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Is Chapter 13 Obsolete?

Posted by David Falvey on Sunday, April 22nd, 2012 - 549 views

Bank of America, Citigroup, J.P. Morgan Chase, Wells Fargo—some of the nation’s largest lenders whose shady banking practices—“robo-signing,” liars loans, and so on—helped tank the housing market and send many millions into foreclosure—out of the goodness of their hearts are coming to the rescue to help beleaguered homeowners. Well, not really.

These banking giants have signed a deal with state attorneys general to provide restitution for their shady foreclosure practices. This settlement will provide tens of billions of dollars to form national and state funds to settle disputed foreclosure claims, and includes provisions for principal reduction for bank mortgage customers.

About one million homeowners who are “underwater”—owing a greater amount on their mortgages than their homes are worth and are customers of these banking entities—will be eligible for “mortgage mediation.” Principal reduction will lower their mortgage balances and provide lower monthly payments so they can avoid foreclosure of their properties.

That’s good—but that’s only about a tenth of the eleven million homeowners across the nation who are currently underwater. And it doesn’t do a thing for the nearly four million people who lost their homes to foreclosure in the past few years since the crash.

It also doesn’t help consumers with mortgages through Fannie Mae or Freddie Mac—about half the housing market. Federal Housing Administration loans are not covered, either. If this is your case, you’re out of luck.

Mortgage mediation vs. Chapter 13 bankruptcy

Mortgage mediation can save your home, preventing foreclosure if you are eligible. If your home goes into ‘official foreclosure’, a state marshal will serve you foreclosure papers which are then taken to the Connecticut Superior Court. In your foreclosure papers are official forms were you can request Mortgage Mediation through the Connecticut State Superior Court. But you have to be very careful. You have to request mediation within 15 days after the state marshal returns the papers to Court. Connecticut is leading the nation with this concept. In other words, before the foreclosure can be granted, the parties have to mediate in order to determine if the homeowner can receive a reduction in his/her monthly payment. And many times, this works!  Now that’s the good news.  But there are pitfalls to this solution.

For example: you also have a second mortgage—and your first mortgage is underwater and you qualify for mortgage mediation. That’s good—but in that case your second mortgage is basically unsecured. In a Chapter 13 bankruptcy, often a second mortgage can be stripped, or ‘crammed down’ or ‘avoided’ when there’s no equity (not even one dollar) for the second mortgage. This probably won’t happen if you pursue mortgage mediation.

Let’s say your first mortgage is for $175, 000 with one lender, and your second is for $50,000 with another company. Your home is devalued and is worth $150,000—yet the total of owed on both mortgages is $225,000. Through mortgage mediation the lender of your first mortgage reduces the principal to $149,000 and you’re finally above water—you think. However, in this circumstance your second loan still puts you underwater—a total of $51,000.

Instead, suppose you file for Chapter 13 bankruptcy—your second mortgage is stripped in the settlement. You still are underwater by $25,000 on the first mortgage—but better off if you participated in mortgage mediation, still owing $51,000.

And when your bank or mortgage company reduces your principal it is considered by the IRS as income. That might mean a tax bill of thousands of dollars. However, there’s the Mortgage Forgiveness Act which usually means you will not owe any income tax on the cancelled portion of the mortgage.

However, debt discharged  in a Chapter 13 bankruptcy does not count as income and you won’t owe any taxes as a result. Filing for Chapter 13 bankruptcy may or may not ultimately make more financial sense than principal reduction through mediation. Every case is different—your bankruptcy attorney can advise you on the pros and cons of both.

We have contacted second mortgage companies and offer them no more than 10% lump sum payment on their second mortgage in exchange for a release. We have achieved this but as we tell clients there can be no guarantee that we’ll be successful. So if someone owes $50,000 on a second mortgage, we have obtained a release of the second mortgage with the payment of a lump-sum of $5,000. Where did the homeowner get the $5,000? They borrowed from their pension account. Now we normally never recommend that anyone borrow from their pension account, but where we get rid of a second mortgage for 10% of the debt and the people have had steady employment and the future employment looks solid, then we believe that this is a ‘safe bet’.

I am worried that any moment the entire house of cards will collapse and we’ll have the Second Great Depression. But if the people intend to stay in the home for the long term, getting rid of the second mortgage for a 10% lump-sum payment does make sense.

Option 3 – Chapter 13 principal reduction

In some states,Connecticut being one, it is possible to have a loan modified during a Chapter 13 bankruptcy after the second mortgage is wiped off the books. You’d file for bankruptcy, strip away your second mortgage so you’re no longer liable for it, then you have to  work with your lender on the first mortgage to have the principal reduced so you’re no longer underwater. But the lender isn’t required to reduce the first mortgage. However, there is no formal or informal program in Connecticut Bankruptcy Courts but from a seminar I attended, this is being done in the Rhode Island Bankruptcy Court. The procedure of mediating on a mortgage in Connecticut Bankruptcy Court could be done on an individual basis but the Court does not supervise this activity or strategy.

In Connecticut, for example, a bank or mortgage company seeking a foreclosure by law must participate in a meeting with the homeowner and a mediator if the property owner requests such a session. This requirement has been on the books since 2009 and has been extended by the legislature to July 1, 2014 and there have been considerable success  stories as a result of this mediation. Further, the Court is supporting and supervising this procedure and if the Court found that the bank was not acting in ‘good faith’ could under its equitable powers either deny the foreclosure or refuse to make a ruling. The result has been that the banks have to take the mediation process seriously which has helped many homeowners.

Ironically, when President Obama took office, a bill passed the U.S. House and went to the Senate where it was defeated by 4 Democrats, 2 from the South and 2 from the West. And this proposed ‘revolutionary legislation’ would have given the power to Bankruptcy Judges to alter or change the interest rate on mortgages and to re-amortize those mortgages to possibly 40 year mortgages. This legislation would have had a powerful effect of stopping foreclosures.

It is my position as a bankruptcy lawyer, that generally, today people are better off trying to use Court Supervised Mediation rather than Chapter 13 because they can achieve far better results! Since the Bankruptcy Code was not updated when it absolutely needed to be updated for today’s financial times, it is seriously becoming an ‘obsolete option’ for saving one’s home here in Connecticut. There’s not enough flexibility or power in the Court to approve a reorganization plan that is practical in light to today’s economy.

However, if the Obama Administration would have ‘change which I can believe in’ , it would push for new bankruptcy legislation which really would be an extension of what is happening in the market place and amend Chapter 13 to become like Chapter 12 and not limit Chapter 12 just to fisherman or farmers. And actually, all that would be needed would be to expand the definition of who could use Chapter 12 to include ordinary homeowners, and you would see a spectacular turn-around  and diminished rate of foreclosures.

I was and I still am severely disappointed in President Obama for not saying one word to defend this legislation. Of course, Goldman Sachs was his largest campaign contributor and they were completely against this legislation due to their market position. The President has not answered anything regarding his silence on what was to be the ‘crown centerpiece’ of his legislative initiative. He campaigned on a platform of ‘Change You Can Believe In’ and his utter failure to speak on this legislation which allowed it to be defeated, makes me not believe in his Secretary of Treasury, Timothy Geitner, a Goldman Sachs devotee and his liaison assistant to Congress, Bruce Patterson, a Vice President with Goldman Sachs and former major lobbyist for Goldman Sachs. I’m still waiting to believe in change.