Think Again Before Walking Away From Second Trust Deeds In Bankruptcy

Banks and credit unions routinely walk away from second trust deeds where there isn't enough equity to cover the outstanding loan balance plus interest, arrears, costs of sale and attorneys' fees. This is especially true where the borrower files a chapter 13 bankruptcy case, which allows certain secured liens to be completely avoided.1

But there is no reason for banks or credit unions to unknowingly and prematurely walk away from second trust deeds that are given special protections in bankruptcy.

The problem for borrowers who file a chapter 13 bankruptcy case is the "anti‐modification provision" of Bankruptcy Code section 1322(b)(2), which protects second trust deed holders from having their loans modified if both: (1) the property securing the lien is the debtor's principal residence and (2) there is any value, even $1, to support the lien.2

Expected Procedure in Chapter 13 Cases

In practice, a debtor may file a chapter 13 case and move the court to avoid her second trust deed on 14 to 21 days' notice. These motions are usually supported by a declaration of the debtor stating some self‐serving belief that her residence is worth a few thousand dollars less than the amount owed on the first trust deed (so as to avoid the anti‐modification provision). Prudent banks and credit unions will (1) quickly determine whether there is any equity to support their second trust deeds3 and (2) if so, file an opposition to the debtor's motion (often due within 7 to 14 days of the notice) and request an opportunity to appraise the property.

Bankruptcy courts typically respond to objections by continuing the hearing on debtor's motion and setting an "evidentiary hearing" to allow the parties to file declarations of appraisers (with full appraisal reports) and request cross‐examination of the other side's appraiser. These evidentiary hearings can be costly and extremely risky to both sides (and the judges often disdain hearing them). In essence, if the bankruptcy court finds any equity to support the second trust deed then the entire loan is preserved. But if the court finds no equity, then the entire loan is avoided. In essence, bankruptcy law creates an all‐ornothing proposition that often can (and should) be avoided.

Striking Deals to Get Around the All‐or‐Nothing Proposition

With increased frequency, informed banks and credit unions make deals with borrowers to reduce the cost and risk of evidentiary hearings for both sides. For example, on a $100,000...