The Housing Bubble and Consumer Bankruptcy (Parts I and II).

AuthorCarlson, David Gray

TABLE OF CONTENTS OVERVIEW PART I. Chapter 7 A. Exempt Property B. Abandonment C. Dewsnup v. Timm D. Avoidance Under [section] 522(f)(1) PART II. Chapter 13 A. Mortgages in Chapter 13 1. Underwater First Priority Mortgages 2. Second Mortgages Out of the Money a. Hints from the Supreme Court b. The Role of [section] 506(d) in Chapter 13 c. Theater of the Absurd B. Chapter 20 Cases Once again, Americans are enjoying the glorious summer of a housing bubble. The clouds of the 2008 recession that loured over the consumer homestead are now in the deep bosom of the ocean buried. Recently bankrupt consumers have found themselves eyeing a stupendous profit if they sell their home. (1) What are the prospects that the debtors can keep this profit away from their prepetition creditors? The answer depends on whether the debtor filed a chapter 7 or chapter 13 bankruptcy.

Part I covers the scene in chapter 7 cases, where the debtor cannot exclude underwater mortgage lenders from appreciation value. Arguably the Bankruptcy Code, as originally promulgated, invited debtors to "strip" underwater mortgages. In the notorious case of Dewsnup v Timm (2) the Supreme Court ended that practice.

A chapter 7 debtor may still strip a judgment lien in whole or part, thereby diverting appreciation value from the judgment creditor to the debtor. Under either federal or state law, a debtor is usually entitled to a monetary exemption on a home. Any appreciation value funds the monetary exemption at the expense of the judgment creditor. (3)

Everything changes in a chapter 13 case. Part II explains that the underwater senior mortgage lender is guaranteed the first right to drink from the waterfall of appreciation value. Nobelman v American Savings Bank (4) expressly protects the senior mortgage lender from lien stripping. A junior mortgage lender, however, can be stripped, if the second mortgage is "out of the money"--the first mortgage lender is under water and there is no valuable remaining equity available for the junior mortgage lender. Once a chapter 13 plan is confirmed, the debtor gets appreciation value above and beyond the claim of the first mortgage lender. But if during the plan, the debtor realizes a capital gain from the sale of the house, the gain can be captured by the creditors because the gain is "disposable income" which the debtor is ultimately supposed to pay into the plan.

Part III (5) addresses the recent developments giving a chapter 13 debtor a real hope in keeping appreciated value away from the unsecured creditors by converting to a chapter 7 case. In such circumstances the law turns especially obscure.

In addressing ownership of appreciation value, I embrace the dry and desiccated spirit of positivism. I take no position on who deserves the windfall of appreciation value. Consumer bankruptcy is founded on the contradiction that creditors deserve to be paid and debtors deserve a discharge and a fresh start in life. I have no moral intuition as to which of these intuitions should predominate. These issues I leave to divine law. Rather, I examine whether allocations of value can be grounded in the text of the Bankruptcy Code as it currently exists.

The result, I fear, will strike the reader as unsatisfactory. Obtuseness and shadow dominate over clarity and light. Dark night strangles the travelling lamp of bankruptcy jurisprudence. A great many issues covered here were obviously not anticipated by the drafters of the Bankruptcy Code, and their scrivenings will seem arbitrary in application. In addition, Supreme Court interventions, no doubt well intentioned, have greatly complicated the scene. One gets the strong impression that the results demanded by a positivist approach are unintended and accidental. It is definitely not possible to say in general that either the creditors are entitled to the appreciation value, or that debtors may retain it as part of their fresh start. The reader should prepare for a bumpy ride.


Prior to examining the fate of the housing bubble in consumer bankruptcies, we need to rehearse the mechanics of liquidating exempt property in bankruptcy. The Bankruptcy Code is surprisingly opaque on these matters.

We learn in [section] 541(a) that "commencement of a case ... creates an estate." (6) The bankruptcy estate includes "all legal and equitable interests in property as of the commencement of the case." (7) Bankruptcy therefore constitutes a transfer by a debtor (D) (8) of property to the bankruptcy trustee (T) on behalf of creditors.

In all bankruptcy cases, whether chapter 7 or 13, exempt property initially goes into the bankruptcy estate and must be fetched out (9) by D This was not so under the 1898 Bankruptcy Act. There, "property of the bankruptcy estate" was defined as property as to which a judicial lien might attach. Exempt property never was part of the bankruptcy estate in the first place. (10) In the modern era, then, whether the home is exempt or not, into the bankruptcy estate it goes.

When D owns a house and files for bankruptcy, the house becomes an asset of the bankruptcy estate. Title to the property does not transfer to T and D continues to hold the fee simple interest to the house. (11) For this reason, D may live in the house after bankruptcy and is no trespasser in it. (12) T, however, may use, sell or lease the house court permission. (13) Thus, D could be in danger of losing the house under certain circumstances.

When the house is D's principal residence it is usually, at least in part, exempt property under state law or as federalized by the Bankruptcy Code.

The homestead is usually exempt from execution by unsecured creditors. In seven jurisdictions, (14) D gets an "exemption in kind" meaning the entire house is exempt. In the other states, and under federal law, (15) D's homestead exemption is monetarily limited. In bankruptcy, T is a hypothetical judicial lien creditor. (16) This means that, where D has only a monetary exemption, T has a judicial lien on the debtor's equity in the home for the value above and beyond the exemption amount. (17)

Very frequently, when the nation is in a recession, the mortgage is under water. The exemption, of course, is no good against the mortgage. (18) Suppose the value of the house exceeds the amount of mortgage liens (ML) on the property plus the monetary exemption (ME). (The sum of these amounts I will refer to as ML+ME). Equity above ML+ME is not common at the commencement of a consumer bankruptcy. If D has a sizable equity in the home after the mortgage, D can often dull the edge of husbandry by borrowing against equity, thus staving off the evil day of bankruptcy.

Nevertheless, it is not unknown for the value of the home to exceed ML+ME. (19) In such a case, T can sell the home free and clear of the mortgages and the exemption. That T may sell free and clear of the mortgages is established by [section] 363(f)(3). (20) The Bankruptcy Code never says that T can sell free and clear of the monetary exemption, but under state law judicial lien creditors can do so. (21) Therefore it is logical and universally assumed that T can also do so, (22) since T is a hypothetical judicial lien creditor under [section] 544(a)(1).

By way of example, here is the situation involving a judicial lien under New York state law. A judgment creditor (JC) may not, apparently, sell free and clear of a senior mortgage. According to New York's CPLR [section] 5236(a), "the interest of the judgment debtor in real property ... which was subject to the lien of judgment ... shall be sold by the sheriff ..." (23) Where D has conveyed a mortgage to ML and where JC subsequently obtains a judgment lien, the sheriff can only sell Ds interest as encumbered by ML.

In New York, if JC wishes to execute on the surplus above the monetary exemption of $150,000, (24) she must start a special proceeding. (25) The court must order that the sale occur, either through a sheriff or a receiver. Presumably, the court must pay D first for the exemption amount (26) (keeping in mind that ML survives the sale). As is true in many states, (27) the money remitted to Dis entailed:

Money, not exceeding [the exemption amount], paid to a judgment debtor, as representing his interest in the proceeds, is exempt for one year, after the payment, unless, before the expiration of the year, he acquires an exempt homestead, in which case, the exemption ceases with respect to so much of the money as was not expended for the purchase of that property[.] (28) As for the surplus above the exemption amount, the court (presumably) pays the sheriff's or receiver's fee (29) and remits the balance to JC (30)

PART I. Chapter 7


    When the house is D's principal residence it is usually, at least in part, exempt property under state law or as federalized by the Bankruptcy Code. If there is no equity beyond ML+ME T cannot, or should not sell, the home in a chapter 7 case. (31) But if equity exists, T can do what JC could not do under state law--sell free and clear of ML. (32) In analogy to JC, T can sell the whole of the house, in spite of the monetary exemption. (33)

    T's power to sell free and clear of ML generally does not exist in state law and is rather unique to federal law. (34)

    Presumably, T must, off the top, pay proceeds to ML. Where in the Bankruptcy Code is this provided for? It is hard to say. According to [section] 552(b)(1):

    [I]f the debtor and an entity [ME] entered into a security agreement (35) before the commencement of the case (36) and if the security interest (37) created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds ... then such security interest extends to such proceeds ... acquired by the estate after the commencement of the case to the extent provided by such security agreement ... (38) This provision is designed (clumsily at that) to cover security interests in personal...

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