My last article laid out the framework for the bankruptcy real estate cocktail. This article will attempt to predict how that cocktail will be served and its ramifications. Remember, this recipe for disaster requires two things: a “Non-Perfected” Mortgage and a Bankruptcy.
So far, about 70 to 80% of the mortgages I see in local Bankruptcy cases here in the Southern District of California Bankruptcy Court appear to be non-perfected. Despite my continued requests to the mortgage companies to produce either proof they possess the underlying note or proof of a recorded assignment, I have received neither. Instead I get the run around, “Yes we have the original note. Really, can I see? Actually no, I thought we had the original, but we have a copy…………Yes we have the assignment. Really, can I see? Sure, here you go. But that was not recorded. Oh…….” Its the same song and dance. So what becomes of this?
Chapter 7: The trustee will most likely put on his “544 hat” and now “strip the lien off the house.”
When he does this, he creates an unencumbered piece of real estate in most cases, with the exception of a small amount of past taxes and HOA fees remaining as liens on the property. The property is then sold and net profits held in trust. A notice is then sent to the creditors of the bankruptcy to submit a claim if they want to get paid.
The claims are then reviewed, and paid pro-rata or objected to with the Bankruptcy Court issuing the final ruling. The Claims process is a complex area too lengthy to discuss for this Blog, but suffice to say, many claims will be objected to as well, since most credit card debt and collection agents have similar problems in proving they too own their debts. Moreover, you might ask what happens to the mortgage lien which has now become a large unsecured debt? It might be paid, provided they can prove they own the note. However, it also may not. There is a Bankruptcy Code section, 11 USC 502(d) which states that a creditor may not be able to share in the distribution if they did not give up there lien when requested by the trustee under 544. So, it could be that any remaining monies may even go back to the debtor if the new unsecured mortgage claim is disallowed! But this remains a grey area, and time will tell.
But what if the debtor wants to keep the house? No problem. Time to make a deal with the trustee. Suppose that the House was bought for $650,000 in 2006 with 100% financing and now is worth $500,000. The debtor is negative $150,000 in equity. Upside Down! Now lets say a bankruptcy is filed. The Mortgage Note was not perfected so Bankruptcy Trustee avoids the lien. Now he has this $500,000 piece of real estate that he wants to sell, but the debtor wants to keep it. So the debtor makes an offer of $430,000 to keep the house and the Trustee agrees. Trustee agrees since he would only net $430,000 anyways after costs of sale, attorney fees, marketing, etc. Debtor gets the $430,000 from a new loan he might qualify for, have cosigned, or have a family member engage their credit. Trustee then takes the $430,000 and distributes to creditors, which include the debtor’
s non-dischargeable taxes, non-dischargeable child support obligations, and non-dischargeable student loans.
Wow! Lets get this straight: Mortgage reduced from $650,000 to $430,000, and over $100,000 in non-dischargeable bankruptcy debt consisting of student loans, taxes, and support obligations also paid, and all other debt wiped out? Sounds like the lemon just turned into lemonade! Also, time to also read the blog on why the credit score is much better after bankruptcy than before now.
Chapter 13: In Chapter 13, the Trustee does not liquidate assets. Instead, he administers a three to five year plan by distributing the monthly payments from the debtor to the creditors, and the avoidance powers of the Chapter 7 Trustee are given to the Debtor(at least here in the Ninth Circuit….western states in the US). This includes the power to remove unperfected liens such as unperfected mortgages.
So now the debtor can remove the mortgage just like a Chapter 7 Trustee.
But that might be a problem. The Chapter 13 Trustee may object now to the bankruptcy since the debtor has too many assets. Well, as discussed above, time to get another smaller mortgage, pay that money into the Chapter 13 plan, and again pay off the non-dischargeable debt. Even better, if not all the creditors filed claims, the money then reverts to the debtor!
In the alternative, the simple threat of litigating the issues to remove the mortgage sure makes for a great negotiating tool to deal with the lender and rewrite the mortgage…..knocking off possibly hundreds of thousands of dollars and also lowering the interest rate substantially.
Involuntary Bankruptcies? Is there such a thing? Unfortunately, YES. And this could be very problematic. If several creditors are owed substantial sums of money, say a SBA Loan, large Medical Bill, or even large credit cards, they could petition the court for an involuntary bankruptcy. The debtor has no control to stop it. Next thing the debtor knows, he is in a bankruptcy and all the property is being liquidated, less the property allowed by exemption law. Then steps up the Chapter 7 Trustee and discovers that the Mortgage is not perfected. Well, there goes the house now! Or does it?
Once again, a smart debtor would argue to the trustee that he will get a loan to pay the trustee as discussed above. Problem solved, and what appears to be disaster at first, may be a blessing in disguise. The debtor keeps his home with a much smaller mortgage and removes non-dischargeable debts. He is better off now than before, even though he did not want this!
So the Recipe for Disaster appears to only affect the Mortgage Companies. They are the losing parties here, and rightly so for getting sloppy…..attempting to save $14 per loan times thousands of loans. Why didn’t they compute losing hundreds of thousands of dollars per loan times thousands of loans? Couldn’
t they connect the dots? No…..like I said, lots of smart Real Estate Attorneys and lots of smart Bankruptcy Attorneys, but not too many Bankruptcy Real Estate Attorneys and none of them worked for the Mortgage industry.
But everyone else now seems to win. The debtor reduces his mortgage, gets a better interest rate, and eliminates the rest of his debts. The trustee makes a healthy profit on distributing such a large dividend to creditors. And the creditors who obey the law now share in a large dividend.
Of course, all the forgoing is Brand New. It has not been done yet in any cases I am aware of. But since talking with other Bankruptcy Attorneys across the Nation for the past couple weeks, its starting to catch on. I’
m told a few trustees back east have started this procedure now. And just today, I get an announcement from our local Chapter 7 Trustee that he is making new requirements concerning producing documents in all cases before him so that he can start avoiding these liens. Coincidentally, this also comes after three of our Local Bankruptcy Judges started denying relief to Mortgage Creditors when coming before the Bankruptcy Court during the past week! Its brand new…but catching on like wildfire.
Housing Bubble? Mortgage Bubble? Well now it’
s a Housing Mortgage Bubble disaster about to happen in Bankruptcy Court. Congress was not able to reform the predatory lending abuses. The Lenders certainly do not seem interested in workout programs. I guess its time for a Bankruptcy Cocktail!
Written by Attorney Michael G. Doan