As the aftermath of the U.S. housing market collapse in 2008 continues to unravel, the U.S. Supreme Court this week heard oral arguments in a case that will decide whether an underwater mortgage loan can be wiped out in a bankruptcy proceeding.

The high court’s decision in the consolidated cases of Bank of America NA v. Caulkett and Bank of America NA v. Toledo-Cardona will decide a common question facing bankruptcy courts in the wake of the housing market collapse and national foreclosure crisis: whether a Chapter 7 debtor may “strip off” a junior mortgage lien in its entirety when the loan is underwater, or when the outstanding debt owed to a senior lien holder exceeds the current value of the collateral.

In both of the cases currently before the court, the respondents filed Chapter 7 bankruptcy petitions in 2013 in Florida. Their homes had second mortgages, or junior liens, that were completely underwater in that their homes were worth less than the amount they owed on their first mortgages, or senior liens, which would recover first in the event of a foreclosure. Bank of America possessed the junior-lien rights in both cases.

The legal question presented in the cases stems from a 1992 Supreme Court case, Dewsnup v. Timm, which barred Chapter 7 bankruptcy debtors from “cramming down” an underwater second mortgage to its current market value, voiding the junior lien holder’s claim. In the current cases, however, the 11th Circuit Court of Appeals went against that ruling by deciding in favor of the homeowners. According to the court, the Dewsnup ruling did not apply in these cases because the junior lien lacked sufficient value.

But all eyes are on the larger economic implications of the case. The Supreme Court’s decision is expected to impact the amount that mortgage lenders like BofA can recover when they are junior lien holders on loans in the event of a debtor’s declaration of bankruptcy — which could, according to some, affect the overall mortgage market.

Some banking and lending trade groups that filed “friend of the court” briefs in the case contend that lenders will hesitate to extend loans to borrowers if they will be secured by a second lien on the property, and that lenders will be reluctant to accept property as collateral if the property’s value fluctuates because they may lose their rights to the property in the event of a bankruptcy.

BofA’s attorneys have noted that between 2012 and 2014, the number of underwater junior mortgages was cut in half from 4.2 million to 2.1 million — “so houses are coming above water every day,” BofA’s attorney, Danielle Spinelli, told the justices in the one-hour oral argument on March 24.

“Bank of America has many cases pending right now in the 11th Circuit,” Spinelli, a partner in WilmerHale’s appellate and Supreme Court litigation group in Washington, D.C., said. “We have cases in which the value of the house would need to rise only by $4,000, where it would need to rise only by $5,000, and given that we’re in the middle of a market upswing, it’s very plausible and very likely that many of these mortgages will regain equity.”

These particular cases, however, are an anomaly, Spinelli said.

“The second liens are deeply underwater. That’s not true in every case, and there’s no reason to think it’s true in the typical case,” she said.

On the flip side, attorneys and bankruptcy experts have countered that investors holding second mortgages often obstruct arrangements that would benefit both homeowners and first mortgage holders. Allowing bankruptcy to strip off second mortgages that no longer contain any actual value will help more homeowners keep their homes, they have argued.

Asked by the court to assess the impact of its decision on second mortgage lending, Stephanos Bibas, attorney for the respondents, told the justices, “Even if there were an effect on second mortgage lending, one has to balance that against maximizing the value of first mortgages, which are purchase-money mortgages which are helped by unclogging the housing market. The chief economist at Moody’s Analytics said that resolving subordinate liens was the biggest obstacle to the housing recovery.”

“When you get to 150 percent of loan-to-value [ratio], at those ranges, lots of people are in default,” Bibas, a professor of law and criminology at the University of Pennsylvania Law School, noted later. “They qualify for bankruptcy because they’ve lost a job, or they are ill. They can’t make the payments and pay into a black hole of negative equity. They walk away. The home is thrown into foreclosure anyway, and the senior creditor is worse off. And the junior doesn’t care because the junior doesn’t get anything either way.”

The Supreme Court is expected to issue a decision on the case in June.

Email Amy Swinderman.

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