Mortgage Modifications: Senior Loans May Become Not So Senior

Sperry Assoc. Fed. Credit Union v. US Bank Nat’l Ass’n (In re White), 514 B.R. 365 (Bankr. E.D.N.Y. 2014)

A junior mortgagee sought to subordinate the senior mortgage loan based on an argument that modification of the senior loan impaired the junior mortgagee’s rights.

The debtor executed a note secured by a first mortgage in favor of the senior lender in the original principal amount of $323,000 that was originally due at the end of 2035. Subsequently the debtor executed a note secured by a second mortgage in favor of the junior lender for $55,000 that was due in May 2022. The senior loan was modified two times. The junior lender was not asked to consent to either modification.

The first senior loan modification reduced the interest rate from 6.925% to 3% for one year, with increases during the following two years, subject to a cap of 5.617%. No new funds were advanced. The junior lender did not argue that this first modification had any impact on its position.

The second modification, which was done pursuant to the Federal Home Affordable Modification Program (HAMP), lowered the monthly payments. Using the HAMP guidelines, the second modification: (1) extended the maturity of the note by one month to January 1, 2036, (2) capitalized $65,300 that was in arrears and deferred payment interest free to the end of the term of the note, (3) reduced the interest rate to 2% for five years, increasing to 3% in year 6, 4% in year 7, and 4.25% for the remaining term of the loan.

The debtor filed for bankruptcy relief under chapter 13. The property securing the loans was valued at ~$300,000 (based on appraisals). Thus, the debtor sought to have the junior creditor’s secured claim deemed to be wholly unsecured (since there was no equity left after consideration of the senior mortgage loan). In response, the junior mortgagee sought to subordinate the senior mortgage to its mortgage, or in the alternative to subordinate the principal balance that was deferred under the second modification.

The junior lender argued that by deferring principal to the maturity date of the note, the note and mortgage were more likely to default at maturity. Also, the junior mortgage was adversely affected prior to maturity because if there was a default and the senior mortgage was foreclosed, the deferred balloon payment and lower monthly payments meant that a higher amount would be due at the time of foreclosure.

In response, the senior lender pointed out that the deferred payment did not bear interest and was due 14 years after the junior loan matured. So, it was hard to see how the junior mortgagee was adversely impacted. The senior lender also argued that the lower monthly payments did not impair the junior mortgagee’s position, but rather improved it, because the debtor was already in default and unable to make its monthly payments before the modification.

Looking to state law, the court outlined the relevant principles as follows:

  • Generally successive mortgages on a property have priority in the order in which they attach to the property (e.g. the order in which they are recorded).
  • A senior mortgagee may modify the terms of its note and mortgage without the consent of a junior mortgagee.
  • “However, if the modification prejudices the rights of the junior lien holder or impairs its security, and is made without the junior lien holder’s consent, courts have divested the senior lien holder of its priority and elevated the junior lien holder to a position of superiority.”
  • If the actions prejudice a junior lender but do not “substantially impair their security interest or destroy their equity,” the junior lender obtains priority only with respect to the modified terms.
  • In determining the impact on a junior lender, a principal consideration is whether the interest rate or principal amount of the senior mortgage is increased.

In considering the arguments made by the junior lender, the court noted that under the second modification the interest rate was substantially lowered. As to the deferred principal payment, it did not bear interest. So, the total amount payable by the debtor was reduced under the modification. And although the maturity of the senior loan was extended by one month, accrual of interest for this additional period did not offset the other savings.

The court noted that the junior mortgagee’s arguments also ignored that the debtor was in default at the time of the modification. The contention that reducing mortgage payments prejudiced the junior creditor assumed that the debtor had the ability to make the pre-modification regular payments – which it did not. As to the argument about the effect of the increase in payment due on maturity, the junior mortgagee ignored that its own loan matured 14 years before that date, so the deferral in fact improved its position.

Consequently the court found no basis for subordinating any portion of the senior mortgage loan to the junior mortgage loan since the modification did not increase the interest rate or the amount secured by the senior mortgage and did not otherwise impair the junior mortgagee.

The effect of a mortgage modification is a matter of state law. As the court’s analysis illustrates, a senior mortgagee should not take for granted that it is free to modify the senior debt as it sees fit without the consent of a junior mortgagee. In connection with a modification, it behooves the senior mortgagee to carefully consider the potential impact on the junior mortgagee position, and if there is an adverse impact, whether that poses any risk of subordination under applicable state law.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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