This is the second part of a two-part series on cram down in chapter 13. In the first part I discussed how cram down can be used to reduce the amount owed on an item of personal property to the amount the property is worth today, instead of the full amount owed under the original loan agreement. In this second part I will briefly discuss limitations on the cram down option.

The “Hanging Paragraph”

In the 2005 revisions to the Bankruptcy Code, Congress inserted a provision that limits the use of cram down when dealing with Purchase Money Security Interests (“PMSI”) (where the lender provides the financing for the property and then takes back a security interest in the collateral – like most auto loans, for example). Because this new provision in the Code was added without being labeled with its own specific identifying citation in the Code, it is referred to as the Hanging Paragraph.

Specifically, the Hanging Paragraph limits the debtor’s ability to strip down to current value the balance owed on personal property when that property was purchased within a certain set number of days prior to filing. For example, the time set for an auto loan is 910 days (approximately 2½ years). The debtor is not permitted to strip down the lien to present-day value on a vehicle purchased for personal use until he or she has owned the car for at least 910 days. For other types of personal property, like furniture and appliances, the time set in the Hanging Paragraph is one year.

As shown above, timing is everything when it comes to cram down. Timing issues must be considered carefully before filing the bankruptcy. Depending on the circumstances it can even be necessary to delay the filing  to allow  additional time to elapse in order to bring cram down within the time restrictions of the Hanging Paragraph.

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The 2005 revisions to the Bankruptcy Code, known as BAPCPA, include provisions that require debtors to complete two separate credit counseling courses before being permitted to obtain a discharge.

These credit counseling provisions have been controversial. Many bankruptcy attorneys and even some judges have questioned whether the courses provide any real value.

However, a new study released last week indicates that these financial education courses may, after all, provide value to consumers.

Congress included these two debtor education requirements in BAPCPA because of Congress’s belief  that debtors could access bankruptcy too easily and that bankruptcy had become the financial remedy of first resort.  By adding these education requirements Congress sought (1) to encourage potential debtors to consider alternatives to bankruptcy before filing; and (2) to discourage debtors from filing bankruptcy in the future.

Since BAPCPA passed Congress and became law most bankruptcy professionals have viewed these education requirements as useless and possibly even harmful.

Nonetheless, there is some new evidence to the contrary.  The results of part one of a multiphase research study, just released in May 2010, indicate and that these courses do appear to provide measurable benefits.

The study was performed by Dr. Angela C. Lyons, Associate Professor, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, in association with Money Management International, Inc. (MMI), one of the largest providers of bankruptcy credit counseling courses in the U.S.

The results of phase one indicate that the financial education courses may in fact benefit debtors after all.

Some of the key findings include:

• Significant objective improvement in overall financial literacy after the counseling. On average, debtors scored 77.1 percent correct on the pre-test and 85.9 percent correct on the post-test for an increase in knowledge of 11.4 percent.

• Significant subjective improvement in overall financial literacy after counseling. Over 97 percent of debtors felt more knowledgeable about the bankruptcy process and the options available to deal with their current financial problems. More than 91 percent felt that their overall ability to manage their finances had improved.

• Debtor satisfaction with the counseling experience. Over 99 percent found the counseling course helpful and about 97 percent admitted that they were more likely to seek counseling again if faced with financial problems in the future. Almost all debtors seemed to appreciate the educational value of the counseling session and did not feel that the requirement had been a burden or an administrative obstacle.

The jury is still out on BAPCPA’s credit counseling requirements.  Notwithstanding the results of this study, many bankruptcy practitioners “in the trenches” have found these credit counseling courses to be a substantial burden on the system. But even so, the results of this study are significant, and further phases of the study bear watching.

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This is a two-part series on “cram down.” This first part provides an overview of the cram down option. The second part will discuss some built-in limitations to cram down.

Overview

“Cram down” is one of the most useful tools available under chapter 13. Cram down provides you with the right to reduce the amount you owe on secured debts on certain items of personal property. “Secured” debts are those where the creditor has the right to take back the property if you don’t make the payments.

When you cram down a secured loan, the balance owed is reduced down to the amount the property is actually worth on the day your chapter 13 plan becomes effective. You will no longer be obligated to pay the full amount that was still due under the terms of the original loan.

Because creditors are not permitted to object to the reduction of the balance owed on the debt, and because creditors can’t stop the court from modifying the loan, this process is referred to as a “cram down.”

The easiest way to show how this works is by example.

Let’s say you are filing chapter 13 and you want to keep your car. You have 24 payments left on the original loan and the interest rate is 15%. Your car payments are $500 month. You still owe $10,000 on the car under the terms of the original loan. Because the car is a few years old  it is now worth only $5000.

In a chapter 13 “cram down” you can (i) strip down the value of the car to its present value of $5000; (ii) extend the payment term over the length of the plan (usually 36 or 60 months); and (iii) reduce the interest rate to the “Till” rate, which is currently about 4.5%. (The interest rate is describes as the “Till” rate because this interest rate formula was established in the Supreme Court case Till v. SCS Credit Corp., 541 U.S. 465 (2004)).

Under the new terms your payment will be reduced from $500 month to between $100 to $150 month (depending on whether you set up a 36 or 60 month plan). The “unsecured” portion of the original loan (the wiped out $5,000.00) will be paid along with your credit cards as an unsecured claim, usually for a small fraction of the original amount due.

This obviously can help to take pressure off your financial situation and free up funds that can be used to help you get rolling on your “fresh start.”

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If you file chapter 7 bankruptcy, section 722 of the Bankruptcy Code provides you with the right to “redeem” certain items of personal property.  This means that you can keep your property by paying the creditor the amount it is actually worth on the day the petition is filed.  If you do redeem property you are not required to pay the full balance due under the terms of the original loan.

An auto redemption provides a good example.  If you owe $10,000 on your car loan, but the car is only worth $5,000 when the bankruptcy is filed, then you can keep the car if you are able to pay to the lender the $5,000 that the car is worth.   (Car valuations can be found at Kelley Blue Book.) This $5,000 payment will fully satisfy the loan and you will then be able to keep the car free and clear of all liens.

The procedure for redeeming is to file with the court a Motion to Redeem Property.

Of course, in order to redeem the car you will need to come up with a lump sum payment of $5,000. This can be difficult when your are already struggling financially. But it can be well worth the trouble to try to find a way to come up with the money.  Sometimes a friend or relative will be willing to help out because they will see that you really need your car or your refrigerator or some other essential item in order to move forward with your life after bankruptcy.

And even if no friend or relative can be found to help, there is still another option.  Certain finance companies specialize in making redemption loans.   Interest rates are higher with this type of loan, but they can still be a good option because the balance due on the redemption loan will usually be much lower than the balance that was due on the original loan.

If you decide to redeem some of your property, you may be able to work out the price through negotiations with your creditor.  The creditor will often be willing to agree to a reasonable price because this saves them the cost and trouble of taking back the property and selling it.   If the creditor will not agree then it will be necessary for you ask the court to determine the value of the property.

Some specific limitations apply to the right of redemption.  These are set forth in Code section 722. Your lawyer will be able to go through those with you and make sure your proposed redemption qualifies. Most personal property can be redeemed.  If you are considering filing chapter 7 bankruptcy in Washington, DC, you should discuss redemption with your lawyer and consider whether it will be a good option for you.

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As reported today in the ABA Journal, the American Bar Association now acknowledges that job prospects are bleak for graduating law students. New students should think twice before taking on massive student loans. The ABA went so far as to recommend that would-be law students should “reconsider” their plans to attend law school.

Allan Tanenbaum, chairman of the ABA Commission on the Impact of the Economic Crisis on the Profession and Legal Needs, explained that the average law-school debt for students is $100,000.  Tanenbaum made clear that in the current job market, many “have no foreseeable way to pay that back.”

Student loans can never be discharged in bankruptcy.  That means that many graduating law students face a lifetime of ruined credit and harassment by bill collectors.

The ABA and other legal organizations should intervene.  Ill-considered student loans have the potential to ruin lives.  Law schools have a conflict of interest and should not be allowed unfettered access to those who are considering law school.  Before being permitted to sign on the dotted line, prospective students should have a thorough understanding of the realities of the legal job market.

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Forbes.com reports that Congress is now considering two bills intended to offer relief to individuals buried by private student loans. See Congress May Allow Private Student Loans To Be Shed In Bankruptcy.

It’s about time.

Under current law, private student loan debt is virtually impossible to discharge in bankruptcy. Before discharge will be allowed, the debtor must show “undue hardship.” This standard is almost impossible to meet. The debtor must show that he or she is physically unable to work and that future work prospects are hopeless.

As a general rule, of course, individuals who seek to further their education should take responsibility for their own lives. They should investigate “return on investment” before signing up for student loans.

But even if that is true as a general matter, we should not be too quick to judge those who overextend. Financial aid “counselors” and “advisors” at colleges and universities have a clear conflict of interest. The schools want to fill seats at $25,000 or $30,000 a year. Financial aid “counselors” are not the least bit reluctant to oversell the job prospects available to their graduates.

This is particularly true with law schools. Very few law graduates, especially those from lower tiered schools, will ever obtain high paying positions with prestigious firms. Most will end up working for relatively modest salaries as small-firm lawyers or solo practitioners. Some who are not able to find even small firm jobs will spend years as document review slaves struggling to put food on the table while they service their massive student loan debts. Yet law schools regularly misrepresent the future of the job market for their graduates, and are all too happy to encourage students to take on $100,000-plus debt loads for an education that will not yield a salary anywhere near sufficient to support such debts.

And the schools themselves are not the only ones who are to blame for this. MarketWatch.com reported on congressional testimony on the student loan issue, quoting witnesses who testified that the private student loan industry preys on those seeking to make a better life for themselves.  These tactics were compared to those used by sub-prime lenders did during the housing bubble. See the April 22, 2010 article, Congress considers easing student-loan burdens:

“At a House hearing on the student loan issue, Deanne Loonin, attorney at the National Consumer Law Center, accused the private student loan industry of practicing subprime lending:

‘[There] are all the features of subprime lending, including failure to access [sic] reasonable ability to repay, [] poor underwriting, irresponsible lending, high fees, origination fees up to 10%, APRs [] at variable rate — 15%, 20%,’ she said. ‘Basically the most vulnerable borrowers are least likely to be able to repay.’”

The fact is, crushing student loan debt is a real and serious problem. Hundreds of thousands of Americans, mostly young Americans, are buried by student loan debt and unable to recover.  This literally ruins lives.  We must find a way to let these people rejoin the mainstream economy.

The purpose of bankruptcy it to provide a relief valve for people who are overwhelmed by debt. Many graduates of colleges and universities fit that description. There is no evidence, and there never has been, that student debtors abuse the bankruptcy system. Bankruptcy law must be changed to allow a way back for people buried by student loans. Congress is now considering two bills intended to do just that.

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Today I ran across a sobering article by Graham Summers. Summers’ bio indicates that he is Senior Market Strategist at OmniSans Research. He is also the author of a large number of articles on various aspects of finance.

The article that caught my eye is titled: “It’s Impossible to ‘Get By’ In the US.” Summers states that he was prompted to write the article by the recent significant uptick in bankruptcy filings.

This article is sobering because it explains in simple terms how the expenses of life in America total more than the U.S. median income. The article shows that the “average” American simply cannot make ends meet and is falling farther and farther behind each month.

I don’t know a lot about Mr. Summers. Perhaps some of his assumptions are open to debate. But still, it is hard to argue with the basic arithmetic.

For me this article raises the question whether a “normal” post-recession recovery is even possible this time around. I wonder whether the economy will be able to recover by simply riding the normal business cycle. To fully recover it seems possible that the United States will need to create a true game changer, perhaps something like a new source of energy, which the world will want in big amounts.  I just don’t know if consumer goods and software are going to be enough this time.

Below I quote the heart of Summers’ article. Emphasis is in the original:

[The latest statistics show that bankruptcy filings are] up 19% from March 2009’s number which occurred at the absolute nadir of the economic decline, when everyone thought the world was ending. It’s also up 35% from last month’s (February 2010) number.

Given the significance of this, I thought today we’d spend some time delving into numbers for the “median” American’s experience in the US today. Regrettably, much of the data is not up to date so we’ve got to go by 2008 numbers.

In 2008, the median US household income was $50,300. Assuming that the person filing is the “head of household” and has two children (dependents), this means a 1040 tax bill of $4,100, which leaves about $45K in income after taxes (we’re not bothering with state taxes). I realize this is a simplistic calculation, but it’s a decent proxy for income in the US in 2008.

Now, $45K in income spread out of 26 pay periods (every two weeks), means a bi-weekly paycheck of $1,730 and a monthly income of $3,460. This is the money “Joe America” and his family to live off of in 2008.

Now, in 2008, the median home value was roughly $225K. Assuming our “median” household put down 20% on their home (unlikely, but it used to be considered the norm), this means a $180K mortgage. Using a 5.5% fixed rate 30-year mortgage, this means Joe America’s 2008 monthly mortgage payments were roughly $1,022.

So, right off the bat, Joe’s monthly income is cut to $2,438.

According to the US Department of Agriculture, the average 2008 monthly food bill for a family of four ranged from $512-$986 depending on how “liberal” you are with your purchases. For simplicity’s sake we’ll take the mid-point of this range ($750) as a monthly food bill.

This brings Joe’s monthly income to $1,688.

Now, Joe needs light, energy, heat, and air conditioning to run his home. According to the Energy Information Administration, the average US household used about 920 kilowatt-hours per month in 2008. At a national average price of 11 cents per kilowatt-hour this comes to a monthly electrical bill of $101.20.

Joe’s now down to $1,587.

Now Joe needs to drive to work to make a living. Similarly, he needs to be able to drive to the grocery store, doctor, etc. According to AAA, the average cost per mile of driving a minivan (Joe’s a family man) in 2008 was 57 cents per mile. This cost is based on average fuel consumption, tires, maintenance, insurance, license and registration, and average loan finance charges.

Multiply this cost by 15,000 miles per year and you’ve got an annual driving bill of $8,550. Divide this into months (by 12) and you’ve got a monthly driving bill of $712.

Joe’s now down to $877 (I’m also assuming Joe’s family only has ONE car). Indeed, if Joe’s family has two cars (one minivan and one sedan) he’s already run out of money for the month.

Now, assuming Joe’s family is one of the lucky ones (depending on your perspective) they’ve got medical insurance. Trying to find an average monthly medical insurance premium for a family in the US is extremely difficult because insurance plans have a wide range in deductibles, premiums, and co-pays. But according to eHealth Insurance, the average monthly premium for family policies in February 2008 was $369.

So if Joe has medical insurance on his family, he’s now down to $508. Throw in cell phone bills, cable TV and Internet bills, and the like, and he’s maybe got $100-200 discretionary income left at the end of the month.

This analysis covers all of the basic necessities of the average American household: mortgage payments, food, energy, gas, driving expenses, and medical insurance. It also assumes that Joe:

1. Didn’t overpay for his house

2. Made a 20% down-payment of $45K on his home purchase

3. Has no debt aside from his mortgage (so no credit card debt, student loans, etc)

4. Only has one car in the family and drives 15,000 miles per year

5. Keeps his energy bill reasonable

6. Does not eat out at restaurants ever/ keeps food expenses moderate

7. Has no pets

8. Pays for health insurance but has no monthly medical expenses (unlikely with two kids)

9. Keeps his personal budget under control regarding cable TV, Internet, and the like

10. Doesn’t spoil his kids with toys, gadgets, trips to the movies, etc.

11. Doesn’t take vacations.

Suffice to say, I am assuming Joe maintains EXTREMELY conservative spending habits. Personally, I know NO ONE who meets all of the above criteria. However, even if the above assumptions applied to the average American, you’re still only looking at $100-200 in “wiggle” room for spending per month!

If Joe:

1. Overpaid on his house

2. Didn’t have a full 20% down payment

3. Owns two cars

4. Eats at restaurants

5. Splurges on heating & A/C bills

6. Has any medical expenses aside from monthly premiums…

… he is running into the red EVERY month.

In plain terms, even if you are extremely frugal and careful with your money, it is virtually impossible to “get by” in the US without using credit cards, home equity lines of credit or burning through savings. The cost of living is simply TOO high relative to incomes.

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On April 4, 2010, the BankruptcyProf Blog (a member of the Law Professor Blogs Network) published this chart showing the number of bankruptcy filings by quarter over the last several years. The chart shows that the filings continue to rise into 2010.  For example, the filings for the first quarter of 2009 totaled 330,500, while the filings for the first quarter of 2010 totaled 378,400. This is an increase of over 14%.

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The Huffington Post is reporting that Bank of America, the nation’s largest lender, now supports the mortgage cramdown bill. This bill, which was defeated at the end of 2009, would give bankruptcy judges the ability to change the terms of a mortgage for the benefit of homeowners who have filed for bankruptcy.

Bankruptcy law allows for the altering of many types of contracts, but banks have generally opposed allowing the same for mortgages on the primary residence. In light of the current foreclosure crisis, many argue that it is now essential to give bankruptcy judges the power to alter the terms of mortgages so that bankruptcy debtors stop losing their homes.

Apparently, Bank of America now agrees. As HuffPost explains:

“But Wednesday, before a nearly-empty Congressional hearing room, Barbara J. Desoer, president of Bank of America Home Loans, said her bank now supports leveling that playing field.

‘As we’ve gone through the lessons that we’ve learned with modifications and other programs, there probably is some segment of borrowers for whom that would be an appropriate alternative,’ Desoer said before the House Financial Services Committee.

‘So you would support that in some circumstances?’ asked Rep. Brad Miller (D-N.C.) in a follow-up to his original question.

‘In some circumstances, yeah,’ Desoer responded.”

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Don’t be deceived by Form 1099-C. Even though a debt may be listed on this form as “canceled,” the debt is not erased, and a lender may still be able to come after you to try to collect the balance.

A 1099-C is required whenever a creditor agrees to accept at least $600 less than the original amount owed. The IRS asserts that “forgiven” debt is the borrower’s “income,” and the IRS wants taxes paid on that income. The lender must file the Form 1099-C with the IRS, and send a copy to the borrower.

One example of where the 1099-C comes into play is with a real estate “short sale.” In a short sale a house is sold for less than the remaining balance on the mortgage. This unpaid balance results in a “deficiency.” When a deficiency occurs, the lender ordinarily “forgives,” or “cancels” that debt and issues a 1099-C to the ex-homeowner.

But a 1099-C can be misleading. People naturally understand this form to be a statement from the lender that the debt has been discharged and that the ex-homeowner no longer owes the money. This interpretation is understandable, but it may not be accurate. See Amtrust Bank v. Fossett, No. 1 CA-CV 08-0840 n. 2 (Ariz. Court of Appeals, Div. 1, Dept. A 2009) (“By providing for issuance of a form called ‘Cancellation Of Debt’ even when a lender may not intend to release debt, [Form 1099-C] is all but certain to confuse borrowers who receive the form under those circumstances.”).

As one Pennsylvania bankruptcy court recently explained:

“[R]egardless of the reason why [the lender] issued the four Forms 1099-C, [the lender’s] issuance of such forms constitutes neither an admission by [the lender] that it, nor consequently demonstrates that [the lender], discharged the Debtor from further liability on any of [the lender’s] four claims.”

In re Zilka, 407 B.R. 684, 689 (Bankr. W.D. Pa. 2009).

If you receive a 1099-C, the best course of action is to discuss it with a knowledgeable bankruptcy attorney. Until you hear otherwise you should assume that you still owe this money. Don’t assume that the underlying debt has been discharged.

If you have any comments about Form 1099-C, please add them below.

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