Meeting with a client with Truth in Lending claims the other day reminded me about the power of the Bankruptcy Code to facilitate the sale of property subject to disputed liens while preserving the claims against a secured creditor.

These clients had property they wanted to sell but the amount they owed the holder of the first was in dispute. They asserted that the lender had violated Truth in Lending and had elected to rescind the loan. The parties were fighting about how much the clients had to tender to the lender as a result of the rescission.

Generally, a seller has to pay off all the liens on the property in order to deliver clear title to the buyer. Outside of bankruptcy, they might have to pay the creditor’s claim and sue to get it back. There is some risk of losing a TILA claim upon sale, as well.
Under Section 363 (f), the bankruptcy court can order the property sold and the liens to attach to the proceeds of sale. Thus, the debtor/seller and the secured creditor can argue later over the fund of money created by the sale, rather than having to resolve disputes before sale of the property. The costs of preserving the property in the interim are eliminated.

This section of the code speaks of the trustee as the seller, but the Chapter 13 debtor has most of the same powers as are granted to a Chapter 7 trustee. One more in my long list of why I love Chapter 13.

The latest governmental response to the mortgage mess is an offer for a 30 day hold on foreclosures offered as a voluntary program by six large mortgage servicers. Sorry, folks, but 30 days is not enough time to solve any one family’s housing problem, let alone the country’s problem.

The two things that are necessary to make any meaningful difference in houses lost to foreclosure is 1) a real willingness on the part of lenders to change the terms and perhaps the principle balance on loans, and 2) the manpower to staff a loss mitigation effort. Right now, I’m seeing neither.

Thirty days or an offer to tack the arrears on to the end of the loan does not solve the problem where the house is worth less than is owed or the arrears have arisen on a negatively amortized loan on impossible terms. Those are fundamental, structural problems in the loan. A remedy requires not a Boy Scout with a band aid but a surgeon with a scalpel.

Sometimes you need reminding about what you know. I’ve been so involved in looking for Truth in Lending violations or other defenses to my clients’ awful mortgages that I forgot the line of attack that is dependent on market value not wrong doing.

Karen Oakes reminded me that a Chapter 13 debtor can avoid a mortgage where there is no equity to secure the debt. At least in the 9th Circuit, even a voluntary lien, such as a mortgage or deed of trust, is avoidable if senior liens equal or exceed the value of the property at the time the bankruptcy is filed.

Supposing that you avoid a junior mortgage, you are still left with the question of whether it makes sense to keep the house: making payments on a loan that equals or exceeds the value of the house is not obviously a smart use of money.

I think, on today’s news, we have to figure that it will be a long while before property values recover from the hit they have taken. More and more, I am advising clients that the best use of the property is to live in it without making payments for as many months as possible before the lender takes it back.

Usually, I try to be the voice of common sense, conservation of energy, and moving on after a debacle. The client I saw the other day had the warrior side of me overwhelming the lawyer’s logic.

The facts: the client, an immigrant carpenter with limited English literacy, “invested” in a rental house with partners who bailed on him. The loan was the typical sub prime, adjustable rate loan where the rents on the house could never have covered the debt service.

Then the “friendly” real estate professional helped him borrow some money on the rental to pay the closing costs on a no-money-down purchase of a home for himself. Realtor gets a real estate commission on the purchase and a fat commission on the two loans to buy the house. Again there were supposed to be partners who would contribute to the debt service and own some interest in the property. None of it was in writing, others bail, and again my client is left holding the mortgage “bag”.

Meanwhile, the home’s value goes down and the mortgage payments go up. While the client is willing to walk away from the rental, some self interested “expert” tells him that if he defaults on the rental mortgages, he will lose his home, on which he is current, even though the property is upside down. He works huge amounts of overtime, loses sleep, figures he will lose everything. He’s near tears when he sees me.
The good news in this scenario is, such as it is, that all the client has invested in these deals is about $15,000, and a year and a half of inflated mortgage payments on “investments” that are worthless now, and probably when purchased.

When I analyzed the first loan on the home, I calculated what the mortgage payment would be if, instead of an exploding ARM, it were a conventional, 30 year fixed rate note at 6.5%. The answer was that the monthly mortgage payment on a loan of that size, if it could be restructured, equaled his gross monthly income! What lender makes such a loan?
The rational part of me wants to tell the client, take your lumps, be glad you didn’t lose any more than you did, following the American dream. The warrior side of me says, who were this guy’s friends who engineered these “deals”, with commissions to themselves? Who gets away with misrepresenting the consequences of a foreclosure on the rental? Who were the lenders who participated in exploiting a simple man who couldn’t read the relevant documents?

Again, my advice will probably be to live in the property payment free til the lender forecloses . But my personal inclination is to sue the assorted bastards involved in this mess.

Carmen Dellutri looked at the effect of the mortgage modification bill in Congress and the claims of bankers that interest rates will rise if bankruptcy judges can modify residential mortgages. He pointed out that the mortgage industry has not offered any proof that interest rates would rise.

Enter Prof. Adam Levitin. He has looked at data from a time when mortgages on a borrower’s principal residence could be modified in bankruptcy. Guess what he found? The risk of judicial modification made no discernible difference in interest rates.

So perhaps there is a very good reason, Carmen, that the bankers offer no proof to back up their scare mongering. Perhaps, there is no such evidence.

As each week brings a new wave of clients who have mortgages they can’t afford even before the loan resets, I ponder what happened in the Northern California real estate market.

While it has been practically a law of nature that California real estate only increases in value (despite not so recent evidence to the contrary), the increases over the past couple of years have been eye popping. With median home prices around $700,000, first time home buyers should be a very small subset of the population.

Yet the clients in my door have been middle income at best, yet they bought one or more properties with mortgages in the $700,000-$800,000 range. Almost invariably, they were told that the “friendly” mortgage broker would get them a better mortgage before the miserable one on the table reset. The ability to do that, of course, was predicated on a rising real estate market which would lower the loan to value ratio.

When you think about it, of course the real estate market was rising, when housing in the Bay Area is a limited commodity, and easy mortgage money has made practically anyone with a pulse eligible for a home loan and therefore a potential buyer. More people chasing fewer goods=price increase.

Of course the housing mania was also dependent on these buyers never having to make a fully amortized payment on a $700,000 mortgage. In most cases, the illusion of affording the house was dependent on mortgage “products” that required payments less than even the interest alone.

So, consider that the loss of value we are seeing, at least here in the Bay Area, merely represents the market wringing out the “value” created by mortgage madness.

For all of the administration hype, I’ve found it hard to get details on the President’s negotiated plan with the mortgage industry to prevent foreclosures. I’ve found a link to the plan.

Elizabeth Warren, Harvard law professor and bankruptcy expert, isn’t impressed. She calls it the Sandbag Plan . I find her conclusion, that the plan was put forth only to derail the pending bill to empower bankruptcy judges to address loan modifications, absolutely plausible.

In my practice I see no evidence that the lenders are interested in voluntarily modifying these loans. My letters on behalf of clients don’t even get a response. My clients seem to have no feasible option but to walk away from exploding ARMS. I’ve likened it to working in a financial emergency room.
I’m rooting for the passage of legislation like Senator Durbin’s bill, S. 2136, which would remove the bar to altering a mortgage secured only by the debtor’s principal residence in a bankruptcy proceeding. Hearings on the bill were held this week and the prepared statements of the witnesses are available.

Tax lawyer Mark Muntean sent around the following thought on lowering the appraised value of a home in a world of declining real estate values.

I think it was Bruce Springsteen who said “Every cloud has its silver lining.”1 One such possible silver lining is emerging from the sub-prime meltdown. My wife was bemusing our property tax bill the other day, and it was my chance to prove that I am not totally worthless around the house.

Similar to many California counties, Alameda County, allows for an Informal Request for the Decline in Market Value Reassessment (Prop. Eight) to be filed, reducing a property owner’s annual property tax bill. This is not a formal property tax appeal. Instead, this is a one page form that any property owner can fill out.

The real beauty of this form is that it does not require a formal appraisal. The property owner merely gives their opinion of value based on recent market information, which most likely found on the Internet.

Nearly every California county has a similar process. However, a word of caution is that this informal process has a deadline for this year. While Alameda County’s deadline is April 10, 2008, according to Los Angeles County’s Decline-In-Value Reassessment Application (Prop.Eight) form, the form must be filed by December 31, 2007. Interestingly, San Mateo County’s form does not list a deadline. However, additional information can be found on the county assessor’s website.

It is possible that a taxpayer may benefit from filing a form this year, reflecting a decrease in value to date, and a second form next year, if there is an additional fall in value. Commercial net leases frequently require the lessee to pay property tax. Thus, the lessee may explore possible property tax savings as well.

Formal property tax appeals can be pursued in 2008. To timely file a property appeal for the 2008/2009 tax roll year, a completed Application for Changed Assessment form must be submitted to the county Assessment Appeals Board where the property is located no later than September 15, 2008. September 15, 2007 was the deadline for the 2007/2008 tax roll.

At least three homeowners called my office this week with a foreclosure sale set in less than 5 days and wanted to file bankruptcy to stop the sale. What is with people who wait until the last minute to look for a solution to losing their home? When I’m tired and cynical, I think they must believe in the genie in a bottle, willing to give them three wishes.

But the stories got stranger still, as we talked to these callers: two of the three wanted to stall the foreclosure so that they could complete a short sale. The sale was going to result in no money to the homeowner and they would lose the home, yet they thought they were ready to spend money to file bankruptcy for the privilege of selling rather than being foreclosed.

Historically, we have found that people who wait til the last minute make difficult clients. They put off unpleasant tasks and fail to appreciate deadlines, or even that their lawyer is bugging them in order to make things better.

I decided that I am not willing to take on emergency bankruptcy filings for procrastinators unless there is something to save by the exercise. Enabling a short sale doesn’t measure up.

The adjustable rate mortgage mess is with us: no amount of pussyfooting about whether a legislative change is necessary will make the problem vanish. The choice we have is whether we sit back and let hundreds of thousands of homes be foreclosed or whether we give bankruptcy courts the tools to soften the impact of the crisis.

Currently, the only mortgage that a bankruptcy judge cannot alter is a home mortgage; mortgages on vacation homes, apartment buildings, and commercial property can all be modified in bankruptcy. The ability to modify these mortgages in bankruptcy does not seem to have ruined the credit markets to date.

A provision of the bankruptcy code, inserted to encourage the home lending industry years ago, now ties the hands of a bankruptcy alternative to massive foreclosures.

If bankruptcy judges were empowered to write mortgages down to the value of the property when the case was filed, and alter the terms, within a Congressionally mandated standard, both homeowner and lender would benefit. The homeowner gets a shot at keeping his home and paying for it, based on today’s values; the lender gets just what he would get if he foreclosed: a house now worth less than the value at the inception of the loan. Plus the administrative costs of restructuring the mortgage have got to be less than either staffing an n house mortgage modification operation or foreclosing, maintaining and trying to sell the foreclosed house.

The only cost here to the taxpayers is perhaps some more court clerks for the bankruptcy system. We don’t bail out the lenders who made foolish (or deceptive) loans; we don’t provide amnesty to the borrowers who at best were overly optimistic, and at worst were sold snake oil that puts their homes at risk.

Surely, permitting the modification of home mortgages has to be a better solution than neighborhoods of empty, bank owned houses, and displaced families. Because that certainly seems to me to be the alternative.