Argument preview: Underwater mortgages and the Bankruptcy Code
on Mar 24, 2015 at 5:40 am
This morning at 10 a.m., the Court will hear oral arguments in two cases that at first blush look like they present a fairly dry bankruptcy question. But once unpacked and translated into less technical terms, Bank of America v. Caulkett and Bank of America v. Toledo-Cardona appear far more interesting and timely. The two cases, which have been consolidated for one hour of oral argument, deal with an all-too-common scenario in the wake of the housing crisis: a homeowner who files for Chapter 7 bankruptcy has two mortgages, but the value of the house is less than the primary mortgage. Does the Bankruptcy Code allow courts to void the second mortgage, which is essentially worthless? The Supreme Court’s answer could (depending on which side is right) hurt the bottom line of banks that have issued second mortgages or, alternatively, reduce the flexibility of debtors and banks holding first mortgages to work together to stave off foreclosures and keep the homeowners in their houses.
In 2006, David Caulkett bought his house for $249,500. He had two mortgages: one for $199,600 and one for $49,000. Then the housing market crashed, and the value of his house fell. In 2012, Edelmiro Toledo-Cardona refinanced his first mortgage for $135,900; there was also a second mortgage on the house for $32,000. Bank of America acquired both of the second mortgages to Caulkett’s and Toledo-Cardona’s houses. When he filed for Chapter 7 bankruptcy in 2013, Caulkett owed $183,000 and $47,000 on his two mortgages, but his house was valued at just $98,000. By the time he filed for bankruptcy that same year, Toledo-Cardona owed $135,000 and $32,000 on the mortgages on his house, which was worth only $77,689. Caulkett and Toledo-Cardona asked the bankruptcy courts to void their second mortgage liens, because both of them were completely “underwater” – that is, worthless, because the property’s value is less than the first mortgage.
Caulkett and Toledo-Cardona fared well in the lower courts. The bankruptcy courts granted the motions, and the lower courts affirmed. The U.S. Court of Appeals for the Eleventh Circuit relied on its 1989 decision holding that Section 506(d) of the Bankruptcy Code, which provides that a lien is void when it “secures a claim against the debtor that is not an allowed secured claim,” allows courts to void second mortgages that are completely underwater. That ruling, the Eleventh Circuit explained, was unaffected by the Supreme Court’s 1992 decision in Dewsnup v. Timm, holding that when a mortgage lien is worth more than the market value of the property, Section 506(d) does not allow courts to reduce the value of the lien to that market value. Because the Eleventh Circuit’s ruling conflicted with the holding of other courts of appeals, last fall the Supreme Court granted Bank of America’s petition for certiorari in both cases.
In its brief on the merits, Bank of America contends that the Court’s decision in Dewsnup made clear that Section 506(d) only allows courts to void liens securing claims that are invalid under non-bankruptcy law. It does not apply, the bank continues, to claims that have been allowed and are secured by liens on the underlying collateral. And that, it says, is precisely the scenario here. Moreover, the bank adds, the context, structure, and drafting history of the statute all indicate that Section 506 is intended to deal with the treatment of secured claims, rather than the treatment of liens. Other parts of the Bankruptcy Code deal with liens, including the limited scenarios in which lien-stripping is permitted. But, the bank warns, if Section 506(d) allowed liens to be stripped down – as the debtors suggest — “not only would those provisions be superfluous, but the limitations they impose on lien-stripping would be eviscerated.” And, it adds, although Congress has made extensive changes to the Bankruptcy Code in the twenty-three years since the Court’s decision in Dewsnup, it has never “giv[en] any sign that it disagreed with Dewsnup’s holding.”
The bank also warns of the practical problems that would follow a decision upholding the Eleventh Circuit’s ruling. As a result of the recession, it explains, scores of second mortgages were completely underwater. That in turn led to thousands of motions and complaints to void such mortgages in bankruptcy courts in the Eleventh Circuit. “Hundreds of such proceedings,” the bank notes, “have been brought against Bank of America alone.” But as the housing market rebounds, the bank explains, and home values rise, second mortgages that had been completely underwater may regain their value – and therefore should not be voided. Industry groups that filed an amicus brief in support of that bank add that junior liens are also an important part of the commercial real estate markets, cautioning the Court that “[t]he decision in these cases inevitably will ripple through that broader market,” which has relied on the Court’s decision in Dewsnup.
In their brief on the merits, Caulkett and Toledo-Cardona also depict the dispute before the Court as equally straightforward, albeit pointing in a different direction from the bank’s argument. They contend that, because each of the homes at issue in this case is completely underwater on the first mortgage, there is nothing left to secure Bank of America’s second mortgages. As such, they argue, the bank’s claims resting on those second mortgages cannot be secured claims, because Section 506(a) provides that a claim is secured “only to the extent of the ‘value of [petitioner’s] interest’ in each property, which is zero.” And if the claims are not secured claims, they conclude, then “the lien associated with that claim is void.”
Caulkett and Toledo-Cardona emphasize that the Court’s holding in Dewsnup did not resolve the question presented by this case. Far from it, they point out: although there was a hypothetical at the oral argument about a second mortgage that was completely underwater, the Court specifically declined to reach that question. And in any event, they add, the policy reasons underlying Dewsnup don’t apply in this scenario. Specifically, although the Court in Dewsnup “sought to stop a debtor from using bankruptcy to give the creditor a worse deal than it might have gotten in foreclosure,” if the Court were to rule in favor of the bank here, the holder of a junior mortgage would get a better deal than it would have gotten in foreclosure. A ruling for the debtors would also be consistent with the Court’s cases before the enactment of the Bankruptcy Code, when it allowed completely underwater second mortgages to be voided because they don’t have any value to protect.
More generally, the debtors contend, allowing debtors to strip off a junior mortgage is a good thing. It can help to prevent foreclosures and the problems that come with it, because it makes it easier for the debtors and the holders of the first mortgage to work together to modify a loan to allow the debtors to keep making payments and stay in their houses. This is not necessarily unfair to the banks that hold the junior mortgages, they tell the Court: “Second mortgagees bargained for their subordinate position and should expect that if their mortgages sink completely underwater, their worthless liens can be extinguished in foreclosure.”
