The SCOTUS has recently decided to hear an appeal to consider whether junior mortgage liens, which are out of the money, on chapter 7 debtor’s homes may be voided simply because there is no equity in the home to attach to the junior lien at the time of the bankruptcy filing. The effect of a win by the debtor would be to permit bankrupt individuals to wipe out junior mortgages in chapter 7 when the senior lender’s lien debt is greater than the value of the home.
In bankruptcy, a secured creditor’s claim is considered to be bifurcated for the purposes treatment under a plan (see chapter 11 or 13 usually). More simply, when the secured claim exceeds the value of the collateral, the secured claim equals the collateral value and the portion of the debt above the collateral value is considered to be unsecured.
In a chapter 13 bankruptcy case (an individual’s version of chapter 11), some secured claims may be stripped down – ie, the secured portion is reduced to the collateral value. Similarly, in chapter 13, junior lien holders who’s debt is behind a senior lien debt which is greater than the collateral value may be stripped off (rendered unsecured entirely).
In chapter 7, there is no plan treatment, and thus the distinction between debt is trumped by the general rule that a lien rides through bankruptcy, and thus – regardless of the valuation of the collateral – the secured lender is entitled to its entire secured claim against the property. The debt is generally not enforceable against the individual, through, after discharge. The SCOTUS has ruled in the past that a chapter 7 debtor may not strip down a lien.
However – the code section that provides for the distinction between the secured vs. unsecured portion of the debt also states that the lien of a purported secured creditor is “void” if the underlying claim is not an allowed secured claim.
Here is the issue:
- A couple of chapter 7 bankrupt debtors in Florida have claimed that a junior lien which is junior to an already underwater senior lien is not a “secured creditor” and thus has no allowed secured claim (ie, there is no secured portion of the claim).
- Thus – they argue – the second lien on their residential mortgage is void under the law because it is not a secured claim.
The Bankruptcy Court agreed with this argument over the objection of Bank of America, who is the junior lien servicer/holder.
BofA, seeing that this might be a little bit of a nationwide issue, promptly appealed two of the rulings to the SCOTUS, which has not yet heard the appeals.
The effect on residential lenders will be a little different depending on their respective position in the lien stack:
- The issue to be determined is of some consequence to senior lien holders because, if the junior lien is voided in a chapter 7 on undersecured collateral, the senior lien holder may have a little more flexibility in deciding whether to negotiate or take back the home.
- For junior mortgage holders, the issue is of greater consequence. While the junior lien may have been out of the money at the time the bankruptcy was filed, the house may appreciate in value before the senior lender forecloses or the borrower sells.
Once the SCOTUS rules on the pending appeals, the ruling will affect the treatment of junior chapter 7 mortgage holders nationwide.
(As a side note, I missed last week’s post because I was in trial. I would also like to thank the folks at Apple, Inc. for the traffic viewing the last post. Swing by anytime.)