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Notes -
Court opinion somewhat relevant to the culture war:
According to lawmakers: "New Jersey is consistently in the top three in the nation with the highest foreclosures. Our state also has the widest racial wealth gap in the country. Black and brown wealth is hemorrhaging through the loss of foreclosed property, and the people who live in the community often do not have deep enough pockets to even participate in the foreclosure process." "The current process favors companies that have the money to purchase property at sheriff sales and resell it for a profit." In response to these concerns, the state govt. enacts a law ensuring that, whenever a residential property is foreclosed on, a right of first refusal is granted to the owner, his next of kin, and his tenants (if the owner is an individual rather than a company), and a right of second refusal is granted to certain redevelopment-oriented nonprofits (regardless of the owner's identity). Normally, foreclosure results in an auction starting at an "upset price" (minimum/reserve price) set by the foreclosing lienholder (presumably the lender of the property's first mortgage). However, these two new rights of refusal allow the property to be purchased for the upset price without an auction. The lawmakers say: "This legislation will help to keep property ownership within the community." "This is what equity in systems looks like."
However, the new law causes problems because it often results in undervaluation of the property, so that junior lienholders don't get paid back. For example, in one of the cases consolidated here: A residential property with estimated fair market value of at least 680 k$ was foreclosed on. US Bank held a first mortgage for 281 k$, and PNC Bank held a second mortgage for an amount that I can't find in the court documents. US Bank set the upset price at 309 k$. PNC was prepared to bid the auction up to 401 k$, which presumably would suffice to pay off both mortgages. However, instead a nonprofit exercised its right of second refusal and bought the property at the upset price of 309 k$, paying off US Bank's mortgage but leaving PNC with substantially less than what it would have gotten at auction. In PNC's words: "The refusal to recognize other bids results in illegal lien-stripping and the illegal taking of substantial surplus that would have been realized, and the deprivation of PNC's property interest that would have attached to that surplus." (PNC also alleges that the nonprofit is a sham. It was created just a few days before the auction would have taken place, and is not registered as a nonprofit with the state govt. or with the federal IRS.)
The trial judge rules that the nonprofits' right of second refusal is an unconstitutional taking without just compensation, and the appeals panel affirms. The federal Supreme Court recently found that it is unconstitutional for the govt. to foreclose on a property for a 200-k$ tax delinquency, sell it at auction for 300 k$, and pocket the extra 100 k$. Likewise, if a property is encumbered with a 300-k$ mortgage, it is unconstitutional for the govt. to let a nonprofit buy it for 200 k$ and magically extinguish the extra 100 k$ of debt owed to a lender. (Nobody has invoked the owner's, next of kin's, and tenants' right of first refusal, so it technically is not at issue in this case. But if the right of first refusal is challenged in the future it presumably will be held unconstitutional under the same rationale.)
As a side note, it seems like this New Jersey law (before it got struck down) was an open invitation for people to engage in this kind of fraud.
As a second side note, I have to ask: If this law had not been struck down, what bank would ever write a HELOC or other loan secured by a second mortgage? Maybe I don't understand the law correctly, but it seems like it's almost guaranteed that if the first mortgage is foreclosed for any reason, the remaining equity will get stripped away.
Basically, it seems like this is a case of liberal legislators not thinking carefully about the incentives they are creating. But maybe I am missing something.
Yeah, the way the law was written, it appears a homeonwer could get a second mortgage, default on the first mortgage, exercise the right of first refusal on the sale, and get the property free and clear of the second mortgage. They'd still owe the second mortgage but they could default on it or even declare bankruptcy (if they dumped all their assets into paying the upset price).
Wouldn't the pursuit of a judgment from the second mortgage (or bankruptcy proceedings, if they're taking that route) just lead to the house being sold?
edit: ok, no, I guess if you default on the mortgage they can't force a sale of the house. I'm pretty sure bankruptcy can lead to it being sold though.
Primary residences have some protection against bankruptcy, though this trick probably works better if you have a relative exercise the right of first refusal.
From what I can tell, in chapter 7 they protect a certain amount of equity on the home: if your equity in the property is less than the legally specified amount, which in New Jersey is 63,150 for a spouse-jointly-owned home, they won't trigger a sale. The original intent seems to be "it's not going to make a significant difference in your debts anyway, so we're not going to bother", although I don't know if subsequent legislation raised it to a point where banks would want to trigger a sale if they could.
That wouldn't be super applicable here, since under this system you'd own the home outright and have the full value of the home in equity. It would work only for very low-value homes where the full value of the house is under the exemption(which might also be hard to get any significant second mortgage on). I'm not actually sure you could use the right of first refusal to have multiple people purchase a house, as well, which might mean you end up with half that amount of equity.
In Chapter 13 it seems like you can keep your house as long as you maintain your payment plan, but they can take it if you fall behind. So you might be able to negotiate some sort of discount, but that requires convincing creditors and/or a judge, and with a newly paid-off house sitting there it might raise some eyebrows.
So I do think you need a cutout here: one person defaults on the first mortgage, the relative uses right of first refusal to snap up the house, and the original homeowner just declares bankruptcy with no remaining assets.
Looping in @The_Nybbler since he's party to this discussion.
I did bankruptcy law fora couple years so I can outline how the process typically works. It's worth pointing out at the beginning the difference between unsecured and secured debts. Unsecured debts, like credit card debt or personal loans, are secured only by the borrower's promise to pay. If the borrower defaults, the lender can attempt to collect the debt, sue and obtain a judgment, and attempt to enforce that judgment through various mechanisms provided by the law. A secured debt includes an additional element where the borrower pledges specific property that the creditor can seize in the event of nonpayment. When a creditor initiates a court action to seize property for payment of debts, state law establishes who gets priority when it comes to payment. Generally speaking the earlier recorded interests get priority, but various policy considerations make this a bit more complicated (for example, taxes and HOA fees almost always get top priority regardless of when they were accrued). Chapter 7 bankruptcy extinguishes the personal obligation to pay, but it does not extinguish security interests. To that extent, the liquidation of the bankruptcy estate is only concerned with assets that can be liquidated to pay unsecured creditors. Additionally, one of the policy goals of bankruptcy is to give the debtor a fresh start, not to leave him destitute, so certain small amounts of assets can be exempted from liquidation as set forth by law.
With that out of the way, let's look at a typical Chapter 7 scenario: Debtor owns a home worth $300,000, subject to a first mortgage with a balance of $200,000 and a HOLC with a balance of $50,000, leaving the debtor $50,000 in equity. The mortgages are current and the property is not in foreclosure. Debtor also has $50,000 in unsecured credit card debt, and no other assets worth mentioning. If the available exemption is $63,150, then it covers the debtor's $50,000 in equity. The trustee classifies the case as "no asset" and the credit card companies get nothing, and the debtor is not required to pay them. As for the mortgages, the debtor is no longer personally obligated to pay them, but they still secure the property, meaning that if the debtor doesn't continue to pay them after the discharge then the bank can foreclose. The practical effect of the discharge, however, means that foreclosure is the only remedy available to them; if the foreclosure sale does not cover the loan, they can't pursue the debtor individually.
When you talk about "triggering a sale", keep in mind that sales are never "triggered" in a Chapter 7 bankruptcy; sale of an asset is wholly within the discretion of the trustee. The more important thing to keep in mind—and I'm not sure if you were insinuating this but I want to make it clear just in case—is that secured creditors play little to no role in the bankruptcy process. The most obvious interaction I can think of is that mortgage payments will be rolled in with Chapter 13 payments, but they won't be reduced like other debts might be. The other one is that if there are any pending or potential foreclosure actions they will automatically be stayed upon filing. This is of little consequence in a Chapter 7 because the stay will be lifted upon discharge, which only takes a few months, and if the bank is impatient they will almost always get the stay lifted if they ask the court. The only consequential involvement of secured creditors in the bankruptcy process is when a debtor in mortgage arrears files Chapter 13, which allows him to repay the arrears under the payment plan.
But in the situation we're talking about with the New Jersey law, we'd end up in a situation in which of the two mortgages on the property, only the first one is paid off (because the first bank is only incentivized to set an upset price that makes them whole, and the second bank isn't capable of outbidding the family because of the right of first refusal). I'm pretty sure the unpaid second mortgage can't follow the property, but it still wasn't paid.
In this situation, does the second mortgage just disintegrate, or does the bank holding the second mortgage have a way to pursue a judgment against the homeowner for the unpaid debt? If so, how does that interact with a subsequent bankruptcy by the homeowner, keeping in mind that the homeowner would have a house with no mortgages attached to it and thus probably be past the equity number for an exemption?
In theory, the bank could sue on the note just like a credit card company can sue you if you don't pay your credit card bills. In practice, those kinds of lawsuits usually don't accomplish much because most people don't have assets which can be seized. Which is why credit card companies usually end up settling for pennies on the dollar.
Let's suppose that the bank holding the second mortgage gets a judgment which then becomes a lien on the original property. I'm pretty sure that this is nowhere near as good as having a mortgage. For one thing, there may be a homestead exemption. For another, it's difficult or impossible to convince a sheriff to actually seize the property in that situation. Usually you will be told to just wait for the person to sell or otherwise transfer the property.
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