'Underwater' homeowners find help in court
A little-known provision in bankruptcy law has been used in hundreds -- maybe thousands -- of Bay Area cases to eliminate second mortgages.
This post comes from Marilyn Lewis at MSN Money.
The mortgage industry doesn't like it. But it can do nothing as lawyers in the San Francisco Bay area use a little-known aspect of the bankruptcy law to help debt-riddled clients get rid of their second mortgages and avoid foreclosure.
The San Jose Mercury News tells the story. Writes Pete Carey:
Statistics are hard to come by, but bankruptcy lawyers say the provision has been used effectively on hundreds, if not thousands, of cases in the Bay Area during the past two years.
"It's a big thing in our valley," said James "Ike" Shulman, a San Jose bankruptcy lawyer. "But it's not widely known."
To stop the practice, the mortgage industry would have to change the law. And that's unlikely in today's political climate, Carey says.
How it works
This provision in bankruptcy law is not new. But it wasn't used much when most owners had plenty of equity in their homes.
It applies only to second mortgages. You must keep paying on your first mortgage if you want to stay in your home after bankruptcy.
But for second mortgages, the rules are different. If you owe more than the home is worth –- and a record 28% of American homeowners are now in this position, Zillow.com reported this week -- you can petition the bankruptcy court to declare your second mortgage unsecured debt. In bankruptcy, unsecured creditors typically receive little or nothing. Post continues after video.
Says the Mercury News:
When that happens in a personal bankruptcy proceeding, the second mortgage is put on hold and no payments are required while the homeowner completes a repayment plan for other debts -- which typically takes three to five years. At that point, the second mortgage is eliminated.
Bay Area bankruptcy attorney Cathy Moran used the technique to get a $132,000 second mortgage voided by the court for a client.
"This is a really big-ticket issue that allows people to keep a home and conform the mortgage to something closer to real value," Moran said.
Second mortgages in Silicon Valley are as big as many homeowners' primary mortgages. A home purchase here takes serious money -- $502,350 for an entry-level home in Santa Clara County, Calif., where San Jose is located. That requires an income of at least $77,400 to make the monthly payment (including taxes and insurance) of $2,580.
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San Jose homeowner Veronica -- her last name was not given -- owns a home purchased in 2005 for $612,000. With a first mortgage of $489,000 and a second mortgage of $122,000, she owed $611,000, even though her home's value had slipped to about $367,000.
Shulman helped her successfully petition the court to have her second mortgage set aside. She recently finished a payment plan for other debts and her second mortgage has been eliminated.
"It's wonderful," she said. "After almost six years, I am finally able to see the light at the end of the tunnel and I'm so, so grateful."
Another San Jose bankruptcy lawyer, Brette Evans, recently helped a small-business owner keep her home by setting aside a $240,000 second mortgage. With that, her debt became manageable enough to work out a modification of the first mortgage.
There's an effort afoot to let judges reduce first mortgages, too. Ever heard of mortgage cramdowns? Homeowners used to be able to erase the unsecured part of their primary home loans through Chapter 13 bankruptcy. Judges reduced the primary mortgages to the fair market value of the property. The homeowner had to keep paying on the reduced balance to keep the home.
But only some judges. Writes Justin Fox at the CuriousCapitalist blog:
Between 1979 and 1993, about half of all federal judicial districts interpreted bankruptcy law to mean that judges could modify first-home mortgages, while the other half interpreted it to mean they couldn't. The Supreme Court put an end to this in 1993 by ruling that the latter approach was what the law called for.
But reviving cramdowns for first mortgages would take an act of Congress. The banking industry has, mostly, been adamantly opposed. Last year, however, Bank of America pronounced itself ready to accept some form of cramdown legislation.
It may not matter anyway.
De facto cramdowns are happening in bankruptcy courts around the country, despite the lack of formal legislation. Most are in California, Texas and Louisiana. Writes DSNews, an industry publication:
The research firm and ratings agency DBRS has learned from various servicers that although Congress never authorized bankruptcy judges to modify mortgages on primary residences, these "cramdowns," as they have been termed, are currently being performed in some courts.
"The amount of the cramdown varies by state, property value, and borrower situation but usually includes a reduction in the principal amount of the loan to fair market value," DBRS said.
One expert predicts that reductions of mortgage balances will become more widespread, making personal bankruptcy increasingly popular.
More on MSN Money:
Bankruptcy cannot be used to erase debt incurred through fraud. If you lied on the application for the mortgage that is fraud, so this may not be an option for some who bought and took out second mortgages during the boom if they were less than truthful on their application.
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