The $700 Billion Bailout, The Problem With Short Sales and The Benefits Of Chapter 13 – What Does It Mean For The Homeowner?

Everyone has been hearing about the government’s unprecedented $700 billion bailout of the financial industry, coming in the wake of the Lehman Brothers Chapter 11 bankruptcy (the biggest bankruptcy ever). Congress is debating the terms of any possible bailout. One of the issues that may be on the table is a revision to Chapter 13 bankruptcy laws to finally allow borrowers to modify the terms of a home mortgage, something that is currently prohibited under the law. Meanwhile, many people are still filing the typical 13 case where mortgage arrears are cured over a 5 year period with monthly payments or where the home is simply surrendered in full satisfaction of the debt.

If a homeowner could “cramdown” a first mortgage and have a bankruptcy court allow payments to be modified in a Chapter 13 plan, it would shift power back in favor of the consumer. I am advising all new clients who are considering a Chapter 13 case because of mortgage or credit card debt to schedule an appointment with our office right away to discuss the specifics of their case. Even those who are inclined to wait for the bailout to become reality should speak to a lawyer without delay. There are many things a lawyer can do to help such as contacting the attorneys for the client’s lender and other creditors, attempting to negotiate workouts or forbearance agreements, or even begin the process of preparing Chapter 13 papers (which takes some time to do properly) without actually filing the case yet. Waiting is risky because foreclosure will continue while interest and lender’s legal fees accumulate.

While refinancing no longer seems to be a viable alternative for many – given the current market, lenders have very strict lending requirements and homeowners do not have sufficient equity — another alternative that is being considered by many is the short sale. This basically involves selling the property to a third party for less than what is owed on the loan and getting the bank to agree to this. This can often be a fantasy with a bitter ending.

Many homeowners have discovered that banks actually do want to get blood from a stone, so to speak. Banks are now asking homeowners, whose short sales are approved, to also sign a promissory note for the deficiency balance. In other words, banks want their borrowers to remain responsible to pay any loan balance that is still due after the property is sold. This will create a situation where borrowers short sell their home and move into a rental apartment while carrying a large deficiency balance to be paid with interest over a period of years under a note.

It seems to me that this brings us back full circle to Chapter 13 where very often the borrower could have accomplished the same thing while saving money and aggravation – by proposing a plan to surrender the home to the lender and then pay the deficiency over 5 years

with no interest

and possibly pay it at a reduced percentage while discharging the rest – in other words, a Chapter 13 debtor may be able to get out of the mortgage debt right now if he is willing to give up the home and may be able to save thousands by paying back remaining debts at far less than 100% depending on the debtor’s income. This is something that anyone considering a short sale should discuss with their lawyer first.

The New York Times has an excellent article on the recent trends of banks asking for repayment of deficiency balances after short sales: “The Pain of Selling a Home for Less Than the Loan.”