Court Deals Setback to Bankrupt Homeowners : ‘Cramdowns’ Reduce Mortgage to Property Value
First Leonard Nobelman’s kidneys failed, leading him and his wife, Harriet, to fall behind on their financial obligations and forcing the Texas couple to declare bankruptcy.
Then the Nobelmans, both in their late 50s, learned that their Dallas condo, which they had bought eight years ago for more than $71,000, had plunged in value to $23,500.
Trying to make the best of a bad situation, they asked the judge hearing their Chapter 13 bankruptcy petition to split their condo mortgage into two parts--secured and unsecured.
The couple offered to continue making payments on the secured amount of $23,500 (the condo’s value) because it represented the lender’s security in the property.
However, they wanted the judge to treat as unsecured debt the $44,750 difference between the mortgage and current property value, plus another $3,145 in related mortgage fees.
In bankruptcy, unsecured debt is routinely repaid, if at all, for as little as 10 cents on the dollar.
In real estate parlance, the practice that the Nobelmans proposed is called a “cramdown” because the mortgage is “crammed down” to the property’s value.
Cramdowns, which are frequently used in commercial real estate “workouts” (restructuring of debts), are controversial. Over the past few years, lenders had repeatedly challenged cramdowns, but four appellate courts covering California and 19 other states consistently sided with the borrowers.
The Nobelmans, however, were to encounter a final stroke of bad luck. Not only did the bankruptcy court reject their cramdown appeal but so did the 5th U.S. Circuit Court of Appeals, creating the split in the circuits needed to trigger a Supreme Court review.
Finally, the Supreme Court earlier this month ruled against the Nobelmans. The judgment significantly limited the ability of borrowers to avoid paying the full amount of their mortgages, but, nevertheless left some maneuvering room for certain bankrupt homeowners in neighborhoods where home prices have fallen.
Essentially, the high court was asked to decide which of seemingly two contradictory portions of the bankruptcy code, one allowing cramdowns and the other protecting a lender’s contractual right to collect the full amount due, takes precedence.
In siding with the lenders, Justice Clarence Thomas, writing for the court in the case of Nobelman vs. American Savings Bank, noted “it would be impossible to reduce (the borrower’s) outstanding mortgage principal to $23,500 (from the $68,000 owed) without modifying the (lender’s) contractual rights as to interest rates, monthly payment amounts or repayment term.”
Expressing disappointment with the decision, Ike Shulman, a San Jose attorney and president of the National Assn. of Consumer Bankruptcy Attorneys, said cramdowns offered one of the few ways debtors can hang on to homes they would otherwise lose by paying off only the lower fair-market value of the properties.
The practice is not unfair to lenders, Shulman said, because “that is all a lender would get from a foreclosure sale.”
The Nobelmans take a similar view of the situation, said their attorney, Philip I. Palmer Jr., following the oral argument of the case before the high court last month.
There is “not a chance the Nobelmans will pay $71,000 for a $23,500 condo” in the event the court voided the cramdown option. They would default on the loan, Palmer said. “We will wheel Mr. Nobelman out in the hall, buy the vacant (condo) next door for $23,500 and move him back in,” he said.
The court was trying to preserve the special status Congress gave mortgage lenders over unsecured lenders when it wrote the bankruptcy code, wrote Justice John Paul Stevens in a concurring opinion.
“At first blush it seems somewhat strange that the bankruptcy code should provide less protection to an individual’s interest in retaining possession of his or her home than of other assets . . . (but) the favorable treatment of residential (lenders) was intended to encourage the flow of capital into the home lending market.”
Despite the Nobelman decision, the cramdown issue is not dead, said Michael S. Polk, a Tarzana bankruptcy attorney representing mortgage companies.
Although Nobelman covers Chapter 13 bankruptcies--which allow individuals or small businesses to pay off only a portion of debts--and a similar Supreme Court decision last year voided cramdowns in Chapter 7 liquidations, the matter remains unresolved under Chapter 11 bankruptcy proceedings, Polk said.
Consequently, Polk said he anticipates a rise in the more cumbersome and expensive Chapter 11 filings as a last resort for cramdowns.
Moreover, cramdowns remain viable under Chapter 13 given that the court’s decision applies only to situations where the mortgage is secured solely by a lien on the debtor’s principle residence, said Newport Beach bankruptcy attorney Alan S. Wolf, who represents lenders.
Borrowers who pledge not only their properties as collateral but also their cars and businesses or sign mortgage contracts that also take a security interest in the appliances and furniture inside the homes can continue to seek cramdown relief, Wolf said.
Although few Californians have sought cramdowns to date, the decision comes amid conditions likely to spawn cramdowns, what with job losses growing, personal bankruptcies climbing and property values dropping.
The state has lost 500,000 jobs since the economy last peaked in mid-1990, according to the U.S. Department of Labor. Last year 88,265 households declared personal bankruptcies in a seven-county area surrounding Los Angeles, up 23% from 1991, figures from the administrative office of the U.S. Courts show.
The real estate community is awash with sad tales of fallen property values, Wolf said.
“We have seen depreciation of 20% to 40% in places like Brentwood, Orange County and San Diego. Generally, the faster prices went up, the faster they are going down,” Wolf said.
On average, the price per square foot of existing homes sold in Southern California has dropped 10% since peaking in May, 1990. In Los Angeles County alone the decline is nearly 13% since reaching an August, 1989, high, according to the Southern California Real Estate Observer.
Consequently, Polk said, the Nobelman decision is welcome news to his mortgage banking clients. “It is the right decision coming at the right time,” he said. “With the real estate market so depressed now, a decision to the contrary could have had catastrophic implications.”
If the ruling had gone against lenders, then the mortgage community would have begun demanding down payments of 50% instead of 20% or less, speculated Los Angeles accountant Richard A. Stewart, to offset the new risk, because “who can predict where the value of property is going.”
