Modifying your Mortgages in Bankruptcy

It must be noted at the outset that the following is applicable to Chapter 13 proceedings only. You cannot modify or strip a lien from real property in a Chapter 7 proceeding.

The United States Court of Appeals for the Third Circuit, (and which is being followed by the 9th Circuit Bankruptcy Court), has held that a second mortgage on a chapter 13 debtor's primary residence may be modified or found to be a unsecured debt subject to discharge if the junior mortgage is wholly unsecured by any remaining value in the debtor's residence. As a general rule, a chapter 13 debtor may modify the rights of most holders of secured claims. For example, a creditor who holds a secured interest in a chapter 13 debtor's automobile or a mortgage on a chapter 13 debtor's property, real or personal, may have that claim bifurcated, separated into a secured and unsecured claim. If the court grants such a motion, each portion of the creditor's claim is entitled to different treatment under the debtor's chapter 13 plan as it will create a secured claim up to the value of the asset and a unsecured claim for that portion of the claim which exceeds the value of the asset.

However, where a creditor holds a claim secured only by a security interest in real property that is the debtor's primary residence, this is protected from modification. Section 1322(b)(2) of the Bankruptcy Code, provides that where a creditor holds such an interest, its claim cannot be modified or reduced by the debtor's chapter 13 plan so long as there is some value in the debtor's principal residence.

This provision is known as the "antimodification clause" of section 1322(b)(2). The Courts have questioned the extent to which a mortgage must be secured before they can apply the anti-modification clause. So long as there is at least some equity value in the debtor's primary residence, the entire value of the mortgagee's claim passes through chapter 13 unscathed. However a series of additional questions arise about the second and third mortgages.

In the case of McDonald v. Master Financial, Inc., the Third Circuit found that a second mortgage that was wholly unsecured was not protected by chapter 13's antimodification provision. In this case, the debtors, the McDonalds, claimed that the value of their home was only $126,400. Under the evidence code a debtor is the person who is best able to determine the value of their own property, and must state so in a declaration which is attached to the motion. In this case, the balance on the first mortgage was $127,633.33. The balance on the second mortgage, was $46,846.42. The debtors held the position that the second mortgage was wholly unsecured because if their home was sold, the first mortgage holder would have a shortfall of $1,233.33. This would leave zero funds for the second mortgage holder.

The bankruptcy initially held that under chapter 13, the debtor could not modify the rights of an unsecured second mortgagee. Strictly construing the statute, the court held that the second mortgage was still "a claim secured by a security interest in real property that is the debtor's primary residence" even if there was not enough equity in the debtor's home to satisfy any of Master Financial's claim. The trial court would not allow the debtor to modify the second mortgage. The debtors rightfully appealed this ruling and the ruling was reversed.

In reversing the lower court's ruling, the Third Circuit relied upon the United States Supreme Court's decision in Nobelman v. American Savings Bank. In the Nobelman case, the Supreme Court held that a chapter 13 debtor who had a single mortgage with an outstanding balance greater than the value of the debtor's home could not treat the mortgage as secured only to the extent of the value of the debtor's home and modify the remaining amount. Justice Thomas, writing for the majority in Nobelman, stated that the full amount of the mortgage survived and could not be modified under the debtor's chapter 13 plan, even though the house was worth less than the amount of the outstanding mortgage. However, the court also wrote that it is "correct to look to Section 506(a) for a judicial valuation of the collateral to determine the status of the bank's secured claim."

Pursuant to Section 506(a) of the Bankruptcy Code, a claim of a creditor which holds a security interest on a asset is bifurcated into two parts: secured claims and unsecured claims. Section 506(a), provides that a claim is a "secured" claim only to the extent of the value of the collateral. The portion of the claim that exceeds the value of the collateral is deemed an "unsecured claim." In the Nobelman case, the Supreme Court held that if the debtor's home at least partially secures the mortgagee's claim, then the bank is considered "secured" for purposes of section 1322(b)(2). The bank in Nobelman was secured because the debtor's home, although worth less than the full amount of the outstanding mortgage, still had some value, (there was equity in the home). Thus, under section 1322(b)(2), none of the bank's rights could be modified under the debtor's chapter 13 plan.

However, the Nobelman case did not address what happens where there is a second or junior mortgage which is wholly unsecured. The court in McDonald observed that the Ninth Circuit is the only other appellate court that has applied the reasoning in Nobelman to a situation involving a wholly unsecured mortgage. The McDonald court also looked to In re Lam. In this case the Ninth Circuit held that a wholly unsecured mortgage holder does not have the protections of the antimodification clause under section 1322(b)(2). In the Lam case, the debtor also applied section 506(a) to determine the status of the bank's claim. The court in finding that there was no value in the home to cover the mortgage claim, the court held that the creditor bank was not the holder of a secured claim for purposes of section 1322(b)(2). The Third Circuit in McDonald concluded that where a court determines under a section 506(a) analysis that there is no existing value to which a bank's lien can attach, the bank is wholly unsecured and does not have a secured claim for purposes of the anti-modification clause.

What this means to us is that the term "claim" applies to both the secured and unsecured parts of a mortgage. If the debtor is able to show that a mortgage against their property is completely unsecured, the lender who is wholly unsecured does not enjoy the protection of the anti-modification clause. However, if ANY portion of the mortgage on a junior lien is secured, then the entire claim will be considered "secured" and is not be subject to modification under section 1322(b)(2).

Conclusion

The net result of the foregoing is that 1) the debt to be modified must be against the debtor's primary residence; 2) there must be a threshold showing by the debtor under section 506(a) of the Bankruptcy Code there is any existing value to cover the bank's secured claim. If there is any equity in the property of the debtor, or any portion of the debt is secured by any value in the residence, then the debt cannot be modified. But, if there is no value in the home, then the lien of the creditor is not a secured claim for purposes of section 1322(b)(2), and it can be treated by the court as a unsecured claim subject to the Chapter 13 plan. This in effect strips the junior liens from the property leaving only those liens which are secured by any portion of the value of the property.

Example:

  1. Debtor's residence is valued at $229,000.00. There is a first mortgage of $279,000.00 and a second mortgage of $76,000.00. The residence is the primary residence of the debtor. The court would order that the first mortgage cannot modified and is to be treated as a secured debt. However, as there would be a shortfall of $50,000.00 if the property were sold, there would be zero funds available for the second mortgage. Therefore the court upon motion by the debtor would hold that the second mortgage of $76,000.00 is a unsecured claim and would be subject to the Chapter 13 repayment plan of the debtor.
  2. Debtor's residence is valued at $450,000.00. There is a first mortgage of $400,000.00 and a second mortgage of $100,000.00. The residence is the primary residence of the debtor. The court would find that both the first and the second mortgages are not subject to modification. The first mortgage is fully secured. If the home were sold, there would be $50,000.00 available to pay to the second mortgage holder. Therefore as there is some equity available to the second mortgage holder, the second mortgage is not subject to modification.

It remains to be seen whether other circuits will adopt the McDonald court's reasoning, or whether another split in the circuit courts will send the issue back to the Supreme Court for further disposition.

McDonald v. Master Financial, Inc., 205 F.3d 606 (3d Cir. 2000). Nobelman v. American Sav. Bank, 508 U.S. 324, 113 S. Ct. 2106, 124 L. Ed. 2d 228 (1993). In re Lam, 211 B.R. 36 (9th Cir. BAP), appeal dismissed, 192 F.3d 1309 (9th Cir. 1999).