Bankrupt homeowners shed second mortgages

SAN JOSE, Calif. — Stung by the crash of the housing market, some struggling homeowners are using a little known but increasingly popular provision of the bankruptcy code to eliminate second mortgages and avoid foreclosure.

Statistics are hard to come by, but bankruptcy lawyers say the provision has been used effectively on hundreds, if not thousands, of cases in the San Francisco Bay Area during the past two years.

“It’s a big thing in our valley,” said James “Ike” Shulman, a San Jose bankruptcy lawyer. “But it’s not widely known.”

Shulman, co-founder of the National Association of Consumer Bankruptcy Attorneys, said he has helped a number of clients who have filed for personal bankruptcy use the law to hold on to their houses — including three last week.

Cathy Moran, a Mountain View, Calif., bankruptcy lawyer, said one of her clients had a $132,000 second mortgage voided by the court.

“This is a really big-ticket issue that allows people to keep a home and conform the mortgage to something closer to real value,” Moran said.

Bankruptcy laws prevent homeowners from eliminating the debt of a first mortgage if they plan to stay in their home. But second mortgages are treated differently. They can be declared unsecured debt when there is no equity to cover them, as is the case for millions of houses that are now worth far less than a few years ago.

When that happens in a personal bankruptcy proceeding, the second mortgage is put on hold and no payments are required while the homeowner completes a repayment plan for other debts — which typically takes three to five years. At that point, the second mortgage is eliminated.

Many second mortgages were granted during the housing bubble, when prices were going in one direction only — up.

Mortgage bankers don’t like the practice.

It’s “a troublesome phenomenon. It’s one of those things that’s just now developing and bubbling up,” said Dustin Hobbs, spokesman for the California Mortgage Bankers Association. But there is little the mortgage industry can do, aside from seeking to change the law. That could be difficult given the current partisan lineup in Washington.