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Seventh Circuit Declines to Strip Off Second Mortgage on Underwater Home - Palomar v. First American Bank

July 16, 2013

Vincent Howard and our Riverside County consumer bankruptcy attorneys have written here several times about "lien stripping" in the wake of the housing crisis. When a homeowner has an entirely worthless second (or subsequent) mortgage--unfortunately now a common occurrence because so many homes are worth less than the first mortgage's value--the bankruptcy court may change it into an unsecured claim. This is lien stripping, and it's available for Chapter 13 debtors on primary homes. But in Palomar v. First American Bank, a bankruptcy judge declined to hear a lien-stripping request because their Chapter 7 case had been closed before the court was ready to consider it. Alejandro and Rafaela Palomar of Illinois appealed the refusal to reopen the case, but the Seventh U.S. Circuit Court of Appeals affirmed, saying the bank made no claim and the lien might even add to the value of their home, if the market reverses.

The Palomars filed for Chapter 7 bankruptcy in July of 2011. A month later, their bankruptcy trustee filed a report showing that they had no assets. They discharged their debts and the case was closed in December of the same year. However, the Palomars had filed an adversary proceeding on the day before the no-assets report, against the holder of their home's $50,000 second mortgage, First American Bank. Their first mortgage was worth $243,000 and their home was appraised at $165,000, so the adversary complaint argued that the second mortgage was worthless and should be stripped. The judge refused to reopen the bankruptcy case once the adversary proceeding was ripe, saying the Palomars' claim was meritless. He dismissed it instead. First American did not respond to the adversary action, the Palomars' appeal to the district court or their subsequent appeal to the Seventh Circuit.

Lien-stripping is largely available only in Chapter 13 (or Chapter 11) cases, the Seventh said, and the Palomars do not fall into one of the cases where it's available in Chapter 7: cases where the lien is on an asset that's already exempt property. The Palomars are attempting to "cram down" their loan, the Seventh observed, which is not permitted. Indeed, the court said, it's unlikely that First American will bother to foreclose right now (though it retains the right); it would have to pay legal fees to acquire property that wouldn't provide any value. From a practical standpoint, the court said, extinguishing the lien would not improve the Palomars' financial situation; it might actually deprive them of a chance to make money if the value of the home rebounded past the value of the first mortgage. It affirmed all of the lower courts.

Vincent Howard and our Westminster personal bankruptcy lawyers sympathize with the Palomars, who likely didn't have the option of filing for Chapter 13, due to their very low assets. The bankruptcy court does not mention this, but with the lien still active against them, they will continue to owe the debt to First American despite the worthlessness of the lien. Thus, they will continue getting bills and having their credit hurt by their presumed inability to pay those bills. That's one reason the Redlands individual bankruptcy attorneys at Howard Law, P.C., supported the brief and unsuccessful attempt to restore bankruptcy judges' ability to cram down underwater mortgage loans. Another is that the prospect of a cramdown might give loan servicers an incentive to offer true loan modifications.

If you're considering bankruptcy as a way to hold on to your home, don't wait to call Vincent Howard and the team at Howard Law to discuss your situation. Send us a message online or call 1-800-872-5925 today.

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