Welcome to the first installment of “Franklin Square’s Supreme Court Picks”, where Franklin Square will go on the record to pick how the Supreme Court will come down on a current case, and will explain what the case is about, and what it means for you. Our first case is Bank of America v. Toledo-Cardona, which involves second mortgages during bankruptcy, and therefore can have potentially far-reaching consequences for homeowners who are underwater.
In the wake of the 2008 financial crisis, home values fell so drastically that many mortgages are underwater, meaning the home is worth less than what is owed on the mortgage. In some cases the second mortgage is completely underwater, meaning the home is worth less than what is owed on the first mortgage. Although bankruptcy allows car owners to cram-down their auto loans, meaning the principal balance of the auto loan is reduced to the present value of the vehicle, bankruptcy does not permit this for home loans. Instead, bankruptcy allows homeowners to strip-off second mortgages when the value of the home is less than the principal balance of the first mortgage. But at this time, homeowners can only strip-off second mortgages in a Chapter 13.
In Caulkett and its sister case, Bank of America v. Toledo-Cardona (both out of the 11th Circuit), Bank of America is arguing that allowing a homeowner to strip-off (essentially cancel) the second mortgage during bankruptcy would rob a creditor of their rights to recover any money should the value increase again. The debtors countered that in most cases, the second mortgage only possesses “hostage value”, as the second mortgage holder may be able to complicate negotiations between debtors and the first mortgage holders (i.e. extracting a payment from the debtor in exchange for not interfering with or delaying a short sale, deed-in-lieu-of-foreclosure or other alternative arrangement between the debtor and the first mortgage holder).
There are a host of policy implications for these cases, from the obvious effect on housing and bankruptcy policy to the effect on the second mortgage market and associated credit availability. This was not lost on the Justices, who questioned both parties on the potential ripple effects of a decision.
Parties also argued about the applicability of Dewsnup v. Timm, a 1992 case holding that when a mortgage lien is worth more than the market value of the property, the Bankruptcy code does not permit a court to reduce the value of the lien to match that value, i.e., it cannot be crammed-down. While the Court could find for the debtors in Caulkett without overturning Dewsnup, they would have to draw a bright-line distinction between partially and fully underwater liens, a position about which several of the Justices voiced hesitation.
However, it is more likely that the Court will either double down on Dewsnup and apply it to fully underwater mortgages or overturn it entirely. Justice Ginsburg stated that, “the law would be much more coherent if either Dewsnup applies to the totally underwater as well as partially underwater, or Dewsnup is overruled.” Justices Scalia and Kennedy are the only members of the current court to have ruled on Dewsnup (Justice Thomas was on the Court, but took no part in the decision). Justice Kennedy joined the majority opinion while Justice Scalia filed a dissent, a position he stated he still held during the oral argument in Caulkett. Justice Kagan, potentially of the same mind with her fellow liberal justices, stated that she had read both Dewsnup opinions, and found Justice Scalia’s dissent to be more convincing (an admission that prompted some celebration from her colleague).
It’s difficult to pick a winner in this case, as both sides faced a fairly equal number of questions (often a good indicator of how the Court will rule). No matter how the Court rules, expect Dewsnup to be a part of it, as the Justices focus on the weakness of the distinction between partially or fully underwater liens. Considering Justice Scalia’s position on Dewsnup, we predict that the Court will find for the debtors in this case and overturn Dewsnup, and we may see a rare situation where the famously conservative Justice Scalia plays the role of the swing vote. It’s worth mentioning that any fears from the conservative wing of the Court, about possible effects on lenders, may be assuaged by the Republican majority in Congress, which has the power to overturn the Court’s ruling via an overhaul of the Bankruptcy Code.
Brian Lee, D.C. State Chair for the National Association of Consumer Bankruptcy Attorneys (NACBA), and a friend of Franklin Square, shares Franklin Square’s pick. He points out that Chapter 7 bankruptcy allows a debtor to discharge unsecured debts, and where a mortgage is completely underwater, no component of the mortgage is secured in bankruptcy. Since, a completely “unsecured claim” under Section 506(a) cannot be “an allowed secured claim” under Section 506(d), he predicts the Supreme Court will allow the stripping of second mortgages in Chapter 7, much as they are currently allowed in Chapter 13.
Prediction: 5/4 or 6/3 in favor of Caulkett and Toledo-Cardona, with Justice Scalia or Justice Roberts authoring the majority.
Either way, expect a ruling this summer, and feel free to share your predictions in our comments section. If you’re looking for help on dealing with a second mortgage, managing a bankruptcy, or dealing with creditors, contact Franklin Square at (202) 779-9711.