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The Value of Lien Stripping

lien stripping & bankruptcy

The depressed real-estate market in Southern California has left many homeowners and commercial-property owners in a difficult position. Their properties are completely "underwater."

The depressed real-estate market in Southern California has left many homeowners and commercial-property owners in a difficult position. Their properties are completely “underwater.”

Believing the value of real estate would continue to rise, many people borrowed heavily against the equity in their real-estate holdings to finance other property acquisitions, property development and rehabilitation and other expenses. In many cases, those with equity in property took out second or even third mortgages to support further acquisitions and expansions.

Now that the real-estate market has declined, these same people and companies are left with so-called underwater mortgages, meaning they owe substantially more on their mortgages than the value of the properties securing them. In many cases, property owners are unable to pay the debt service and other expenses associated with their properties.

This is especially true when loan terms “reset” — meaning that the low “introductory” or “preliminary” interest rate offered under the loan is no longer available. Pursuant to the terms of the promissory note, the loan interest rate adjusts to the market rate plus an index, or the option of paying an interest only or negative amortization rate payment expires.

The loan often adjusts at this time to a fully amortized payment schedule, resulting in a substantially higher payment. When these payments are significantly greater than the income received on the property, borrowers are often unable to make the payments. In these circumstances, many property owners have chosen to file for bankruptcy relief in order to “strip” the excesses debt from their property.

Lien Stripping

For someone in this position, lien stripping may be an effective way to address the situation without losing the property to foreclosure. Generally, lien stripping is the process of reducing a secured claim to the value of the underlying collateral.

So, for example, if the owner of commercial real estate has a $10 million mortgage on it but the property’s present-day value is only $6 million, the property owner may be able to essentially reduce the mortgage to $6 million through lien stripping.

How Does This Work?

Lien stripping divides a creditor’s claim into two pieces, secured and unsecured portions. The secured portion must be paid in full, but this claim is equal to the value of the property (see the example above). The unsecured portion is “stripped” and removed from the property entirely, becoming an unsecured claim, like credit card debt, which can be paid at pennies on the dollar under a bankruptcy plan of reorganization.

The analysis of what debt can be stripped and the ability of a debtor to propose a feasible plan of reorganization in bankruptcy is a complex matter which requires the assistance of experienced Chapter 11 counsel. Among other things, a bankruptcy attorney must evaluate the ability to service the restructured debt and the application of the provisions of the bankruptcy code to each individual’s circumstances.

Restrictions for Primary Residential Property

Although this option might sound promising for many homeowners with underwater mortgages, there is unfortunately one important restriction. For a primary residence, unless the creditor consents, a homeowner is only eligible for lien stripping if the mortgage in question is completely underwater.

If any part of the mortgage is eligible to be secure based on the value of the home, the entire mortgage is secure and the lenders agreement is required in order to modify it. This makes reduction of principal balance of first mortgages difficult. However, it generally has a lesser impact on second and third position mortgages which are often completely “underwater”.

For example, if a homeowner’s primary residence is currently valued at $800,000 (or less), and the homeowner has a first mortgage for $800,000 and a second mortgage for $300,000, the second mortgage can be stripped completely. The first mortgage is the only allowed secure claim.

If instead the home is valued at $900,000, the first mortgage is $800,000 and the second mortgage is $300,000, both mortgages are secure. Because $100,000 of the second mortgage is eligible to be an allowed secure claim, the entire mortgage is secure. As the Supreme Court clarified in Nobelman v. American Savings Bank, one cannot strip off the unsecured portion of an undersecured claim from a debtor’s personal residence.

A Noteworthy Exception: Section 1111(b)

Although the bankruptcy code provides for lien stripping, it also provides an alternative for creditors who are only partially secured. A creditor who has both an allowed secured claim and an unsecured claim may elect to have the entire claim treated as a secured claim.

However, when creditors elect this option, debtors are only required to pay the present value of the interest. Although such creditors will ultimately receive a higher payout than those who divide their claims into secured and unsecured claims, this payout will come over a much longer period of time.

As a practical matter, creditors rarely elect this option. However, anyone considering lien stripping should be aware of all potential outcomes.

Conclusion

Despite significant efforts to improve the real-estate climate, the market continues to struggle. According to a newly released report by the U.S. Commerce Department, new home sales tumbled 33 percent in May, and sales of previously owned homes fell unexpectedly as well.

Commercial real estate does not seem to be faring much better. Though the numbers indicate that values are rebounding, Business Week reports that commercial property values may ultimately remain more than 40 percent below their 2007 peak levels. Accordingly, many commercial property owners will likely find themselves liable for mortgages that far outpace the actual value of their properties.

In such cases, bankruptcy and lien stripping may be among the most promising options for ensuring future profitable operations and retention of the properties. To learn more about these options, speak with a knowledgeable bankruptcy attorney.

Article provided by Weintraub & Selth, A Professional Corporation
Visit us at http://www.wsrlaw.net

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