R. Travis Santos, the Legal Way to Defeat Optimus Sub-prime

• Publication year: 2011

THE LEGAL WAY TO DEFEAT OPTIMUS SUB-PRIME

INTRODUCTION

Everyday, Americans turn on their televisions or open their newspapers and cannot escape the endless media coverage of the subprime mortgage crisis. The subprime mortgage crisis, characterized by a sharp rise in home foreclosures, serves as a gloomy reminder of the repercussions of the "mortgage lending spree that fed the real estate boom during the first half of this decade."¹As the number of foreclosures continues accelerating at a remarkable rate,²the shattering of the American Dream becomes a stark reality for many. The American Dream is grounded in the idea of homeownership, and the purchase of a home is usually the greatest investment, in terms of both equity and personal attachment, that a person will make in his lifetime.³

During the housing boom earlier this decade, when interest rates were considerably lower and loans were consequently easier to obtain, home ownership became a deceptive economic status symbol. Today, many Americans' opportunities to live the American Dream slowly dwindle into oblivion as subprime mortgage interest rates commence their hike.

The illusion that anyone can own a home was driven by subprime mortgage lenders who employed creative financing mechanisms to enable people with poor credit history or high debt-to-income ratios to obtain home mortgages.⁴

The borrowers could afford the initial low monthly payments, but once the payments associated with the subprime credit increased, these borrowers were only one unfortunate situation away from filing for bankruptcy.⁵

The suspect actions and lending strategies of the subprime mortgage lenders raise many fascinating questions. This Comment leaves the issues of predatory lending to other scholars⁶and instead focuses on how the subprime mortgage industry has affected the area of bankruptcy law and what should be done to curtail this problem.

When an individual files for bankruptcy, he generally has the choice of liquidation under chapter 7 or rehabilitation under chapter 13.⁷Rehabilitation promotes the restructuring of debt and preservation of the estate,⁸and as a result, homeowners facing possible foreclosure can use this as a last resort to save their homes.⁹The Bankruptcy Code allows homeowners who have defaulted on their mortgage to cure within a reasonable time, thus undoing acceleration and preventing foreclosures.¹⁰Although in the past this simple provision in the Bankruptcy Code averted many foreclosures, the recent surge of the subprime mortgage in the mortgage lending industry carried borrowers too far past the possibility of curing defaults, rendering this provision useless in many instances.

The main problem arises when debtors in bankruptcy get so far behind on their mortgage payments that they are financially unable to cure the default. When this situation occurs, the debtor has no way of salvaging his house because the Bankruptcy Code does not permit borrowers to modify the mortgage on their principal place of residence.¹¹Despite the multitude of issues raised by Sec. 1322(b)(2), the Supreme Court has only decided one case regarding the interpretation of the antimodification provision: Nobelman v.

American Savings Bank.¹²Even more problematic, the Supreme Court's decision failed to resolve ambiguities created by the antimodification provision.¹³Ultimately, lower courts bear the burden of attempting to clear up the ambiguous interpretations associated with the antimodification provision.

As a result, lower courts have taken one of two approaches: a strict interpretation of the provision or a liberal interpretation.¹⁴

Although the antimodification provision in the Bankruptcy Code has always played a significant role in bankruptcy because of the limitation it places on the borrower,¹⁵it has not received much attention until recently. The recent attention is due to the implosion in the subprime mortgage lending market.¹⁶This market implosion demands that the current deficiency in bankruptcy policy concerning the effects of the subprime mortgage be resolved quickly. The best method of resolving any inadequacy is by attacking it directly.

In 2008, Congress passed a housing rescue bill designed to stabilize the housing market and keep homeowners out of foreclosure.¹⁷The major problem with the bill is that it is unlikely to make a substantial difference, and it fails to account for the number of foreclosures expected over the next five years. Enacting a bill to alleviate some problems of the subprime mess is crucial to a rebound in the housing market, but Congress must address an issue closely associated with many foreclosures: bankruptcy.

To achieve this end, Congress must amend the Bankruptcy Code to provide chapter 13 debtors with the opportunity to modify existing home mortgages when they are on the brink of foreclosure. Congress proposed legislation in an attempt to end the subprime lending crisis.¹⁸In addition to the recently enacted bill, there were multiple bills in both the Senate and the House of Representatives. One of the bills would have provided emergency funding to raise the portfolio caps of government-sponsored enterprises that operate to fund the development of the secondary mortgage market.¹⁹The proposed bills would all amend the Bankruptcy Code to allow modification of mortgages on the debtor's principal residence.²⁰

This Comment explains the different bills proposed in Congress and analyzes their positive and negative aspects. All of these pieces of legislation propose additions or changes to specific provisions of the Bankruptcy Code. This Comment grapples with the various proposed bills and urges the adoption of a more lenient statutory provision for chapter 13 debtors, while offering flexible solutions for those borrowers specifically affected by subprime mortgage lending. This Comment makes it apparent that an amendment must be made to the antimodification provision as currently written in Sec. 1322(b)(2).

Part I of this Comment provides background information about the subprime mortgage market, the interplay between foreclosure law and bankruptcy law, and the chapter 13 plan confirmation process. Part II discusses the adverse effects that the subprime mortgage crisis has had on other sectors of American society. Part III addresses the legislative history and Congressional intent behind Sec. 1322(b)(2) and the antimodification provision located therein. Part IV examines the Supreme Court's only decision interpreting Sec. 1322(b)(2), as well as the lower courts' varying interpretations of Sec. 1322(b)(2) that the Supreme Court's decision failed to clear up. Further, Part V explains how Congress implemented chapter 12 of the Bankruptcy Code to alleviate the burden placed on family farmers in the midst of the farm crisis in the 1980s and the corollaries to Sec. 1322(b)(2) in chapters 11 and 12. Finally, Part VI introduces and analyzes the various bills proposed in the House and Senate regarding attempts to mitigate the crippling effect of the subprime mortgage crisis on chapter 13 home mortgagors, and urges that Congress pass a flexible but limiting resolution.

I. BACKGROUND

A. Subprime Mortgage Market

Since the enactment of the Bankruptcy Code, the types of mortgages that lenders offer continue to change and evolve.²¹In the early to mid-1990s, many lending institutions adopted a type of lending scheme known as the subprime mortgage.²²This new loan product divided the lending market into prime and subprime mortgages.²³Prime market rate mortgages tend to be delivered only to the "most creditworthy borrowers."²⁴Subprime mortgages are loans to those individuals who do not qualify for prime mortgages because of their risky credit ratings or to those who are unable to show that they can make necessary payments on a prime mortgage.²⁵As the subprime mortgage market emerged in the mid-1990s, so did several types of subprime mortgages.²⁶The most popular included the adjustable rate mortgage ("ARM"), interest-only mortgage, and Alternative-A ("Alt-A") mortgage.²⁷

An ARM is a loan that "provide[s] short term benefits to encourage borrowing by offering initially low rates of interest which eventually reset to significantly higher levels."²⁸Among the types of ARMs saturating the subprime mortgage market are the hybrid ARM and payment-option ARM.²⁹

Hybrid ARMs contain a combination of a fixed-rate term and an adjustable- rate term and are appropriately coined 2/28, 3/27, etc.³⁰Similarly, payment- option ARMs provide very low interest rates during the initial monthly payments, but the interest rate rises shortly thereafter.³¹

In an interest-only mortgage, which can either be classified as an ARM or a fixed-rate mortgage, the mortgagor pays only the interest for a specified time period.³²The monthly mortgage payments start low because the borrower is only paying interest, but once the interest-only period ends, the mortgagor must pay back a portion of principal in addition to monthly interest.³³For example, if a homeowner takes out a twenty-five year mortgage loan with a three year interest-only payment period, the borrower only makes payments on interest for the first three years, but in the fourth year, the borrower must start making principal and interest payments, which substantially increase the borrower's monthly payment.³⁴

In contrast, Alt-A mortgages do not necessarily involve lending to the most credit-risky individuals. Alt-A borrowers often have unpredictable sources of income or lack the necessary proof or documentation to be approved for a prime loan.³⁵Thus, Alt-A lenders take serious risks in approving borrowers that merely state their income without sufficient documentation to prove that the stated income or source of income is correct.³⁶Not surprisingly, these types of loans are a major driver of the subprime mortgage crisis.³⁷

Although the subprime lending market was once dominated by small community banks, many of the nation's largest banks and...