The ongoing turmoil being felt within the mortgage industry has had far-reaching effects upon both the local and national economies.
With foreclosure rates skyrocketing, many regions of the country have seen a decrease in home values due to the glut of homes on the market, the increased numbers of vacant or abandoned homes, and the decrease in creditworthy buyers due to the inevitable tightening of credit standards across the industry.
As the mortgage industry has seen an unprecedented increase in the number of defaults and foreclosures, the inevitable result has been an increase in bankruptcy filings across the nation, coupled with a groundswell of negative publicity and litigation directed at mortgage lenders and servicers.
Further, bankrupt borrowers are simply surrendering homes in ever-larger numbers and discharging their obligations under the promissory note. Consequently, mortgage servicers and their counsel have been forced to reevaluate the handling of these defaulted loans in bankruptcy.
The traditional reaction to a defaulted loan in bankruptcy has always been to seek relief from the automatic stay provided by 11 U.S.C. 362 in order to get the loan back into the foreclosure stream as soon as possible – leading ultimately to a sheriff's sale of the property.
In the past, the assumption had always been that lenders would recover all, or a large portion, of their balance from the sale proceeds. However, with the new reality of decreasing home values setting in across the country, servicers and their counsel have been seeking creative ways to keep borrowers in their homes and maintain a stream of payments.
Recently, lenders dealing with a defaulted loan in bankruptcy have been much more likely to offer loss mitigation options to the borrower in the form of reduced interest rates, conversion from adjustable- to fixed-rate interest, forbearance agreements or short sales.
All of these options take into account the reality that the housing market simply cannot sustain the constant addition of newly foreclosed properties to the inventory. For the short term, it would seem practical for servicers to create and expand loss mitigation programs for bankrupt borrowers as a way to maximize recovery and minimize the losses incurred.
The continuing wave of real estate loan defaults and the corresponding negative media coverage of mortgage lenders and servicers has created an unfriendly climate throughout the nation's bankruptcy courts within which lenders and servicers must now operate.
A number of recent bankruptcy court rulings, along with potential congressional action, have illustrated to lenders and their counsel in no uncertain terms that the bankruptcy landscape is fraught with peril.
As a reaction to the current mortgage crisis, both the U.S. House of Representatives and the Senate have proposed amendments to the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act which would radically alter the treatment of real estate secured loans in bankruptcy.
The Emergency Home Ownership and Mortgage Equity Protection Act (H.R.3609) and the Helping Families Save Their Homes in Bankruptcy Act (S.2136) seek to allow bankrupt borrowers to adjust the secured portion of their loans down to the property's value, reduce the interest rate on the loan and reschedule or adjust payments.
If enacted, the damaging long-term effects of these proposals cannot be overstated. No longer would lenders be secure in the knowledge that the original terms of their loans could not be altered. Instead, every new loan issued would need to include a risk factor that the contractual balance, interest rate or payment structure may be altered if the borrower sought bankruptcy relief.
This turn of events would have a chilling effect upon the industry as a whole. Mortgage lenders and their servicers should monitor these events closely and are encouraged to lobby Congress in opposition to the proposed bills.
Several bankruptcy judges also appear to have taken up the cause of borrowers, to the detriment of mortgage lenders.
The Schuessler case, which is currently pending in the U.S. Bankruptcy Court for the Southern District of New York, demonstrates the potential hazard to lenders in maintaining long-standing internal policies which appear benign in their intent, but which courts are increasingly calling into question.
Basically, the Schuessler court is challenging a lender's policy of refusing to accept bankrupt debtors' payments made directly at branch locations.
In support of its policies, the Schuessler lender has reasoned that, by requiring bankrupt borrowers to make their mortgage payments either by mail or phone, a protection is afforded to the borrower by ensuring that payments are accurately processed.
However, the Schuessler court, in issuing its order upon the lender to appear and show cause, has hinted that sanctions may very well be warranted and that its policies have ‘created an obstacle course for debtors who desire to make their contractual mortgage payments.’
A recent class-action lawsuit filed in the U.S. Bankruptcy Court for the Southern District of Texas is attempting to challenge the use of default servicing companies by mortgage servicers.
The suit centers on the legal fees incurred when a default servicer hires an attorney to provide representation to a mortgage servicer in a bankruptcy proceeding. The allegations include ‘illegal kickbacks’ to the default servicer and the improper assessment of attorney fees back to the borrower.
While the ultimate outcome of this class-action suit will not be determined for some time, it is fair to say that the case will have significant effects upon the relationship between lenders and servicers and will impact how servicers conduct their bankruptcy business in the future.
The issue of mortgage assignments has become a hot-button issue in northeast Ohio, both in state court and bankruptcy court. For instance, a federal judge in Cleveland recently dismissed several pending foreclosure actions due to the lender's failure to record assignments in the name of the filing plaintiff prior to commencement of the foreclosure suits.
In turn, several bankruptcy judges sitting on the bench throughout the Northern District of Ohio have revised their policies related to lenders' motions to lift the automatic stay. The bankruptcy courts are now routinely denying lenders' motions based upon ‘chain of title’ issues, including assignments and servicing agreements.
In the long run, this trend will require lenders to modify the manner in which mortgages are assigned and will require closer scrutiny by lenders and their counsel when a loan is ripe to refer for bankruptcy representation.
These recent developments will require mortgage lenders and servicers to implement creative and innovative loss mitigation programs for their borrowers and will further require increasing vigilance in handling defaulted loans in bankruptcy.
Regardless of whether an amendment to bankruptcy code is implemented or not, lenders can expect continued challenges to the way they conduct business.
Scott D. Fink is senior bankruptcy associate in the Brooklyn Heights, Ohio, office of Weltman, Weinberg & Reis Co. LPA. He can be reached at (216) 739-5644 or firstname.lastname@example.org.