The following post was contributed by Ken Andrews of the Doan Law Firm in California. Ken also runs a blog called “San Diego Predatory Lending”, where the original of this article is posted. The article discusses a bankruptcy defense based on existing law to dispense with second mortgages.

A lot has been written by me and others about How To Walk Away From Your Home. My blog has become more of a self-help guide to walking away in California. I get at least 25 calls and emails a week from people who want to get out from their underwater homes, but are scared they will be liable for the unpaid mortgage debt. As I previously explained, California homeowners who used 80/20 loans to purchase their homes and have not refinanced the second mortgage

But I also get many folks who have refinanced that second mortgage, or who want to keep their homes, but can’t pay for the adjusted payment on their mortgage, or don’t want to pay on a house that worth substantially less than they owe on it. They have tried to get the bank to work with them, but are frustrated because the bank won’t talk unless they are two payments behind and the only thing the bank will do is freeze their payments or add their arrears to their loan balance. Banks will not reduce the principal amount on loans to fair market value to save a borrower from foreclosure. They just won’t do it.

Once again it’s the 80/20 loan to the rescue. This beautiful piece of financial engineering genius (you really need to click on that link, it’s hilarious!) has found yet another way to help distressed home owners. And not just in California, this trick works all over the United States.

The trick is called a “Chapter 13 Lien Strip” but I like to call it the “Back Door Cram Down.” You may have read about the proposed mortgage “Cram Down” legislation that would allow Chapter 13 judges to reduce or “Cram Down” mortgages balances to fair market value in a Chapter 13 case. This legislation has zero chance of passing until a new election and Congress are seated next January.

Instead, we are “Cramming Down” second mortgages using the old Bankruptcy code section 1322 which states:

“Contents of plan

(b) The plan may–

(2) 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.”

What’s not obvious about this code section is a loan is not “secured” by your personal residence if there is no value or equity in your home that would go to the lender if the home was sold. That means the loan can be converted to unsecured or the lien “stripped” from the house by “modifying the rights of holders of secured claims.” This turns it into unsecured debt, like credit card debt, which can be discharged!!!! This is why I call it a “Back Door” cram down because we are cramming down the second mortgage to unsecured status.

Here is an example. You bought your home in 2006 for $500k with 100% financing using an 80/20 loan. So your first mortgage is 80% or $400k and your second mortgage is 20% or $100k. The market is down more than 20% from its peak and your house is now only worth $375k. This means if the house was sold, the first mortgage would take all $375k and the second mortgage would get nothing. In this case the second mortgage is “wholly unsecured” and the second clause of section 1322(b) does not apply, so we can modify the rights of the second mortgage holder and turn it into unsecured debt.

What happens to the now unsecured stripped off second mortgage? It gets paid in your Chapter 13 plan but only after your other secured debts are paid. Secured debts are the first mortgage, your property taxes, and your car payments. And because a Chapter 13 plan lasts only 3-5 years (usually 5) a whole lot of that unsecured debt does not get paid. At the end of 5 years, most unsecured debts (not student loans, back income taxes, or family support payments) are discharged so you don’t have to repay them.

So at the end of 5 years, you are left with just your just mortgage payment on your house. Your cars and your back property taxes are paid off, your student loans and back income taxes are paid down, but your second mortgage and your credit card debt is gone! Beautiful isn’t it? God bless the 80/20! It just keeps on giving.

You can read more about Chapter 13 plans here so I’m not go into great detail on them other than to say they are like debt consolidation inside of a bankruptcy, they last 3 to 5 years (usually 5) and you also can included student loans and back income taxes.

So what is the downside? First off, you will have gone “Bankrupt.” Your creditors will report that for 7 years and it will appear as a public record for 10 years on your credit report. Creditors do not really distinguish between a Chapter 7 or a Chapter 13 bankruptcy so your credit will take a beating. But I like to point out to people that if they do nothing, their credit will likely take a beating anyway, so it’s not really any worse.

The other major downside is you must make every plan payment for 3 to 5 years. If you fail, everything goes back to the way it was. You owe all that debt, and the second lien is no longer stripped off. So I always tell my clients to make a budget that will work for 5 years, not just one that looks good to the Bankruptcy Court.

Presidential candidate Hillary Clinton unveiled a new four-part mortgage relief plan at a speech before 150 elected officials and students at the University of Pennsylvania yesterday. The plan calls for immediate action and direct government intervention.

Senator Hillary Clinton has been proposing ideas to provide foreclosure relief for more than a year now. On Monday, she added to those proposals, calling for $30 billion and government intervention.

Her new four-part plan, which includes some of her previous proposals, is the most aggressive plan floated by a presidential candidate so far. In addition to interest rate freezes and a foreclosure moratorium, Clinton wants to see a $30 billion fund that will allow cities and states to improve neighborhoods by buying foreclosed properties.

To encourage loan restructuring, she suggested mortgage servicers be given more protection against lawsuits from investors. According to her, evidence suggests servicers are less willing to modify mortgages because they fear litigation.

Clinton also stated that she would support controversial legislation recently introduced by Representative Barney Frank (D) and Senator Christopher Dodd (D) that calls for $20 billion in public funds to establish a federally backed mortgage auction. 

Other ideas she mentioned included a huge expansion of the Federal Housing Administration (FHA) and an emergency, non-partisan “working group” that could brainstorm new ways to prevent more foreclosures. She recommended tapping economists, as well as former Federal Reserve chairmen Alan Greenspan and Paul Volcker and former Treasury Secretary Robert Rubin to lead the group.

Her speech comes as the mortgage crisis threatens to overwhelm the economy. The latest statistics show that nearly one million people are facing foreclosure, and more trouble is expected as rates reset and home prices continue to fall.

Senator Barrack Obama’s campaign issued a statement after Clinton’s speech to say that Obama is also working to ease the credit crisis. He too has suggested a “homeownership preservation summit,” expansion of the FHA and a larger mortgage bond program.

Other ideas Obama has come out with previously include stiffer penalties for predatory lenders and a simplified tax code that will allow more people to benefit from the mortgage income tax credit.

Republican presidential candidate John McCain is traveling down a different road. Today, he warned against government intervention, saying it is not the “duty of the government” to bailout irresponsible borrowers or lenders.

Breakdown of Hillary’s Proposals

• 90-day foreclosure moratorium
• Freeze the interest rates on subprime ARMs for at least five years
• Allow the FHA to guarantee up to $400 billion in refinanced mortgages
• Put underwater mortgages on the government’s balance sheet on a temporary basis
• Introduce legislation to protect mortgage servicers from investor lawsuits
• Create a $30 billion stimulus package to allow cities and states to purchase foreclosed properties
• Set aside $10 billion to expand the mortgage revenue bond program
• Create a “high-level emergency working group” to brainstorm more ideas to help ease the foreclosure crisis

By Moe Bedard Founder of Loan Safe 

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