It’s that second mortgage that’s causing all the problems. Values have taken a nosedive in the last 5 years and many of those junior liens are now completely underwater. Say the home is worth $250,000, the first mortgage is $300,000 and the second mortgage, maybe a home equity line of credit (HELOC) is $75,000. The first mortgage is undersecured in the amount of $50,000; the HELOC is totally unsecured.
In Chapter 13 the debtor could strip off that HELOC as described in this video. But in Chapter 7 most courts say no. Why? Because the US Supreme Court says so. For more details, see this article. The Supreme Court case that has caused this hardship (Dewsnup v. Timm for the legally minded) stems from 1992, more than 15 years before the current real estate and foreclosure crisis that has caused the loss of trillions of dollars of value in the residential home market.
This result makes no sense. Why should other unsecured creditors get a windfall by receiving coerced payments in Chapter 13 just because the debtors have a junior mortgage that is completely unsecured? The bankruptcy code is clear: “to the extent that a lien secures a claim against the debtor that is not an allowed secured claim (i.e., completely underwater) such lien is void.”
This result is especially wrong in light of the recent Atty. Gen. nationwide mortgage settlement which followed years of abusive foreclosure practices by the major mortgage servicers. Part of the settlement, which will be implemented in the months and years to come, is that mortgage companies need to adjust to the collapsed real estate market by writing down the principal on their loans when the property value does not support the mortgage.
The bankruptcy world should adapt to these realities and recognize that completely unsecured junior mortgages need to be stripped off in chapter 7 so that homeowners will be able to realize the appreciation in their properties and not simply pay rent or its equivalent to mortgage holders until the time comes that they are ready to abandon the home. Congress needs to amend the bankruptcy code to make clear that “void” means “void” and give homeowners real relief in chapter 7.