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Loan Modification or Chapter 13 Cram-down?

In 2009 Congress enacted the Helping Families Save Their Homes Act of 2009, which among other things requires federally insured lenders to engage in loss mitigation actions for the purpose of providing an alternative to foreclosure, including forbearance, loan modification, and deeds in lieu of foreclosure.  Perhaps the most popular among these initiatives is loan modification. Loan Modification is the restructuring of the loan.

But how successful is loan modifications as a foreclosure alternative and how well does it compare to other loan restructuring alternatives including chapter 13 bankruptcy’s so-called cram down strategies?

In our debt relief practice we find that most clients would prefer a loan modification strategy to chapter 13 cram down strategy–at least initially.  While motivations may vary somewhat, it appears to us anecdotally that loan modification is preferred primarily as a method to avoid the stigma of filing for bankruptcy. We appreciate the well-intentioned motive, but question whether loan modification alone is a superior financial strategy in the long-term.

Loan modification, in our experience, typically involves a rate reduction, extension of the loan term, and re-amortization of past due amounts.  In contrast, a successful cram down following a chapter 13 is in effect a discharge or principal reduction of a second mortgage.  While we have seen lenders occasionally include a principal reduction as part of a loan modification, our experience is that a principal reduction is rare.

Because nearly all of these properties that are pursuing a modification are already upside-down, a modification merely addresses the symptom of an overpriced property and doesn’t address the underlying negative equity problem.  For those of us who do not believe that real estate will “recover” in the near future (we believe the current depreciation is a natural course correction following false appreciation), a modification will exacerbate and perpetuate the negative equity problem.  The negative equity will invariably rear it’s head when the borrower wants or needs to sale the property in the future.

In contrast a successful chapter 13 cram down will bring the debt on the property more in line with the true or corrected value of the property with the under secured portion being discharged.  For this reason cram down will leave the borrower in a better long-term financial position standing alone.

Chapter 13 cram down is not available in every situation.  Sections 1322 and 506 of the bankruptcy code permits bankruptcy courts to reduce or “cram-down” a wholly unsecured second mortgage of a principal residence in Chapter 13 bankruptcy. The unsecured portion is lumped with all other unsecured debt of the debtor, potentially receives some repayment under the Chapter 13 plan and then discharged upon completion of the plan. This is true because no portion of the debt is “secured” as defined by Section 506 of the code. If any portion of a mortgage of a principal residence is secured (based on its replacement value), however, the mortgage may not be crammed-down.  In addition cram-down is available on all second homes or investment properties to the extent that ANY portion of any debt is under-secured.

For these reasons standing alone chapter 13 is a financially preferable strategy when the debtor’s situation avails itself to a cram down.  Loan modification is not without its place, however.  When a debtor’s financial distress is limited or the debtor doesn’t qualify for chapter 13, then loan modification is a good alternative to foreclosure.

Moreover, chapter 13 cram-down and loan modification are not mutually exclusive.  The most powerful restructure of the debt would be to cram-down the second mortgage and modify the primary debt of the property.  The combination of cram-down and loan modification would address both monthly mortgage expense as well as addressing the property’s negative equity leaving the debtor in the best possible financial position for the future and avoiding foreclosure.