence. It may be more meaningful if an amendment to the Bankruptcy Code permitted a chapter 13 plan and the bankruptcy court to reduce the interest rate and perhaps extend the term of a loan secured by a primary residence. Unless an amendment to the Bankruptcy Code provides such forms of relief, it is questionable whether the desired reduction in the number of foreclosure actions will be achieved.
Regardless of whether one deems the proposed amendments to address the residential foreclosure crisis to go too far or not far enough, it is clear that the legislation raises more questions than it appears to answer. If legislation is enacted that grants all or some of the modifications contained in the proposed amendments, only time will tell whether the Mortgage Bankers Association is correct in its contention that the result will be an interest rate increase on mortgages and whether the legislation will achieve the intended result.
For more information, email James Fly or Alvin Benton, Jr. at james.fly@hklaw.com or alvin.benton@hklaw.com, respectively, or call toll free, 1-888-688-8500.
1 All section references are to Title 11, United States Code (Bankruptcy Code).
2 Nobleman v. American Savings Bank, 508 U.S. 324, 326, 113 S. Ct. 2106 (1999).
3 Grubbs v. Houston First American Sav. Ass’n, 730 F.2d 236, 246 (5th Cir. 1984).
4 Grubbs v. Houston First American Sav. Ass’n, 730 F.2d 236, 246 (5th Cir. 1984).