WASHINGTON -- In a big victory for home lenders, the Supreme Court ruled Tuesday that borrowers who file for bankruptcy cannot reduce their mortgage debt to the current value of the property.
The decision, which settles conflicting rulings from lower courts, apparently will stop a practice that the mortgage industry had feared would lead to big loan losses.
In recent years, bankruptcy courts have increasingly permitted borrowers to reduce the value of home loans to market value, known as a "cramdown."
For example, a $170,000 loan might be chopped $100,000 if local housing prices had dropped sharply. The remaining $70,000 becomes an unsecured debt, which a lender is much less likely to recoup.
While figures on the number of cramdowns and resulting losses are not available, the practice has been a significant worry for lenders in California, the Northeast, and the Oil Patch, according to a spokesman for the Mortgage Bankers Association of America.
The Supreme Court's unanimous ruling was warmly greeted by the mortgage industry. "This is an excellent decision," said Phil Corwin, director of retail banking at the American Bankers Association.
Warren Lasko, executive vice president of the Mortgage Bankers Association, said that preventing borrowers from walking away from their debts would avoid major losses.
Mr. Lasko said that "the vast majority of borrowers" will also benefit from the decision. The reason: Lenders will be able to reduce their provisions for loan losses, enabling them to offer lower interest rates.
The decision resolved conflicting sections of the U.S. Bankruptcy Code. The court rules that a provision of Chapter 13 of the code prohibiting cramdowns overrides a more general section that permits debtors to modify some of their debts.
"This will probably make moot" a cramdown provision in the bankruptcy reform bill now pending in the Senate, said Roger M. Whelan, a Washington bankruptcy lawyer.
The bill sponsored by Sens. Howell T. Heflin, D-Ala., and Charles E. Grassley, R-Iowa, prohibits cramdowns on first mortgages, but permits them on subsequent mortgages on the same property.
"There's nothing in the decision that distinguishes between different mortgages," according to Mr. Corwin, which he said implied that the court means to prohibit all cramdowns.
The case involved a Dallas couple, Leonard and Harriet Nobelman, who owned about $70,000 to American Savings Bank, Stockton, Calif., on a condominium whose market value had sunk to $23,500.
The couple proposed a repayment plan that reduced their outstanding mortgage debt to the condominium's market value and treated the balance as an unsecured claim.
Borrowers filing under Chapter 13 may propose a plan to pay back creditors over three years. After that, they "discharged" from remaining debts, except for certain long-term obligations such as alimony and mortgage payments.
The U.S. Court of Appeals for the Fifth Circuit denied the couple's proposed cramdown. Four earlier appellate courts' decisions had approved cramdowns.
"If there's any circuit court out there that still thinks [cramdowns are permitted], now they know they're wrong," Mr. Corwin said.
The Supreme Court had earlier prohibited cramdowns in Chapter 7 bankruptcy cases, which involve businesses, but had not reviewed a Chapter 13 case before.
Michael Schroeder, the lawyer who argued the case for American Savings, said previously resolved cases would not be affected by Tuesday's ruling, but that pending cases would.
Mr. Reerink writes for the Medill New Service. Ed Kulkosky in New York contributed to this article.