Is your second mortgage safe? Supreme Court to decide whether second mortgages are worth the paper they’re printed on

On March 24, 2014, the Supreme Court heard argument in a pair of cases that present an important question for banks holding second mortgages: Can a debtor who files for Chapter 7 bankruptcy strip off a second mortgage if the outstanding debt owed on the first mortgage exceeds the value of the collateral. The Court of Appeals for the Eleventh Circuit (which covers Alabama, Florida, and Georgia) held that § 506(d) of the Bankruptcy Code gives the bankruptcy court authority to strip off second mortgages when the collateral’s value is less than the debt owed on the first mortgage.

Bank of America has appealed both of the cases on review. In the first case, Bank of America v. Caulkett, the debtor purchased his house of $249,500. The house was subject to a first mortgage for $199,600 and a second mortgage for $49,000. After the recession the debtor’s house depreciated to $98,000. At the time that he filed for Chapter 7 bankruptcy the balance owed pursuant to the first mortgage was $183,000 and the balanced owed pursuant to the second mortgage was $47,000.

The second case, Bank of America v. Toledo-Cardona, has a similar fact pattern. When the debtor filed for Chapter 7 bankruptcy $135,000 was owed pursuant to the first mortgage and $32,000 was owed pursuant to the second mortgage. The debtor’s house was valued at $77,689.

Bank of America, which has lost at every level up to this point, argues that stripping off second mortgages creates a host of problems for lenders. In particular, Bank of American contends that as the economy improves some second mortgages may regain value. Bank of America also points out that finding in favor of the debtors will subject banks to thousands of debtors’ motions trying to invalidate second mortgages.

Until these cases reached the Supreme Court, most courts had relied on a prior Supreme Court decision that seemed to close the door on bankruptcy courts stripping off second mortgages. That case, Dewsnup v. Timm, held that in a Chapter 7 bankruptcy § 506(d) of the Bankruptcy Code does not give the bankruptcy court authority to “cram down” the value of the lien to equal the value of the collateral. In other words, a Chapter 7 debtor whose home is underwater cannot use the bankruptcy court to reduce the amount of the mortgage lien against his property.

The Supreme Court will likely take at least a month or two to issue a decision after argument. The consequences of this decision could be significant. Outside of the Eleventh Circuit, every other federal court of appeals, including the court that covers Iowa, to have considered this issue has ruled in favor of the banks. As always, banks should discuss their concerns about security interests with their attorneys.