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Why the Supreme Court Might Actually Rule Against the Corporate Interest

Homeowners have a lot at stake in Tuesday's Bank of America case

Spencer Platt/Getty Images

King v. Burwell isn't the only Supreme Court case this term that will determine the fate of millions of poor and vulnerable Americans. Bank of America v. Caulkett, to be heard Tuesday, is a technical case about the bankruptcy code, but if the bank succeeds, it would make it more difficult for people to start over when debt burdens become unmanageable. “It will affect many people’s pocketbooks,” said Bob Lawless, bankruptcy law professor at the University of Illinois. 

The Caulkett case has a link to the foreclosure crisis. Under current law, primary residence mortgages cannot be modified in bankruptcy, unlike vacation homes, yachts, car leases, and almost every other form of debt, with the notable exception of student loans. That’s because of a 1992 Supreme Court case called Dewsnup, which barred bankruptcy judges from stripping down an underwater first mortgage to its market value. Liberals wanted the bankruptcy “cram-down” option available to prevent a flood of foreclosures, but a bill to change the law failed in the Senate in 2009. As Dick Durbin famously said, the banks "frankly own the place.”

In Caulkett we’ll see if they own the Supreme Court too, and if they can extend that prohibition on modifying primary mortgages in bankruptcy to a prohibition on extinguishing second mortgages in one part of the bankruptcy code. Second mortgages, often home equity loans, use the home as collateral, but the secured claim is junior to the first mortgage. So if the house is worth $200,000, and the first mortgage is owed $250,000—a phenomenon known as an “underwater” home—that second mortgage will receive no money in a foreclosure sale. 

Right now, in a Chapter 13 bankruptcy, you can “strip off” a second mortgage on an underwater home, but you weren’t allowed to do it in a Chapter 7 bankruptcy. The 11th Circuit Court of Appeals, using an old case in its circuit as precedent, said that stripping off the second mortgage was allowed under Chapter 7, and did so for Mr. David Caulkett of Melbourne, Florida.

In June 2006, Caulkett purchased a classic “80/20” loan from Countrywide Financial (now part of Bank of America), entirely financed with no money down, with 80 percent as a first mortgage and 20 percent as a second. In 2013, he filed for Chapter 7 bankruptcy. The home was valued at $98,000, but Caulkett owed $183,264 on just the first mortgage, and $47,855 on the second. The bankruptcy judge in the 11th Circuit stripped off the worthless second mortgage, but Bank of America appealed, arguing that Dewsnup also applies to this second mortgage, which they say cannot be extinguished under Chapter 7. 

The reason it matters that you can strip off a second loan in Chapter 13 bankruptcy but not Chapter 7 is that Chapter 7 is a much more affordable part of the bankruptcy code. “Chapter 13 has a payment plan, you only get the strip-off if you complete the plan,” said bankruptcy expert Bob Lawless. Only about 40 percent of Chapter 13 cases complete the payment plan, which is three times as expensive as in Chapter 7. In cases where debtors have a second mortgage—and a large number were sold during the housing bubble—Chapter 7 would be effectively unavailable to them unless Caulkett prevails. 

That’s because of what happens after bankruptcy. Bank of America argues that the second mortgage should remain an “allowed secured claim,” holding onto its lien on the property regardless of the state of the first mortgage. Subsequently, the second mortgage holder would have “hostage value.” Even if the debtor wants to come to a loan modification or short sale on the first mortgage, the second mortgage holder could block it, and demand a settlement payment, basically a bribe, to make their claim go away. This creates a valuable asset out of something with no value. 

Supporters of Caulkett argue that the secured claim of the second mortgage becomes unsecured when the house is so far underwater as to make it worthless. Under bankruptcy, the owner of the second mortgage can go in and try to show value, and receive some level of payment. But under Chapter 13, they don’t keep the lien, and under this argument, they shouldn’t in Chapter 7 either. “Back in the day there was this thinking that it’s property, we treat it differently,” said Bob Lawless, who wrote an amicus brief in the case. “In a context where the lien has no value, the code should properly allow the court to make that lien go away.”

Second mortgages have high interest rates precisely because of the junior nature of their collateral claim, and the risk of getting nothing back in a foreclosure. “Applying Dewsnup to cases involving wholly underwater second-lien mortgages would have the perverse effect of enabling (Bank of America) to do better in bankruptcy than it would at state law,” wrote Adam Levitin, law professor at Georgetown University, in his amicus brief.

Bank of America argues that lien-stripping in bankruptcy would make mortgages more expensive, but losses from foreclosure usually exceed those on a modified loan, particularly in the case of second mortgages. Anyway, as Levitin says, the second-mortgage market has shrunk since the housing bubble collapsed (although it’s been coming back a bit lately); a stronger claim in bankruptcy could strengthen the riskiest versions of the product. “Given the abuses that occurred in the second-lien mortgage market,” Levitin wrote, “this Court should not resuscitate it.”

The outcome has implications for more than people in bankruptcy. “The rule merely sets the default,” Bob Lawless said, “but then what happens in the real world, debtors and creditors bargain against the rule.” Allowing strip-off would give borrowers more negotiating leverage prior to bankruptcy to reach an equitable solution, precisely the thinking behind cram-down.

Don't assume that John Roberts' Court will automatically rule for the corporate interest over the individual. In Dewsnup, the case Bank of America is trying to expand, Justice Scalia wrote the dissent. He said the victorious argument relied on a very strange reading of the bankruptcy code, and particularly the phrase “allowed secured claim.” This created to Scalia an absurdity, which he spells out by making the exact example at issue in Caulkett: “A secured creditor holding a lien on property that is completely worthless would not face lien avoidance… even if the claim secured by that lien were disallowed entirely.” Justice Clarence Thomas did not participate in Dewsnup, but criticized it later.

Bankruptcy law evolved over 150 years to protect only that which has value. Since 1992, the financial industry has chipped away at it to give protections to property regardless of the value of the claim. Now they want to chip away some more. There are real-world effects here for whether people in financial distress will be allowed to get a second chance, a core American value prescribed in the law.