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Notes -
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?
The New Jersey law would strip the second lien, but it wouldn't absolve the debtor of the requirement to pay the note. The creditor could sue the debtor for nonpayment and get a recorded judgment, which would allow them to garnish wages, levy bank accounts, and, yes, attach a judgment lien to the debtor's property. While it sounds like they get their mortgage back, this is more of a consolation prize, because in any foreclosure action they would be junior to any real mortgages, including ones that were recorded after the judgment lien. They would also be junior to any mechanic's liens. Effectively, they're now at the bottom of the list. If the debtor receives a bankruptcy discharge at any point in this process, it would eliminate their obligation to pay anything. The only exception would be if the creditor obtained a judgment and recorded a judgment lien against the property before the creditor filed. Then the lien would remain, though the personal obligation would be extinguished and they couldn't continue any other collection activities.
I apologize because it's only now that I'm wrapping my head around what you guys were talking about; before I was just trying to give some general background on how bankruptcies work. Suppose the house is worth $400,000. Mortgage 1 is $200,000 and Mortgage 2 is $100,000. Under the NJ law, Mortgagor 1 initiates a foreclosure action with an upset price of $200,000. Per the law, the owner exercises his right of first refusal and buys the house at the upset price, stripping Mortgage 2. Mortgagor 2 now has a note worth $100,000 but no security interest in the property. Mortgagor 2 then sues the owner for nonpayment of the note, but the owner files for Chapter 7 bankruptcy before judgment is entered, staying the suit. There are no other liens on the property at this point, and the owner's only debt is the $100,000 he owes to Mortgagor 2. After applying the exemption, the trustee has $336,850 available to distribute to unsecured creditors, which easily covers the $100,000 owed to Mortgagor 2. The property is sold for $400,000, $100,000 of which goes to Mortgagor 2, $100,000 goes to the trustee's commission, and $200,000 of which goes back to the owner. Maybe this counts as "abusing the system" in a strict technical sense, but like most such abuses, you'd have to be really stupid to think you're getting one over on anyone.
Awesome, this makes it a lot more clear to me. Thank you for providing your expertise on the topic!
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