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Bankruptcy and Loan Modifications


     The key demand of homeowners, who are seeking a loan modification, is that the lender lower the principal of the mortgage to the value of the property, which is lower now than when the homeowners bought the property.  With the decreased mortgage principal, the monthly mortgage payment will  now be lowered to an affordable amount.

     Bankruptcy law generally prevents this modification of mortgage principal except under limited circumstances. First, the debtor may not modify the mortgage in Chapter 7, only in Chapter 13 or Chapter 11. Under Chapter 13 or Chapter 11, the debtor must propose a plan to repay creditors. In Chapter 13, the debtor's plan must propose to repay creditors over three to five years.  The debtor may not "strip" mortgage liens in Chapter 7. Therefore, any modification must take place under the rules of Chapter 13 or Chapter 11.

     Second, the key rule is that a Chapter 13 plan may not modify the rights of secured creditors (mortgagors on debtor's principal residence) except to provide for the repayment of missed mortgage payments. This rule is codified in Bankruptcy Code Section 1322(b)(2).  It does not apply to investment property, such as a second home which debtors lease to tenants for extra income.  Particularly with debtors who have sought pre-bankruptcy relief in the HAMP federal program,  this is a helpful remedy in Chapter 13 as debtors find themselves more than 12 months behind on their home mortgage payments while awaiting word of approval under the program.  At the same time, the lender usually has initiated foreclosure with the filing of a Notice of Default. The filing for Chapter 13 stops the foreclosure process and provides a means for debtors to cure substantial pre-petition arrearages of their monthly mortgage payments.  But this initial relief in Chapter 13 is small consolation for debtors in Chapter 13 who still wish to reduce the principal balance of their mortgage to the value of the property.

     In Zimmer v. PSB Lending Corp., 313 F.3d 1220 (9th Cir. 2002), the court has held that the anti-modification rule of Bankruptcy Code Section 1322(b)(2) does not apply to totally unsecured claims.  Section 506(a)(1) of the Bankruptcy Code determines whether a creditor (even a mortgagor) is secured or not.  If the mortgage debt is deemed "unsecured" in its entirety, then the lender has no rights of a secured creditor and debtor may "strip" the mortgage lien. Section 506(d) of the Bankruptcy Code states that the lien is void.

     Third, whether or not a mortgage is "unsecured" depends on the value of the property. If the mortgage is completely underwater, then the mortgage is considered to be unsecured.  The debtor in Chapter 13 or Chapter 11 may then strip the lien (by moving the court to order the lien removed) and the creditor will be paid the percentage due other unsecured creditors of the debtor. Notice that a mortgage which serves as the principal residence of the debtor cannot be partially stripped.

     Fourth, the order to strip the lien will only be "permanent" if the debtor completes his or her Chapter 13 (3 to 5 years) or Chapter 11 plan.  If the plan in either Chapter is not completed per the terms of the plan and the case is dismissed, then the order stripping the lien will be of no force and effect.