• The Congress, The Code, And The Cramdown
  • June 23, 2009 | Author: Jeffrey A. Kreibich
  • Law Firm: Potestivo & Associates, P.C. - Rochester Hills Office
  • The so-called cramdown is a tool often employed by bankrupt debtors and their counsel. It finds its origin in Section (§) 506(a)(1) of the bankruptcy code, which - put simply - permits bifurcation of an allowed claim into secured and unsecured components. The claim is secured only to the extent of the collateral’s value.

    The impact of this provision is brought into sharp focus when a depreciating asset serves as collateral. For example, a $30,000 auto loan secured by a vehicle valued at $14,500 would give rise to a secured claim in the amount of $14,500 and an unsecured claim in the amount of $15,500. The lender’s secured claim is said to be crammed down to the value of the vehicle - $14,500.

    Residential mortgage lenders have long operated under the safe harbor of 11 U.S.C. §1322(b), commonly known as the anti-modification clause. This provision generally bars a Chapter 13 debtor from modifying the rights of a creditor holding a “claim secured only by a security interest in real property that is the debtor’s principal residence.”

    The U.S. Supreme Court in Nobelman v. American Savings Bank made it clear that the cramdown of an undersecured residential mortgage lien is impermissible in a Chapter 13 proceeding.

    The court’s analysis in Nobelman regarding the interplay between the anti-modification clause of §1322(b) and the valuation and bifurcation of claims under §506(a)(1) gives rise to the following proposition of law: If a junior residential mortgagee holds merely a wholly unsecured claim as determined under §506(a) (i.e., the value of all senior liens combined exceeds the value of the home), then the lender is, in no respect, a holder of a “claim secured only by a security interest in real property that is the debtor’s principal residence.” In that event, the anti-modification clause is inapplicable, and the junior residential mortgage holder’s secured claim is, in essence, crammed down to $0 – or “stripped off” in the vernacular.

    This is the rule espoused by the vast majority of bankruptcy courts around the country.

    The death of the junior mortgage?
    The protection accorded a junior mortgagee by the anti-modification clause is virtually ironclad in a rising - or even stable - residential real estate market, as a junior mortgagee with even $1 in equity can preserve the entirety of its secured claim by resorting to the anti-modification clause of 11 U.S.C. §1322(b).

    But let’s hypothesize a precipitously declining residential real estate market.  Consider, for example, today’s market in most regions of the country.  Let’s also assume a massive volume of junior mortgages, precipitated by free-flowing credit, borrowers’ endless propensity to extract equity from their homes and creative piggyback financing, among other factors.

    This is the reality lenders and servicers face today. Vast numbers of Chapter 13 debtors - whose home values are almost inevitably deeply underwater - stand before the bankruptcy courts, facing multiple claims secured by their residences.

    In this environment, there is often no refuge - or legal defense - for the junior lienholder who holds a wholly unsecured claim. Conversely, if any part of the junior mortgagee’s claim is secured, then under the Supreme Court’s interpretation of “claim,” the entire claim - both secured and unsecured portions - is non-modifiable.

    There are a few glimmers of hope for servicers and lenders confronted with Chapter 13 plans proposing to cramdown or strip off their junior liens.

    The mortgagee may find it economically rational to contest the valuation of the property. This would entail an evidentiary hearing or adversary proceeding before the bankruptcy court, the production of evidence (likely including the testimony of an appraiser) and the corollary costs of litigation. The necessary calculus implicates a business - not legal - decision.

    Likewise, a mortgagee may seek to invalidate the lien(s) in priority. For example, the junior lienholder might seek to establish that the senior lien is facially defective, or that the lien was not properly recorded so as to assume priority. Again, the likelihood of success hinges almost entirely on the specific facts presented.
    Finally, a mortgagee or servicer may merely closely monitor the progression of the debtor’s Chapter 13 proceeding. The unsecured junior lien is not stripped off upon plan confirmation, but only upon completion of the plan and discharge. Therefore, any failure to maintain plan payments or to adequately protect the secured property may give rise to a well-pled motion for relief or a trustee’s motion to dismiss.

    At ground level, debtors and their counsel are only now awakening to the ability to cram down a junior lien.  As home values continue their decline nationally, and as legislative changes to Chapter 13 of the bankruptcy code seem increasingly inevitable, the frequency of proposed cramdowns of junior residential mortgage liens seems almost certain to accelerate rapidly.

    The diminution of the first mortgage
    In the overtly political rush to stem the tide of foreclosures in the face of plummeting home values across most regions of the nation, Congress has introduced a dizzying array of proposed legislation. Ignoring certain unavoidable truisms, such as, “Only a debtor with regular income... may be a debtor under Chapter 13” of the bankruptcy code, the House of Representatives has introduced the ironically named Helping Families Save Their Homes in Bankruptcy Act of 2009 (H.R.200).

    The Senate has introduced a similar piece of legislation, S.61. The Senate bill awaits further committee action. However, the House bill was referred to committee in early January.  Committee hearings were held Jan. 22, and the committee consideration and markup session was held Jan. 27, when the bill was ordered to be reported - as amended - to the full House of Representatives. Translating the rather self-important parliamentary language, the amended bill is to be introduced into the House for consideration and debate.

    Anecdotal evidence suggests that House passage of the bill is highly likely, while a tougher road may be encountered in the Senate. Regardless, it seems probable that these, or similar amendments to the bankruptcy code, will be enacted in the near future.

    At committee hearings, support for and opposition of the bill followed predictable political and doctrinal lines.  Supporters decried the failure of existing government programs to meaningfully stem foreclosures, emphasized the severity and importance of the problem and noted the arguable incongruity of the availability of a cramdown with respect to any claim other than one secured by the debtor’s principal residence.

    Opponents focused on the moral hazard issue, the anticipated strain imposed upon the bankruptcy courts as a result of massive spikes in the volume of Chapter 13 filings, and the expected negative impact on the mortgage credit markets.

    Dean Christopher Mayer of the Columbia Business School presented novel testimony of particular interest to mortgage servicers. At the outset, Mayer said mortgage servicers should be the focus of bankruptcy reform, as foreclosure rates are significantly higher for securitized mortgages than for portfolio mortgages held by the lender.

    In that light, Mayer proposed that servicers be compensated periodically (for example, monthly) while a serviced loan is performing. This measure, he argued, would efficiently realign servicers’ economic incentives with those of the debtor. Mayer viewed as flawed the present mechanism in which foreclosure may often be more profitable for a servicer than the pursuit of a viable loan modification.

    He also pressed for the adoption of a safe-harbor provision for loan servicers to protect them from litigation arising from good-faith loan modification efforts. This proposal is adopted from existing federal legislation designed to spur loan modification and stem foreclosures.

    While Mayer’s proposals may be better addressed by private contract than bankruptcy legislation, they remain intriguing. In sum, it does not appear the proffered testimony at the committee hearing had any substantive impact on the bill reported to the House.

    In significant part, H.R.200 (as currently amended) proposes to render modifiable any loan originated prior to the effective date of the proposed law and “secured by a security interest in the debtor’s principal residence that is the subject of a notice that a foreclosure may be commenced.”

    The proposed amendments to §1322(b) of the code would authorize a bankruptcy judge to confirm a Chapter 13 plan that provides for the cramdown of undersecured first mortgages under 506(a)(1); prohibits, reduces or delays interest-rate adjustments under the note; extends the repayment term under the note; or fixes the annual rate of interest on the loan pursuant to a prescribed formula.

    In several key concessions to the mortgage banking industry, the bill would enact a new §1322(h) mandating that a debtor certify he attempted to contact his mortgage lender or servicer no less than 15 days prior to filing a petition, plan or modified plan under Chapter 13 in order to explore loan modification options, unless a foreclosure sale is scheduled to occur within 30 days of the debtor’s filing date.

    Moreover, a new §1322(g) would provide a “clawback” provision of amounts crammed down on the undersecured first mortgage. The Explanation of the

    Manager’s Amendment to H.R.200 describes the provision as follows: Section 1322(g) provides that if a mortgage is modified under new section 1322(b)(11)(A) and the debtor sells the home securing such mortgage prior to receiving a discharge under Chapter 13, the debtor is obligated to pay from the net proceeds of such sale a portion of such proceeds to the mortgagee, under certain circumstances.

    If the residence is sold in the first year following the effective date of the Chapter 13 plan, the mortgagee is to receive 80% of the amount of the difference between the sales price and the amount of the mortgagee’s claim (plus costs of sale and improvements), but not to exceed the amount of the allowed secured claim determined as if such claim had not been reduced under new section 1322(b)(11)(A).

    The clawback provision mandates diminishing recoupment to the mortgagee over five years. This is, interestingly, a term that may exceed the length of a confirmed Chapter 13 plan. The bill, in amending §1325, provides that a first mortgagee would retain its lien until its modified secured claim is fully paid or the debtor obtains a discharge, and requires a specific finding of the court that any cramdown by the debtor of an undersecured mortgage in accordance with §1322(b)(11) was undertaken in good faith.

    Finally, the bill amends §1328 of the bankruptcy code to make clear that the unpaid portion of an allowed secured claim modified under §1322(b) (11) is not subject to discharge.

    The outlook for servicers
    Mortgage servicers are squeezed both politically and economically. Borrowers deeply underwater demand economic relief bolstered by a highly favorable political climate, while investors demand maximum return on their investment, bolstered by the real threat of litigation.

    The goals of these respective parties are largely antithetical: If a servicer fails to proffer a loan modification to “save” a home, the servicer is vilified by the public, press and self-serving politicians. If the servicer does enter into a loan modification, the servicer opens itself up to litigation and potential liability at the hands of its investors.

    Ironically, bankruptcy court-ordered cramdowns of first residential mortgages may well prove highly beneficial to servicers, alleviating these competing pressures. Debtors’ expectations are constrained by the bankruptcy code and the authority conferred upon bankruptcy judges; unappeased ones leave angry with the court, not the servicer.

    Moreover, if lenders fail to accede to reasonable voluntary loan modifications, they will be made by order of the bankruptcy courts, providing servicers with the perfect defense to claims lodged by disgruntled investors. 

    Of course, on the flip side, the bill would impose significant transaction costs on all parties, creating further inefficiencies in the already crippled mortgage credit markets and straining the capacity of the bankruptcy courts and servicers’ loss mitigation and bankruptcy departments. Regardless of the fate of these pending bills, the time to ramp up these capabilities is now.