Since the price peak in 2006, home values have fallen more than 30 percent, leaving millions of Americans with negative equity in their homes. Until the Supreme Court's 1993 decision in Nobelman v. American Savings Bank, the bankruptcy system would have provided many such homeowners with a remedy. They could have filed bankruptcy, discharged the negative equity, committed to pay the mortgage holders the full values of their homes, and retained those homes. In Nobelman, however, the Court misinterpreted reasonably clear statutory language and invented legislative history to resolve a three-to-one split of circuits in favor of the minority view that debtors could not modify even the unsecured portions of the mortgages on their principal residences. Courts and commentators have since assumed that modifying home mortgages in bankruptcy is impossible.
This Article presents a legal strategy for modifying home mortgages despite Nobelman. The strategy requires that debtors move out of their houses, lease the houses for one year, file bankruptcy, and propose mortgage modification plans that pay mortgage holders the full current values of the houses. This Article argues that despite the artificiality of a move-out with the intention to return, bankruptcy judges will approve the modification plans. The judges will do so because existing precedent requires approval and because the modification plans will be in the best interests of not only the debtors but also the mortgage holders and the American economy. The strategy will enable hundreds of thousands of homeowners to retain homes they would otherwise have lost to foreclosure.
TABLE OF CONTENTS INTRODUCTION I. THE SUPERIORITY OF THE BANKRUPTCY SOLUTION A. The Debtors' Perspective B. The Mortgage Lenders' Perspective C. The Social Perspective II. LEGAL ISSUES PRESENTED A. The Definition of "Principal Residence" B. The Timing Issue 1. The Move-Out Cases 2. The Different-Collateral Cases C. Good Faith 1. The Contractual Right to Move 2. The Statutory Right to Move III. LEGISLATIVE HISTORY A. Irrelevance B. Nonexistence C. Legislative Purpose IV. PLAN CONFIRMABILITY A. Modification and Payment Maintenance B. Balloon Payment Plans 1. Feasibility 2. Periodic Payments C. House-Distribution Plans V. Advantages of Swapping CONCLUSION 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.' 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 bankruptcy. 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 strategy 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 million--still exceeded the value of the home. (7)
Homeowners with negative equity are more likely to default. For example, 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 homeowners 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. Foreclosure 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 materials. (11) Mortgage holders must pay attorneys' fees and court costs. They may be able to obtain deficiency judgments against their borrowers, but the judgments are usually uncollectible. They must nearly always purchase the property 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 mortgage foreclosure costs the lender $50,000 (13) 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) Homeowners 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. Mortgage 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 mortgage 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 decision 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 mortgages remain modifiable because they are secured by nonreal property, such as a mortgage escrow account. (21) Because the vast majority of home mortgages are secured only by the debtors' principal residences, (22) however, mortgage 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 average 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 language does not prohibit modification of a home mortgage once the debtor ceases use of the home as a principal residence. Most courts that have considered 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 principal 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 Bankruptcy 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...