Bankruptcy

Redemption (of the 722 variety) for Struggling Homeowners

By Katie Porter

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.

Full post as published by Credit Slips on March 30, 2010 (boomark / email).