Part III: Modifications Post-Discharge
Welcome to Part III of our series on the servicing of discharged mortgage debt. This part will discuss modifying a borrower’s loan after a discharge. (If you missed Part I or Part II, go ahead and catch up.)
Servicers and borrowers struggle with lack of clarity regarding the nature of the relationship between borrower and servicer when the borrower discharges personal liability in bankruptcy. In an ideal world, the borrower would a) reaffirm, b) surrender and move out, or c) if he doesn’t reaffirm or surrender, make timely payments until the debt is paid in full. Unfortunately, borrowers often follow a different path. For example, some make payments after they surrender, only to later become delinquent. Other Chapter 7 borrowers are current when they file for bankruptcy, choose not to surrender or reaffirm, and become delinquent post-discharge. In either of those instances, can a borrower modify his loan? And should the servicer offer modifications in these scenarios?
Discharge of personal liability does not preclude the borrower from making payments voluntarily. Neither does that discharge preclude the delinquent borrower from seeking a loan modification. Some practitioners insist that post-discharge loans cannot be modified because there is no note, only a security instrument, and therefore there is no loan to modify. This relationship can be more accurately described as one where the borrower must pay to remain in the house, and where the note has become non-recourse as to the borrower. The enforceability of that relationship is now anchored only in the property itself. The Department of the Treasury, through its directive regarding HAMP modifications, has explicitly said that this relationship can be modified. Fannie Mae and Freddie Mac have, in turn, suggested language to be used in agreements with these borrowers. All three of those entities have encouraged a servicer that modifies a loan after the borrower has discharged his personal liability to use a disclaimer that all payments are voluntary, and an acknowledgement that the servicer cannot seek to collect against the borrower personally.
While borrowers may seek to modify their relationship with the servicer following discharge, a servicer is not required by law to modify the loan. Instead, the servicer is directed through the modification process by investor guidelines and its own policies. Understandably, where a borrower has received a discharge of personal liability, servicers are wary of violating the discharge injunction, and therefore may be wary of offering loan modifications to these borrowers.
If a servicer intends to offer loan modifications to borrowers post-discharge, it should tailor the population to only those borrowers who have indicated an intent to retain the property. Case law outlining when loss mitigation for discharged borrowers may result in a discharge violation is unclear and fact-specific. However, discharge violations are most often found where a borrower surrenders the property and a servicer solicits that borrower for loss mitigation. Upon surrender, the borrower indicates intent to sever the relationship with the servicer, and the servicer should not offer loss mitigation to that borrower.
Once the servicer confirms the borrower’s intention in the bankruptcy filing, it should carefully consider which products are offered. A loan modification is a hybrid of an old agreement (of which the debt has been discharged) and a new agreement. Investors, particularly GSEs, offer numerous modification products. One such product is referred to as a “Partial Claim Modification,” which involves the borrower entering into a separate note, with a second lien position, in favor of the Department of Housing and Urban Development. Outside of the bankruptcy context, this is a commonly used product with few, if any, negative implications. When considered within the context of a discharge of personal liability, the subordinate note required by this product may be viewed as an impermissible post-discharge reaffirmation when it lacks language acknowledging the discharge. The standard subordinate note provided by HUD does not contain such language.
Servicers should take care when deciding whether, and how, to modify discharged borrowers’ loans. Servicers who choose to modify these borrowers’ loans should ensure the loan modification process is tailored to mitigate risk of discharge injunction violations. Part IV will dive deeper into solicitation of such borrowers and papering any ensuing loan modification agreements to avoid discharge violations.