Underwater homeowners are jumping onto an unexpected financial life raft that lets them escape crippling second mortgage debts and keep their homes -- Chapter 13 bankruptcy.
It's an unprecedented byproduct of the housing price collapse, says New York City bankruptcy attorney David Shaev of Shaev & Fleischman.
How it works is this: If the home is appraised at less than the value of the first mortgage, the owner can apply for permission in bankruptcy court to reclassify the second mortgage debt. That changes it from a secured debt, which must be repaid, into an unsecured debt, which does not have to be paid in full. The homeowner can then focus on paying off the first mortgage.
"This is the only time where you see such a huge percentage of houses worth less than the first loan, allowing us to basically get rid of the second loan," says Shaev, who estimates that 20 percent of his Chapter 13 clients who own homes qualify for this type of workout. "We're at a unique place in history."
The nation's banks could take a huge hit from the increased use of Chapter 13 protection. The big four banks, Wells Fargo, Citigroup, JP Morgan Chase and Bank of America, hold $435 billion of the $1 trillion in second liens outstanding, according to a new report by Amherst Securities. These banks are also the largest servicers of first mortgage loans.
Borrowers generally prefer loan modifications to bankruptcy. But desperate clients often arrive in Shaev's office after failing to reach agreements with their banks, despite new government efforts to encourage out-of-court deals.
Reclassifying a second lien helped Westchester homeowner Stuart S., who withheld his last name because of embarrassment about filing for bankruptcy, keep the home he bought for his wife and two children.
In 2005, at the height of the real estate frenzy, a professional appraiser valued his home at $850,000. When illness prevented his wife from working, Stuart obtained a $180,000 second mortgage. She planned to return to work, and the couple figured they could sell their home if they ran into financial trouble.
Instead, the financial crisis hit. Stuart's wife has been unable to regain the high salary she once enjoyed, and their house is now worth only $550,000 -- a stunning 35 percent drop in value that leaves them underwater on their $570,000 mortgage.
Before heading to bankruptcy court, Stuart tried to work out a deal with second-lien holder Wells Fargo.
Wells granted a temporary reduction, said Stuart, but then asked for full payments again. Unable to comply, he found a solution in bankruptcy court. Wells Fargo declined to comment.
"It's not a thing you want to do unless you're desperate enough," said Stuart S. "But I couldn't do anything by negotiating directly with the lender."
Second mortgages are dragging borrowers down for several reasons. First, homeowners with second mortgages are more likely to be underwater and to struggle to meet their first mortgage obligations. In addition, second liens average about 20 percent of the loan amount -- a significant chunk -- according to Laurie Goodman, senior managing director at mortgage-bond trader Amherst Securities Group.
The Obama administration has moved to address this crisis with its Second Lien Modification Program, or 2MP, announced with great fanfare earlier this year with a target of helping 1 million to 1.5 million homeowners.
The program, part of Making Home Affordable Program, has been slow to get off the ground.
The four major banks have signed on. But a JP Morgan Chase spokesman gripes that the bank is currently limited to working with borrowers for whom it services both the first and second liens, because the government's loan matching files won't be available until next month. This spring, Chase identified 1,251 accounts that meet the 2MP guidelines. More than 800 of those qualified without a trial period, and 593 sent in completed documents to Chase. Another 224 had worked out three-month trial deals as of late June.
"The housing problem is going to go on for years and years and years, and seconds are a major contributor to the problem," said Amherst's Goodman.
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