Recently, the U.S. Supreme Court heard a consolidated lawsuit that involved whether a secondary lien placed on the asset of a debtor can be reduced to the value of the collateral securing the obligation obligation and reduced to zero if there is no asset coverage.. The decision could have broad implications, potentially impacting many bankruptcy proceedings that followed the nationwide housing crisis, according to Inman Magazine.
The consolidated lawsuit involves two Florida homeowners who had underwater homes and then filed for Chapter 7 bankruptcy, the media outlet reported. When these individuals filed for protection from creditors, their second mortgages were voided, according to American Banker. Bank of America, which owns the second mortgages in each case, has taken legal action because it wants to reverse the ruling.
The first case, titled Bank of America, N.A., v. Davie B Caulkett, involves a $199,600 first mortgage and a $49,000 second mortgage the defendant bought for his $249,500 home (100% purchase money
financing), American Banker reported. By the time Caulkett filed for Chapter 7 bankruptcy protection, the value of his home had fallen to $98,000. However, he was $183,000 in debt for his first mortgage and $47,000 for his second mortgage.
Edelmiro Toledo-Cardona, the second defendant, found himself in a similar situation, owing $135,000 and $32,000 for his first and second mortgages when he filed for Chapter 7 bankruptcy, but having a home with a value of $77,700, according to American Banker.
During this legal challenge, the various parties involved have repeatedly brought up a 1992 Supreme Court case, Dewsnup v. Timm, Inman Magazine reported. The High Court ruled debtors in Chapter 7 bankruptcy cannot reduce a second mortgage on an underwater property to its current market value, which could then void the claim of the second mortgage holder.
Since that aforementioned case was resolved, courts have not applied the Dewsnup ruling to completely underwater second liens in a consistent manner, according to American Banker.
Danielle Spinelli of Wilmer Cutler Pickering Hale and Dorr, who is representing Bank of America in the case, said during her opening statement that the ruling the Supreme Court provided in Dewsnup v. Timm "applies with equal force to completely underwater mortgages."
While it remains to be seen what the Supreme Court will decide, its ruling could have a major impact on second mortgage loan originations and pricing. If the high court rules that second liens can be stripped to their market value, and potentially to zero, in instances where the borrower files for Chapter 7 bankruptcy, this development will increase the cost of credit for such liens.