Lien Stripping and Chapter 13 By Mark Saiki 8/10/2010

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1 Lien Stripping and Chapter 13 By Mark Saiki 8/10/2010 I. Strip Off Second and Third Mortgages. Homeowner has a first and second mortgage on a primary residence (Home). If the value of your house has fallen below the value of your first mortgage, and your second and third mortgages are wholly unsecured, then you may be able to strip off these mortgages from your house. This requires that a special motion be filed with the Bankruptcy Court and not a drop of (home) equity exists to secure these additional encumbrances. Lien Strip Example? In this example, debtor owes $1,200 per month on a first mortgage, with a $185,000 balance. She owes $400 per month on a second mortgage, with a $24,000 balance. At the time that she received her second mortgage, the house was appraised at $219,450 and the Home Equity Line of Credit (HELOC) loaned her up to $24,000, which represented 95% of the home s appraised value. Subsequently, home values in this neighborhood dropped 18%, due to the bursting of the housing bubble and recession. The primary residence is now worth $180,000, which is $5,000 less than the first mortgage, meaning that there is no equity that the second mortgage can attach to. This debtor can keep their house, by paying $1,200 per month to the first mortgagor, and by making all of their Chapter 13 plan payments for a three-to-five year period. If they prevail on their Motion to Strip off a wholly unsecured second mortgage, they do not have to make the second mortgage payment, during their Chapter 13 plan. After they complete all of their plan payments, the second mortgage will be removed, by operation of the Bankruptcy Code. The $24,000 second mortgage is totally unsecured, in this example, and it disappears after the discharge. This debtor could sell the property, after her bankruptcy has been completed, without having to pay the second mortgage. Some title companies understand this, others do not. Bankruptcy Law. The Bankruptcy Code distinguishes between secured and unsecured debts. If the Court finds that there is no equity, to which the secured collateral attaches, then they allow the debtor to value their lien at zero. After the Chapter 13 plan pays them zero dollars on their secured claim, the Court cancels their second mortgage as unsecured. In effect the Court removes the lien, whose collateral is valued at zero dollars. This debt is removed by operation of case law. Although this gray area of the law exists between the ambiguity left by two Supreme Court decisions, the majority and trend rule allows debtors to strip off, but not strip down, second mortgages. There is a risk that if your certified market analysis or appraisal comes in low, and theirs shows equity, the Court will split the difference concerning the value of your house. There is a risk that the Court will decide to follow the minority rule. If the Court allows you to strip off these additional mortgages, saving your house might be much more affordable, by eliminating these 1

2 second mortgage payments. Around 80% of mortgage strip offs go uncontested. This means that most second mortgage holders do not even respond or request a hearing, after the motion is filed. Line up your ducks and you may find that your motion goes unopposed. II. When is a Strip Off Available? Payoff balance on 1 st or other senior mortgages is more than current fair market value of the property All owners (individuals on title) of the property are filing You generally cannot strip off a mortgage as to non-filing owners. Clients have solid and feasible Chapter 13 case ** This is not something to try when client's budget is very tight and there is not a reasonable expectation he will be able to complete the plan.** Disadvantage. One of the disadvantages of Chapter 13 is that you get your discharge at the end. If you miss plan payments, you will get dismissed, and you will not get a discharge. This will mean that you are still liable on all of your debts. Only if you make all of your Chapter 13 plan payments for a three-to-five year period, will you get a discharge. If you seek to strip off a second mortgage, this also occurred after you make your last plan payment. Consequently, if you miss plan payments and are dismissed, your second mortgage will not be stripped off. If you want to sell your house, during the term of your plan, then the second mortgage will remain. III. Documents 1. Payoff Statements a payoff statement is the most accurate method for determining the balance due to the senior mortgage holders. 2. Mortgage Statements statements are not the best source of information about balances owed, but can be sufficient if value is not a close call. Statements for all loans can also be a helpful source of notice addresses. 3. Original Notes & Deeds of Trust for all outstanding loans on the property. Will have the legal description for the property and can aid in determining potential pitfalls with senior obligations. 4. Property Tax Statement if client can't produce the last bill, obtain a copy from the county assessor. 5. Title Search or County Property Ownership records need to ensure anyone on title is filing. 6. Credit Reports will show outstanding principal balance, but usually arrears, pre-payment penalties, legal fees and charges will not be included. 7. Past Due Home Owners Association Dues and_ Assessments at least a portion of these are superpriority and will increase the amount of senior liens against the property. IV. Valuation There are various methods for obtaining values of the property. Some are better than others. A CMA is recommended. Website Values Can be used as a starting point, but 2

3 never recommended as the only value when attempting to strip the 2nd. County Tax Value Another decent starting point, but keep in mind these are often old values. Not to be used as a sole value. Comparative Market Analysis - Have a local real estate professional puts together a CMA for the property. This will show recent sales, length of time on the market, etc. In most cases, this is sufficient evidence for a Motion to Determine Secured Status, Recommendation find a Realtor who has extensive experience in the area who you can obtain reliable CMAs from for a small fee. Linda Spray is an excellent resource and performs CMAs for my office. Appraisal An appraisal is the most reliable source of valuation information. However, they can also be costly. If CMA valuation is close, consider an appraisal. It may also be necessary if the lender challenges the Motion to Determine Secured Status. V. Strategy. a) Non-Payment of 1 st Mortgage If the value of the property is very close to balance due on the first, consider having debtor stop payment on mortgage temporarily to increase the balance due on 1 st mortgage. b) Pre-payment penalties Review the note and deed of trust to determine whether there are any pre-payment penalties on the first mortgage. These pre-payment penalties will be reflected on payoffs, but not on statements or credit reports. c) Past Due Property Taxes or Home Owners' Association Dues These obligations often have super-priority status, which is they step in front of consensual liens, including first and second mortgages. d) Tax Consequences. While the strip off of the mortgage is not a taxable event, it's critical to remember that when the 2nd is not being paid, the client will lose the ability to deduct the mortgage interest. If you strip off the second mortgage, you will lose the interest income tax deduction on your taxes. This may mean that you will owe more taxes in future years. Consult an accountant to determine possible tax liability. e) ARM Loans. If you have an Adjustable Rate Mortgage (ARM) loan, neither the Chapter 13 Bankruptcy nor the Motion to Strip Second Mortgage affects your ARM loans. Payment may increase or adjust during the plan or thereafter, and you will be liable for the higher payments. This may affect your ability to keep your home. VI. Housing Market. Because the speculative housing bubble burst, home values have been declining. This means that many second and third mortgages on residential houses may be stripped off under Chapter 13, because the value of the house has fallen below the balance of the first mortgage. As of the second quarter of 2009, over 16% of homeowners had negative equity exceeding 20% of their home s value, and over 22% of homeowners had negative equity exceeding 10% of their home s value. 1 Brent T. White, University of Arizona College of Law, Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, Arizona Legal Studies, Discussion Paper No , October 2009, 3. 1 First American CoreLogic, Negative Equity Report (Aug. 13, 2009). 3

4 In particular areas, home values have fallen substantially. Again, however, the situation is worse in the hardest hit markets. For example, 47% percent of homeowners in Nevada had negative equity exceeding 25% of their home s value, as did 30% of homeowners in Florida, 29% in Arizona, and 25% in California. Moreover, given the high median home prices at the peak within these markets, a large percentage of these homeowners are underwater by hundreds of thousands of dollars. 2 Brent T. White, University of Arizona College of Law, Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, Arizona Legal Studies, Discussion Paper No , October 2009, 3. Substantial losses in home values is confirmed on the national scene. Freddie Mac CEO Richard Syron concluded, "We had a bubble", and concurred with Yale economist Robert Shiller's warning that home prices appear overvalued and that the correction could last years, with trillions of dollars of home value being lost. Greenspan warned of "large double digit declines" in home values "larger than most people expect." 3 Wikipedia, United States Housing Bubble, Home values have fallen an average of six percent. National home sales and prices both fell dramatically in March 2007 the steepest plunge since the 1989 Savings and Loan crisis. According to NAR data, sales were down 13% to 482,000 from the peak of 554,000 in March 2006, and the national median price fell nearly 6% to $217,000 from a peak of $230,200 in July Wikipedia, United States Housing Bubble, First American CoreLogic, Negative Equity Report (Aug. 13, 2009). For example, a homeowner who bought a home in 2006 in Salinas, California, where home prices have dropped 70% from the peak, has on average $214,000 in negative equity. Luigi Guiso, Paola Sapienza & Luigi Zingales, Moral and Social Constraints to Strategic Default on Mortgages 2 (Nat l Bureau of Econ. Research, Working Paper No , July 2009) Moreover, given that average home prices reached over $580,000 in Salinas at the peak, homeowners who bought even slightly better-than-average homes could easily have negative equity exceeding $300,000. The story is the same, of course, in other California metro areas, including Los Angeles, Modesto, El Centro, Merced, Riverside, and Redding. The situation is also dire outside of California. A homeowner who bought an average home near the peak in Las Vegas for example where prices have dropped 52% - would likely have negative equity in excess of $120,000. The situation is the same in Miami where prices are down 48%, and in Phoenix, where prices have dropped 54%. Furthermore, with such significant price decreases in each of these markets, a large number of individuals who bought more-expensive-than-average homes have negative equity easily topping $200,000 to $300,000. Standard & Poor s/case-schiller, Home Price Values for July 2009 (Sep. 29, 2009)(on file with author) 2 3 "Subprime shockwaves". Bloomberg "Greenspan alert on US house prices". Financial Times Nancy Trejos ( ). "Existing-Home Sales Fall Steeply". The Washington Post. Retrieved

5 Foreclosures in your area can depress home sales. John A. Kilpatrick, of Greenfield Advisors, was cited by Bloomberg News on June 14, 2007, on the linkage between increased foreclosures and localized housing price declines: "Living in an area with multiple foreclosures can result in a 10 per cent to 20 per cent decrease in property values." He went on to say, "In some cases that can wipe out the equity of homeowners or leave them owing more on their mortgage than the house is worth. The innocent houses that just happen to be sitting next to those properties are going to take a hit." 5 Wikipedia, United States Housing Bubble, When the housing market was good, second mortgages were secured and protected by the value of the property. Given the economic downturn, the bursting of the housing bubble, and the sheer number of foreclosed houses on the market, many second mortgages are now unsecured. They run the risk of being stripped off under Chapter 13. As a practical matter, most second mortgages will not bid at foreclosure sales, as they would have to pay cash to the first mortgagor, and then try to resell the property just to cut their losses. As a result, one Attorney on Debtors List Serve reported that, some second mortgage companies are offering to settle their claims. GMAC Mortgage dba Ditech has written clients offering to settle 2d, now about $39,000, for > $3,200. A majority of states allow second mortgages to be stripped off under Chapter 13. A substantial number of second mortgages are being stripped off in those jurisdictions. In Colorado, as in other states, most of these lien strips go unopposed. In many cases, it is not worth the time, effort and expenses for these second mortgagors to buy at foreclosure sales or to oppose these motions to strip off liens. VII. Mortgage Broker. Jim Spray, JimSpray@AOL.COM Indeed I am still advising folks on mortgages (have been for 30+ years), including loan modifications - I still offer a no-cost 20/30 minute phone consultation. And we will work with a payment plan where necessary or I will advise and then refer them to one of the HUD certified housing counselors. Heck, every now and again I even get to fund a mortgage or two. And yes, the banks are still dictating what will and what will not be. They have the key to the Treasury. So, why not? Jim James Spray, CCMB, Mortgage Banker & Mortgage Broker Mortgage Loss Mitigation Specialist Licensed - Bonded - Insured (303) Direct "The Consumer Oriented Mortgage Broker "(TM) 5 Howley, Kathleen ( ). "U.S. Mortgages Enter Foreclosure at Record Pace". Bloomberg News. 5

6 VIII. Comparative Market Analysis. Linda Spray (303) Mark, To make sure there is not a whit of equity, contact Linda Spray (my wife) for a Comparable Market Analysis on each property you wish to strip a junior lien(s). She takes a holistic view as to valuing real estate as opposed to your rose colored glasses, sales oriented Realtors. LGSpray@aol.com (303) Direct James Spray, CCMB, Mortgage Banker & Mortgage Broker Mortgage Loss Mitigation Specialist Licensed - Bonded - Insured (303) Direct "The Consumer Oriented Mortgage Broker "(TM) Tell her that you are trying to strip off a second mortgage. Tell her the balance on the first mortgage, and ask to see if the CMA can be below the balance on the first mortgage. 6