House Swaps: A Strategic Bankruptcy Solution to the Foreclosure Crisis

• Author: Lopucki, Lynn M

Introduction

The nonmodifiability of home mortgages in bankruptcy is one of the many ways in which the American legal system is rigged against the middle class.1 The bankruptcy system allows debtors to strip mortgages and security interest debts down to the collateral value on virtually every kind of debt, except the two kinds that middle-class Americans are most likely to owe: (1) mortgages against individual debtors' principal residences and (2) security interests in individual debtors' automobiles if the debtors financed those automobiles within the 910-day period preceding bankruptcy. By contrast, corporations, large or small, can strip down and modify mortgages or security interests against any kind of asset-including homes acquired through foreclosure and automobiles financed in the 910-day period preceding bank- ruptcy. Wealthy individuals can likewise strip down and modify mortgages against second and third homes.

Contrary to popular belief, the inability to strip down home mortgages does not result from congressional action. It is the product of the Supreme Court's 1993 decision in Nobelman v. American Savings Bank.2 In that case, the Court ignored the plain meaning of Bankruptcy Code subsection 1322(b)(2) and invented legislative history to resolve a conflict of circuits against the majority view.3

This Article presents a legal strategy by which individuals can modify their home mortgages and retain their homes despite Nobelman.4 The strat- egy requires that debtors move out of their homes for periods of one year. In most parts of the United States, judges need only follow well-established legal precedent for the strategy to succeed.

The implementation of this strategy has important implications not only for individuals struggling to save their homes but also for the American economy. Five years after the onset of the financial crisis, the United States remains mired in the ensuing mortgage foreclosure crisis.5 Negative equity- debtors owing more than their homes are worth-drives the crisis.6 At the end of the first quarter of 2013, about one in five of the approximately 49 million home mortgages outstanding in the United States-about 9.7 mil- lion-still exceeded the value of the home.7

Homeowners with negative equity are more likely to default. For exam- ple, a recent study found that an additional 16% of homeowners who owed more than 140% of the values of their homes transitioned into default each year, as compared with only 2.5% of homeowners with equity.8 Once home- owners transitioned into default, the odds were "well over 90%" that the homeowners would never resume payments unless their loans were modified.9

The process that follows mortgage default is highly inefficient. Foreclo- sure takes months and sometimes years.10 In the interim, the debtor is often without the means or the incentive to maintain the property. Some sever and sell appliances, fixtures, trees, plants, and even basic building materi- als.11 Mortgage holders must pay attorneys' fees and court costs. They may be able to obtain deficiency judgments against their borrowers, but the judg- ments are usually uncollectible. They must nearly always purchase the prop- erty at the foreclosure sale.12 The mortgage holder may then incur additional legal expenses in evicting the former owner. After obtaining possession, the mortgage holder must maintain the vacant property and pay the costs of reselling it. The most widely quoted estimates state that, on average, a mort- gage foreclosure costs the lender $50,00013 or 27% to 60% of the outstanding loan balance,14 but in actuality, little hard public data exists.

Foreclosures are often personal tragedies for homeowners.15 Homeown- ers may struggle for years, lose their homes in the end, and sacrifice their mobility in the interim. The process also destroys their credit ratings.16

Collectively, foreclosures are problematic for the American economy. A flood of foreclosed homes puts downward pressure on housing prices. Mort- gage holders' capital is tied up in illiquid, nonproducing mortgages. The result is that new loans are often not available for qualified buyers who would otherwise have taken advantage of the reduced prices. The workforce is less mobile because homeowners with negative equity are not entitled to sell their homes without paying negative equity in cash at closing.

A broad consensus exists that eliminating negative equity through mort- gage modification is the best solution to the mortgage crisis.17 Bankruptcy academics overwhelmingly endorse mortgage modification in bankruptcy as a means to that end.18 Bankruptcy mortgage modification would entitle qualified debtors to file bankruptcy, strip their mortgages down to the values of the homes, and agree to pay the remaining balances in full, with interest. Debtors would benefit by retaining their homes, mortgage holders would benefit by recovering more than they could get through foreclosure, and the economy would benefit through the stabilization of the housing market and the elimination of some of the consumer debt overhang.

Such reform would effectively reverse the Supreme Court's 1993 deci- sion in Nobelman v. American Savings Bank.19 In Nobelman, the Court held that bankrupt homeowners could not strip down mortgages secured only by the debtors' principal residences.20 Even after Nobelman, some home mort- gages remain modifiable because they are secured by nonreal property, such as a mortgage escrow account.21 Because the vast majority of home mort- gages are secured only by the debtors' principal residences,22 however, mort- gage modification is currently not generally available.

Unless someone takes action, the negative equity problem will persist. One research firm projects that "[a]t the current rate of decline, negative equity will persist and remain a market factor for years to come, with aver- age underwater borrowers taking more than 10 years in some markets to regain positive equity."23

The strip-down prohibition in subsection 1322(b)(2) of the Bankruptcy Code applies only to "a claim secured only by a security interest in real property that is the debtor's principal residence."24 Read literally, that lan- guage does not prohibit modification of a home mortgage once the debtor ceases use of the home as a principal residence. Most courts that have con- sidered the issue since Nobelman have read the language literally. They have held that, if a debtor has, in good faith, moved out of the mortgaged home prior to filing the bankruptcy case, the house is no longer the debtor's prin- cipal residence and the prohibition does not apply.25 As a result, the debtor can strip the mortgage down.

This reading provides the foundation for a strategy in which debtors who seek to retain their homes rather than lose them to foreclosure can move out of their homes in good faith, file under Chapter 13 of the Bank- ruptcy Code, confirm plans that strip down their mortgages, and then move back into those homes and retain them. This Article explores the real-world viability of this strategy.

Robert Hockett initially proposed the swap aspect of this strategy.26 This aspect involves matching two neighbors, each seeking to retain their homes through bankruptcy. Simultaneously, each leases the home of the other for a period of one year, moves into it, and files bankruptcy. Both strip down their mortgages, and, at the end of the leases, both move back into their own homes.

This strategy will work because it both conforms to the letter of the law and serves rather than thwarts public policy. A large majority of the courts that have considered the issue have held that a house is no longer a debtor's principal residence once the debtor moves out of it-even if the debtor plans a later return.27 That the debtor's purpose in moving is to render the mortgage eligible for strip-down is not alone sufficient to demonstrate bad faith. It is merely a type of bankruptcy planning that the courts have held unobjectionable in analogous contexts. The principal impediment to this strategy is the myth that Congress intended to prohibit the strip-down mod- ification of all principal residence mortgages.28

Using the facts of Nobelman, Part I of this Article explains why strip- down is beneficial not only to homeowners but also to their mortgage hold- ers and to the economy as a whole.

Part II shows that the majority view favors strip-down on each of the three legal issues on which the house-swap strategy depends. First, once a debtor moves out of a home and rents it to someone else, the home is no longer the debtor's "principal residence"-even if the debtor plans to return in the future. Second, whether the home is a debtor's principal residence for purposes of bankruptcy strip-down is determined as of the time of bank- ruptcy, not as of the time of the mortgage contract. Third, debtors who move out of their homes prior to bankruptcy so that they will be entitled to strip-down are not, for that reason alone, acting in bad faith and so ren- dered ineligible for Chapter 13 relief.

Part III addresses the common misconception that Congress sought to attract capital to the housing market by prohibiting strip-down of all home mortgages. Although such an intent would be legally irrelevant in light of the clear statutory language to the contrary, the legislative history contains no evidence that Congress intended to prohibit all home mortgage strip- downs.

Part IV describes three kinds of plans through which debtors can pro- pose to pay their stripped-down mortgages: (1) modification and reinstate- ment, (2) balloon payment, and (3) house distribution. Under existing case law, all, some, or none of these options might be available in a particular district. Part V explains the practical advantages of swapping houses rather than simply moving out and renting. The Article concludes that a move-out, strip-down strategy is viable in most districts and can be...