by Calculated Risk on 7/12/2010 11:12:00 AM

From Catherine Curan writing at the NY Post: Liening on banks

Underwater homeowners are jumping onto an unexpected financial life raft that lets them escape crippling second mortgage debts and keep their homes -- Chapter 13 bankruptcy.
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How it works is this: If the home is appraised at less than the value of the first mortgage, the owner can apply for permission in bankruptcy court to reclassify the second mortgage debt. That changes it from a secured debt, which must be repaid, into an unsecured debt, which does not have to be paid in full. The homeowner can then focus on paying off the first mortgage.

"This is the only time where you see such a huge percentage of houses worth less than the first loan, allowing us to basically get rid of the second loan," says [New York City bankruptcy attorney David Shaev of Shaev & Fleischman], who estimates that 20 percent of his Chapter 13 clients who own homes qualify for this type of workout. "We're at a unique place in history."

For many borrowers, this makes a Chapter 13 bankruptcy a better choice than a foreclosure. With a foreclosure, the borrower loses the house - and the 2nd lien holder might still pursue the borrower (unless they release the lien for some compensation, like under HAFA).

With a bankruptcy - under certain circumstances - the borrower keeps the house, and the 2nd lien is converted to unsecured debt and does not have to be paid in full. This is probably part of the reason for sharp increase in bankruptcy filings.