Holding Back the Invasion of the Zombie Mortgages

Understand the complexities and nuances of the Bankruptcy Code to better advise clients and prepare for court.

By Deborah Swann and Daniel Gill

Abandoned by the homeowner but stalled in foreclosure, thousands of vacant properties across the United States exist in a financial limbo, inevitably crumbling into dilapidation, attracting crime, and ultimately depressing home values in surrounding neighborhoods.

The bank keeps its lien but doesn’t foreclose. The title remains with the homeowner, who may not even know she’s liable for property taxes and responsible for upkeep. This unfortunate phenomenon is called a “zombie mortgage.”

Zombie mortgages have created a crisis in some parts of the country that can result in unexpected costs and huge debts for property owners. But now in some cities, lenders are starting to be held accountable, and communities are finding means to transfer title away from the beleaguered homeowner.

Still, some cases result in bankruptcy, but homeowners holding “zombie” properties can find it difficult to achieve a “fresh start” by restructuring their finances in court.

The sections of the bankruptcy code available to corporations and high-wealth individuals are actually more forgiving than those available to the average debtor faced with a zombie problem.

And at least one bankruptcy judge suggested to Bloomberg BNA that such deficiencies make the issue ripe for a legislative fix.

Banks Lose Interest

New York and New Jersey had the highest numbers of zombie mortgages at the end of the third quarter of 2016. They are also states where home prices have not recovered from their pre-recession peaks, according to Daren Blomquist, senior vice president of Attom Data Solutions.

Much of the problem arises because banks seek and obtain foreclosure judgments before they understand the value of the property, Judy Fox, a clinical law professor at Notre Dame Law School, told Bloomberg BNA in a telephone interview.

When banks realize that they can’t recoup their costs on these properties—let alone the underlying debt—they lose interest. They cancel their foreclosure sales and even void their foreclosure judgments, often without ever providing any notice to the property owner, Fox said.

For banks, it’s a question of an extended foreclosure process. By the time, the property gets to a sheriff’s sale, its value no longer justifies the expense.

Yet, “the human element of the zombie mortgage crisis is real and it’s very painful for some debtors,” Jeffery P. Hopkins, Chief Judge of the U.S. Bankruptcy Court for the Southern District of Ohio, noted in a Feb. 23 e-mail to Bloomberg BNA. Hopkins is an editor of Bloomberg Law: Bankruptcy Treatise, and has written a treatise chapter on this subject.

What’s a Debtor to Do?

Many homeowners file bankruptcy hoping to get out from under their unwanted properties and the continuing debts that come with them.

"[B]ankruptcy courts struggle with what to do with debtors seeking a ‘fresh start’ in cases where lenders refused to complete the foreclosure, leaving debtors with huge property tax bills and maintenance costs—anything but a fresh start,” Hopkins said.

In Marrama v. Citizens Bank of Mass. , 549 U.S. 365 (U.S. 2007), the Supreme Court emphasized that “the principal purpose of the Bankruptcy Code is to grant a ‘fresh start’ to the ‘honest but unfortunate debtor.’”

However, “the promise of a fresh start in bankruptcy remains in jeopardy so long as lenders have the legitimate option for business reasons of refusing to complete a foreclosure,” Hopkins said.

Bankruptcy Options

A debtor can force the bank to accept the property in payment of its claim in a Chapter 11 reorganization, but Chapter 11 is typically too expensive for a low-income debtor. Most homeowners in these circumstances turn to a Chapter 13 wage-earner plan.

Under Chapter 13, an individual with regular income may propose a bankruptcy plan to repay all or part of her debts over three to five years. If the bankruptcy court confirms the plan and the debtor carries it out, she is released from her remaining debt.

The Bankruptcy Code—and the model Chapter 13 plan being used by the courts—allow the debtor to “surrender” real property. However, surrender does not force the bank to foreclose or to accept a deed in lieu of foreclosure. The debtor remains liable for all post-petition taxes and upkeep.

Those who have sought to transfer unwanted properties by making the bank take title in the property, using Bankruptcy Code section 1322(b)(9), also have had limited success.

While this section permits a Chapter 13 plan to “provide for the vesting of property of the estate ..., in the debtor or in any other entity,” most bankruptcy courts have refused to confirm plans that force vesting in the creditor.

The U.S. District Court for the District of Oregon in Bank of NY Mellon v. Watt , 2015 BL 116981 (D. Or. 2015), applying section 1325(a)(5), required that plans vesting property in the secured creditor must have either creditor acceptance or a distribution of payments or property not less than the present value of the collateral.

The decision is on appeal to the Ninth Circuit Court of Appeals, where it remains to be seen whether a Chapter 13 plan can compel vesting. No other circuit has ruled on the question.

Dirt for Debt?

Some experts believe that Chapter 13 permits a plan that would satisfy a secured claim by tendering the property to the lien-holder.

Eugene Wedoff, a retired bankruptcy judge who often represents consumer debtors pro bono in consumer bankruptcy appeals, told Bloomberg BNA that the Bankruptcy Code section governing the confirmation of Chapter 13 plans authorizes such a “dirt for debt” arrangement using estate property like the collateral to pay the claim. The relief is similar to that available in Chapter 11.

The lender’s hand could also be forced by selling the property at a bargain-basement price, using Section 363(f) of the Bankruptcy Code to approve the sale of the property free and clear, with the liens attaching to the sale proceeds, as some courts in New York have done. If a secured lender wants to preserve its interest in the property, it can bid at the sale, using a credit bid up to the amount of its lien, with a successful bid transferring title.

In short, Chapter 13 bankruptcies have provided only limited means to avoid zombie mortgages. Where individuals have failed to rid themselves of title, and banks have failed to accept responsibility for the property, the burden to remedy the prospective decline in property value falls on local or state government.

Holding Lenders Accountable

To protect threatened communities, governments have begun the process of holding lenders accountable for the condition of vacant property. For example, New York state requires lenders to inspect single to four-family residential property within 90 days of the loan delinquency, and if the property is vacant, the lender is required to maintain it. N.Y. RPAPL § 1308.

Similar legislative solutions can be found in Chicago, Los Angeles, and Las Vegas. In Las Vegas, not only must vacant property be maintained by lenders in accordance with applicable codes and ordinances, but all visible landscaping in front and side yards must meet neighborhood standards.

Evicted or abandoning homeowners still cannot escape title, but these laws attempt to preserve property, protecting neighbors from diminishing value and making it possible for the surrounding community through its land banks and community organizations, or through vacant property receiverships, to provide a second life for property deemed undesirable.

Land Banks.

Land banks are nonprofit organizations working in cooperation with governments to reclaim blighted and abandoned properties. Their purpose is to revitalize communities by acquiring distressed or underutilized properties for rehab so they can be sold as affordable housing or, if the property is beyond repair, it is cleared to be put to some other use.

Eighteen land banks operate in New York at the county and city level. Since 2013, the state has committed more than $33 million to their funding. Of this amount, $20 million was secured in 2016 through settlements with Morgan Stanley and Goldman Sachs Group Inc. over misconduct that contributed to the housing crisis, according to the New York Attorney General’s office.

Ohio has over 40 county land banks. One of its most progressive is the Cuyahoga County Land Reutilization Corporation, which has been instrumental in bringing Cleveland’s number of vacant properties in foreclosure down from 1,259 in 2013 to its current 356. “We have three engines of success,” Gus Frangos, president and general counsel of the Cuyahoga County Land Bank, told Bloomberg BNA.

First, as land banks are separate non-profit, government-purposed entities, Frangos said the Cuyahoga County Land Bank is able to “operate outside of government.” Second, it can “interpose itself in the tax foreclosure process, without a sheriff’s sale.” Finally, it has an “embedded reliable funding stream,” Frangos said. The Cuyahoga Land Bank is able to use delinquent tax penalties and interest from other properties as funding sources, making it unnecessary to seek financing from the legislature for each year’s funding.

“Whether a mortgage lender will foreclose on a property (stripped or intact) is all market based,” Frangos said. “But when it will not, tax foreclosure is a good remedy. Receivership is good also, but with tax foreclosure, all liens, bank and subordinate, come off. Land comes to the land bank free and clear.”

The land bank will then slate blighted property for demolition, repurposing the property for future development or green space. Those properties that can be rehabilitated are sold at a highly incentivized low price through a deed in escrow where the buyer fixes the property to land bank specifications before receiving the deed.

Vacant Property Receiverships

In Baltimore, once an unoccupied house is declared vacant or a nuisance property, the city or a community organization acting on the city’s behalf can petition the court to intervene through a receivership. Receivership allows a third party—a court-appointed receiver—to auction the property to a buyer who will redevelop it. The sales price at auction goes first to satisfy fees and outstanding taxes.

By selling to a buyer who has the ability to rehabilitate the property immediately, the receiver in effect uses private capital to abate the nuisance, James J. Kelly Jr., Clinical Professor of Law at the Notre Dame Law School told Bloomberg BNA.

The receiver can foreclose its lien for the property’s repair before the rehabilitation work is done, and because the receiver’s lien has a super-priority over any pre-existing mortgages or judgments, its foreclosure clears title, terminating owner and mortgage lender rights.

For the receivership model to work, usually a buyer is identified before or at the time the receivership is created, Kelly said.

Can the Zombie Be Stopped?

Where banks refuse to take title to zombie properties, the burden of remedying declining property values and attendant community blight falls on local or state government. However, debtors will continue to struggle with their problem.

A debtor stuck with title to a zombie property, even after completing a Chapter 13 repayment plan, “will still have a significant amount of debt ... hanging around ... her neck like an albatross,” Judge Hopkins said. “The debt may last a lifetime,” he said. “The whole matter begs for a legislative fix.”

To contact the reporters on this story: Deborah Swann in Washington at dswann@bna.com; Daniel Gill in Washington at dgill@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

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