Small-business bankruptcy program adds new risk to home equity loans

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To their list of worries about how the coronavirus pandemic is affecting customers and their own bottom lines, bankers can now add this: a potential spike in home mortgage modifications tied to small-businesses bankruptcies.

Many entrepreneurs opening a business for the first time will often use the equity in their homes as collateral on loans needed to buy equipment or hire workers.

Last year, Congress made changes to the bankruptcy code that allowed borrowers to modify these second mortgages in the event their businesses fail, perhaps saving them from having to sell their homes to settle their debts. Protections were further expanded when the coronavirus relief package was passed in March.

But while these changes provide a measure of relief to borrowers — particularly with bankruptcies expected to increase as the pandemic drags on — they can cause problems for banks and investors that hold the loans.

That’s because interest rates are often lowered in the modification process, reducing a loan’s value. In one case involving a mortgage on a bed and breakfast in California, the owner proposed a plan in the new bankruptcy program that would have reduced the secured portion of the mortgage to the value of the property and would be paid down over a new 30-year term at 4.25% interest. The servicing company handling the loan had proposed selling the property to satisfy the owner’s debts, though the case has yet to be resolved.

“It could be a headache in that a mortgage that a lender thought was not modifiable is now suddenly modifiable,” said Bonnie Pollack, a partner at Cullen and Dykman who represents lenders in these new bankruptcy cases.

The new subchapter V of the Chapter 11 bankruptcy process was signed into law last year and became available in February. It provides small-business owners and individuals with business debt of up to a little more than $2.7 million with a streamlined path to restructuring. One of the advantages to subchapter V allows a residential property owner to have their mortgage modified to lower their monthly payments and ease some terms as long as the home loan was taken out to fund their business — often in the form of a cash-out home equity refinance, or collateral mortgage for business debt.

The coronavirus relief package expands, until March 2021, the debt limit for subchapter V to $7.5 million, increasing the number of potential mortgages with terms once thought set in stone at risk of being eased.

Banks have been combing through their portfolios searching for which mortgages might suddenly be modified in the new bankruptcy program. An exact number across the industry is hard to pin down, but a 2018 survey by the Federal Deposit Insurance Corp. shed some light on how often small-business owners use the equity in their homes to secure a loan.

Roughly $18.3 billion in C&I loans were secured by one-to-four unit residential properties at the time of the survey, according to the FDIC report.

A Wells Fargo spokesman, after consulting with mortgage and bankruptcy experts within the San Fransisco bank, indicated the scope of the issue has yet to come into focus but that lenders were wary of the potential impact.

“We’re aware of the changes to the bankruptcy code that were enacted as part of the CARES Act and will monitor any potential impacts to our portfolio,” the spokesman said, referring to the Coronavirus Aid, Relief, and Economic Security Act. “However, it’s too early to speculate about what those might be.”

Pollack said that loans backed by the U.S. Small Business Administration can shed some light on the size of the universe of mortgages affected by the change. The agency, Pollack said, often requires some kind of collateral for financing, which could take the form of equity tapped from a second mortgage on the borrower’s home.

So far, relatively few businesses have tested the new bankruptcy program. But John McMickle, co-founder of North South Government Strategies, a regulatory affairs consultancy, said that is expected to change. Many forbearance plans banks granted to businesses at the start of the crisis are scheduled to expire in the months ahead, and it’s unclear how many will be able to make their payments again. The SBA’s Paycheck Protection Program stopped taking new applications on June 30. And Congress has been slow to pass any further stimulus, though negotiations are underway.

Meanwhile, there have been more than 500 bankruptcy filings in the new subchapter V program since it launched in February, according to legal data company Epiq AACER, and the pace is picking up. Of those, 133 were filed in June alone.

“Everybody anticipates that at some point there will be an increase in these,” McMickle said. “Will it work? No one really knows, especially if a lot of cases come in.”

Already small business owners are testing the revised bankruptcy laws and seeking to modify mortgages secured by their residences.

James Bailey, a bankruptcy attorney and partner at the law firm Bradley, said that some small-business owners have had their modification under subchapter V challenged by the lender, notably in the case of the bed and breakfast.

The company handling that mortgage objected to the modification of the loan against a mansion that was both operated as a business and served as the owner’s principal residence. The court held that it would need to consider a number of factors to determine whether the mortgage was not used primarily to acquire the property and whether the loan proceeds were used primarily in connection with the small business. Bailey said lenders should continue to monitor the development of the law in this area.

“Lenders need to be aware that this is out there,” Bailey said.

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Loan modifications Mortgages Home equity loans Small business Bankruptcy Coronavirus