Second Mortgage In Chapter 7 and Chapter 13 Bankruptcy

It is common for someone who is about to file Chapter 7 Bankruptcy to have a pending or upcoming foreclosure action.  It is also common for the debtors to have a house that is “under water”, i.e., to owe more on their first mortgage than their house is worth.  It is also common for the debtors to have a second mortgage such as a standard mortgage, line of credit or a home equity line of credit. If the first mortgage exceeds the value of the home, it is clear that the second mortgage has no equity in the house to support it, and is fully unsecured.

Once the debtors or their bankruptcy attorney realize the above, the debtors have a choice to make. They can file a Chapter 7 Bankruptcy, assuming that they can pass the means test. If the debtors are eligible for Chapter 7 Bankruptcy, their personal liability under both mortgages can be eliminated. Then, the debtors can decide to pay the first mortgage only. They may also decide to take a calculated risk that the second mortgage holder would try to foreclose on its mortgage.  But would the lender actually commence a foreclosure?  Initially, unless the second mortgage holder acquires the first mortgage, it would end up with a house subject to a first mortgage that exceeds what the house is worth.  That would likely make any such attempted foreclosure a money losing proposition.  Also, if the first mortgage holder forecloses, that foreclosure would eliminate the second mortgage.

Another option that the debtors have is to file Chapter 13 Bankruptcy. While Chapter 13 will carry with it a repayment plan that may last as long as 5 years, it also allows for “lien stripping”, otherwise known as “Pond” motion.  In Chapter 13 Bankruptcy, the totally unsecured mortgage is wiped away and no longer a lien on the debtors’ home.  Then, the second mortgage is treated as unsecured debt that gets repaid in the bankruptcy in accordance with the terms of their repayment plan. According to bankruptcy courts’ decisions, the debtors have to receive a Chapter 13 discharge before the lien is stripped.

Most of the decisions addressing Chapter 7 Bankruptcies hold that the debtors cannot “strip” their fully second unsecured mortgage in a Chapter 7 Bankruptcy case.

One important reason for many debtors to stay in their house after Chapter 7 is that it may cost them less to pay the mortgage than to rent another place to live.  The second mortgage becomes a lot less important since the debtors may be able to strip it right away in Chapter 13, and, if economic conditions don’t improve, the debtors might be able to strip it 4 years from the date they filed their chapter 7 case – when they are eligible for a discharge under Chapter 13.

Another option that may be available to some debtors is to have their mortgage recast under the new Home Mortgage Modification Program.  In my experience, here in Rochester, lenders are willing to work with debtors to recast their mortgages.  Assuming that the debtors have ability to pay their mortgage, and meet other financial requirements, their mortgage may be modified by their lender.

If you are contemplating filing Chapter 7 Bankruptcy or Chapter 13 Bankruptcy, or are dealing with debt problems in Western New York, including Rochester, New York, Canandaigua, Brighton, Pittsford, Penfield, Perinton, Fairport, Webster, Victor, Farmington, Greece, Gates, Hilton, Parma, Brockport, Spencerport, LeRoy, Chili, Churchville, Monroe County, Ontario County, Wayne County, Orleans County, Livingston County, and being harassed by bill collectors, and would like to know more about how bankruptcy may be able to help you, contact me today by phone or email to schedule a FREE initial consultation with a Rochester, NY, bankruptcy lawyer.

Chapter 7 Bankruptcy and Stripping of Unsecured Second Mortgage

One question that I am often asked is whether the unsecured second or third mortgage on the property owned by the debtor can be stripped in Chapter 7 Bankruptcy.  In Chapter 13 Bankruptcy, the unsecured second mortgage can be stripped by bringing a Ponds motion.

Unfortunately, in Chapter 7 Bankruptcy, the unsecured second or third mortgage cannot be stripped.  In a recent decision which also applies to the bankruptcy cases in Rochester, New York,  In re Grano, the Buffalo Bankruptcy Judge Bucki held that in Chapter 7 Bankruptcy cases, the debtors cannot avoid wholly unsecured second or third mortgages.

Joseph and Ann Grano owned a residence in the Town of Amherst, New York.  After filing a Chapter 7 Bankruptcy petition, they commenced the adversary proceeding against Wells Fargo Bank, N.A., to avoid a second mortgage.  In their complaint, they alleged that their real estate has a current fair market value of $445,000 and that it is encumbered by two mortgages: a first lien with an outstanding principal balance of $511,000, and the second mortgage of Wells Fargo with a balance of $95,837.60.

Granos asserted that they can avoid the second mortgage pursuant to the authority of 11 U.S.C. § 506(a) and (d).  In lieu of an answer, Wells Fargo moved to dismiss the complaint for failure to state a cause of action.  In relevant part, section 506(a)(1) of the Bankruptcy Code states that “[a]n allowed claim of a creditor secured by a lien on property in which the estate has an interest . . . is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property . . . and is an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” Asserting that the first mortgage secures a debt greater than the value of the property, the debtors argue that in its status as a second mortgagee, Wells Fargo retains only an unsecured claim.  Subject to exceptions not here present, 11 U.S.C. § 506(d) states that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” In reliance upon this later subdivision, the debtors commenced their  adversary proceeding to avoid the second mortgage of Wells Fargo.

In Dewsnup, the Supreme Court accepted the position of the secured creditor, that “the words ‘allowed secured claim’ in §506(d) need not be read as an indivisible term of art defined by reference to § 506(a).”  Instead, the language of section 506(d) “should be read term-by-term to refer to any claim that is, first, allowed, and, second, secured.  Because there is no question that the claim at issue here has been ‘allowed’ pursuant to §502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of §506(d), which voids only liens  corresponding to claims that have not been allowed and secured.” 502 U.S.at 415.  Effectively, therefore, the Supreme Court refused to recognize section 506(d) as a grant of authority to a debtor in Chapter 7 to “strip-down” or cancel the lien of an undersecured mortgage.

In contrast to Chapter 7, debtors in Chapter 13 may assert rights under special statutory provisions for the treatment of secured claims.  Specifically, 11 U.S.C. § 1322(b)(2) provides that a Chapter 13 plan may “modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims.” InNobelman v. American Savings Bank, 508 U.S. 324 (1993), the Supreme Court held that the language of section 1322(b)(2) precluded the bifurcation of an undersecured homestead mortgage into secured and unsecured claims. Consequently, to the extent that a homestead has value to collateralize any portion of a mortgage, a chapter 13 plan must treat that lien as fully secured.  However, in In re Pond, 252 F.3d 122 (2001), the Second Circuit distinguished those circumstances where the homestead lacks equity to collateralize any portion of an inferior lien. In this special circumstance, because the lien is wholly unsecured, the debtors “are not ‘holders of . . . a claim secured only by a security interest in . . . the debtor’s principal residence,’ 11 U.S.C. § 1322(b)(2), and their rights in the lien are not protected under the antimodification exception of Section 1322(b)(2).” 252 F.3d at 127.

In the present instance, Mr. and Mrs. Grano contended that this court should adopt for Chapter 7 the same exception that the Second Circuit has recognized for cases in Chapter 13, to the effect of permitting the avoidance of secondary liens that are totally undercollateralized. Unfortunately, this argument overlooks the unique statutory predicate of Chapter 13.  In allowing a debtor in Chapter 13 to avoid a fully unsecured homestead mortgage, the decision in In re Pond utilized the authority of 11 U.S.C. § 1322(b)(2). No parallel provision applies in Chapter 7.  The court concluded that notwithstanding the absence of equity beyond superior liens, the debtors may not avoid the second mortgage of Wells Fargo Bank, N.A.

This decision forces the debtors and their bankruptcy lawyer to engage in a cost benefit analysis in a situation where there is a wholly unsecured second or mortgage.  Assuming the debtors can file either Chapter 7 or Chapter 13 Bankruptcy, the benefit of filing Chapter 7 Bankruptcy and discharging all unsecured debt, should be compared to the benefit of a Chapter 13 Bankruptcy plan payments over 5 years, and a likely discharge of the unsecured second or third mortgage.  Assuming the debtors wish to retain their residence, the comparison of two figures should point them in the right direction.

If you contemplating filing Chapter 7 Bankruptcy or Chapter 13 Bankruptcy, or are dealing with debt problems in Western New York, including Rochester, Canandaigua, Brighton, Pittsford, Penfield, Perinton, Fairport, Webster, Victor, Farmington, Greece, Gates, Hilton, Parma, Brockport, Spencerport, LeRoy, Chili, Churchville, Monroe County, Ontario County, Wayne County, Orleans County, Livingston County, and being harassed by bill collectors, and would like to know more about how bankruptcy may be able to help you, contact me today by phone or email to schedule a FREE initial consultation with a Rochester, NY, bankruptcy lawyer.