Appreciating the remaining risks of bankruptcy strip-off of home mortgages

Investments in mortgage-backed debts carry reduced risk in light of the special protections afforded to collateralized claims. Second-lien investing, however, is subject to enhanced risk due to the greater likelihood of collateral value insufficiency.  

As widely reported, the U.S. Supreme Court recently mitigated this risk by reaffirming restrictions on homeowners use of bankruptcy law to strip off second mortgages backed by no current collateral value.  

But careful investors should appreciate the context of that decision and the remaining risks of strip-off (and strip-down) second-lien mortgages in similar but distinct bankruptcy proceedings.

First, the good news. In 1992, the Supreme Court interpreted a key provision in the Bankruptcy Code to prohibit a homeowner from reducing the amount of a home mortgage to the depressed value of the home. That provision seemed to say that underwater liens, partially or wholly not backed by collateral value, may be stripped away so long as the debtor-homeowner manages to comply in full with any mortgage loans that are actually backed by the value of the home.

The Supreme Court in Dewsnup v. Timm struggled with the “plain language” of the statute and ultimately held that the law must not mean what it says. At least in the particular context of that Chapter 7 liquidation case, the Court prohibited strip-down of partially underwater mortgages, requiring homeowners to satisfy the mortgage loan in full or cede the home to the mortgagee.

A few lower courts strained to understand the particulars of this confused ruling. Acknowledging that mortgages backed by some value were inviolate after Dewsnup, these courts drew a distinction for mortgages that were wholly underwater; that is, not backed by any collateral value at all. In an era when secondary subprime mortgage lending (and investments in securities collateralized by such loans) had wrought terrible turmoil around the globe, high-risk second-lien lenders were not in a favorable public relations position to argue that their theoretical mortgage rights should be retained in the hope of distant future value appreciation.

Yet that is the position established by the Supreme Court in June 2015 in a pair of cases involving subprime second mortgage loans extended by the infamous Countrywide Bank and later acquired by Bank of America. In Caulkett and a materially identical companion case, Bank of America’s second mortgages were deep underwater, standing behind first mortgages that themselves exceeded the depressed value of the mortgaged homes by almost 100 percent.

The likelihood of a massive rebound in home prices making any value available to Bank of America’s secondary mortgages was remote at best, yet the bank opposed the homeowners’ requests to have the second liens stripped off of the homes. Bank of America pressed its right to retain its liens, in the event that any value was ever to become available. Based on its previous holding in Dewsnup, and despite acknowledging serious and sustained criticism of that case, the Court agreed with Bank of America and held that even wholly underwater liens cannot be stripped off.

Now for the important contextual limitation. Both Dewsnup and Caulkett arose in the context of Chapter 7 liquidation. In a Chapter 13 payment plan case, in contrast, the rules are different. First, mortgages not encumbering the debtor’s principal residence may be either stripped down or stripped off (whether partially or wholly underwater) if the debtor can pay the mortgagee(s) the present value of the mortgaged property within the 60-month statutory term of the payment plan. Second, the court in a case called Nobleman extended something like the Dewsnup rule to Chapter 13 plans involving partially underwater home mortgages.

That is, primary mortgages secured by the debtor’s principal residence cannot be stripped down to the value of the home. Third, however, that rule does not directly apply to wholly underwater second liens, and by negative implication, most lower courts have consistently allowed debtors to strip off naked second liens upon completion of a Chapter 13 repayment plan (so long as the debtor is entitled to a Chapter 13 discharge, another unresolved battleground limitation).

The saving grace for lenders and investors here is two-fold: Only about 30 percent of U.S. debtors choose to pursue a Chapter 13 payment plan rather than a Chapter 7 liquidation, and only about one-third of Chapter 13 debtors manage to confirm and complete a repayment plan. No plan completion; no strip-off.

In addition, more individuals are seeking relief today under the business reorganization Chapter 11. As any distressed-debt investor knows, Chapter 11 affords debtors powerful mechanisms for undermining the rights even of secured creditors. A Chapter 11 plan can be “crammed down” on a dissenting mortgage creditor so long as it provides for a stream of payments equal to the present value of the mortgaged property.

Like in Chapter 13, the Caulkett rule does not apply to wholly underwater mortgages in Chapter 11, which presumably can be stripped off entirely. Under-secured mortgages can be stripped down to the value of the property, like in Chapter 13, so long as the debtor manages to pay the present value of that sum over an essentially unlimited period of time pursuant to a confirmed reorganization plan.

Unlike in Chapter 13, however, a savvy mortgagee can mitigate the effects of strip-down in Chapter 11 by making a special election under section 1111(b) to have its entire claim treated as secured.

The debtor can strip down a mortgage after an 1111(b) election only if the creditor receives payment of the full amount of its entire claim, paid out over perhaps a very long time, so long as the time-value discounted payments equal the present value of the mortgaged property at the time of plan confirmation. This election prevents debtors from selling the property soon after confirmation and enjoying the upside of recent property value appreciation.

If the debtor holds the property for many years, or if the value of the property remains depressed or appreciates only slightly, the election will likely do the mortgagee little good as time passes.

The bottom line here is that the much-heralded decision in Caulkett may have at least some less meaning for lenders and investors than many have suggested. The likelihood of property value appreciation on many if not most subprime secondary home mortgages remains slim, and Chapters 11 and 13 provide legal mechanisms for debtors to achieve the strip-off (or even strip-down) of secondary mortgages otherwise prohibited in Chapter 7.

The glass may well be half-full, but proper risk valuation requires appreciation of the part that is half-empty, as well.

 

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Jason Kilborn

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

Jason Kilborn
Professor of Law
John Marshall Law School, Chicago
315 S. Plymouth Court
Chicago, IL 60604
USA

T: +1 (312) 386 2860+1 (312) 386 2860
E: jkilborn@jmls.edu
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John Marshall Law

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The John Marshall Law School
315 S. Plymouth CourtChicago, IL 60604
USA

T: +1 (312) 386 2860
E: jkilborn@jmls.edu
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