Five on Why Second Liens are Important to the Mortgage Settlement.

Jesse Eisinger writes In Proposed Mortgage Fraud Settlement, a Gift to Big Banks, arguing that “when the principal on the first mortgage is reduced, the second lien is typically wiped out. The first lien holder has the first right to any money recovered, and the second lien holder has to wait its turn.” Since the rule in the leaked mortgage settlement says that seconds should be written down “at least proportionately to the first” this is a gift to the banks.

Eisinger quotes Arthur Wilmarth, a law professor at George Washington University, sayin “seems astonishingly generous to the second-lien holders…And who are those? Of course, they are the big mortgage servicers” and goes on to note: “But this suggests that the banks, with the authorities’ tacit approval, think contracts are for thee and not for me. The price to get the banks to do the right thing contractually with mortgage modifications and foreclosure is to allow them to not do the right thing elsewhere.”

Felix Salmon responds with Why the AGs are right to leave second liens alone:

The mortgage settlement is designed to lay out basic minimum standards that mortgage servicers have to live up to. There have been a lot of sleazy practices to date, and the settlement is designed to put an end to such practices. But if you owe a bank a large amount of money on your home equity line, it’s not sleazy for the bank to ask you to pay at least some of that money back.

In any event, the settlement is in no sense allowing banks to do something they weren’t allowed to do before. The idea is to set rules for banks servicing first liens, remember — and the owner of the first lien has always had the freedom to leave the second lien entirely untouched if they want. In most cases, banks don’t actually want to do that. If you’re taking a hit on a secured loan, you don’t want to be bailing out someone whose debt junior to your own….

Eisinger and Morgenson might want to force banks to write second liens down to zero as a matter of public policy whenever there’s a loan mod on the first, but that would be step too far for me. Sophisticated banks already do a delicate dance with each other in these situations: the owner of the first lien wants the owner of the second to write down that loan as much as possible, but the owner of the second has a certain amount of negotiating leverage in terms of being able to hold up the modification or even push for outright foreclosure.

There’s two issues here, whether 2nd should be extinguished completely before a modification on the first happens, and whether or not bringing process in on 2nd mortgages is essential for any mortgage foreclosure settlement. I’m going to put out the current evidence we have that conflicts with second-lien mortgages are an important part of the story of what is going on with the foreclosure situation.

First, some aggregate data.  The servicers work for the largest banks:

The largest banks have about half of second lien debt on their books, over $400 billion, second liens that are valued very high from the stress tests:

The largest four banks have half the second-lien market, and they also manage the first lien.   For a modification to the first lien to happen, it is customary for the second-lien lien to be wiped out.  Conflict?

The junior liens have a pretty high valuation from the spring 2009 stress test, valued at 85 cents on the dollar or so.   If you want to see a deeper dig into the valuation issue that I brought up here, John Cassidy did some investigating and James Kwak responded to his arguments, and until we know more I’m in Kwak’s camp.  Second-lien exposure is about 3/5ths bank common equity, and if these things get written down aggressive the four largest banks could have to go back into TARP or we’d have to test out this resolution authority mechanism.  Maybe that’s why HAMP hasn’t been all that aggressively enforced and has left people worse off over the past two years?

Second, our best empirical evidence is that seconds are getting in the way of successful modifications.   From October 2010, here’s Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet and Douglas Evanoff on “Market-Based Loss Mitigation Practices for Troubled Mortgages Following the Financial Crisis.”  Three of the authors are from the Federal Reserve Bank of Chicago, and I believe it is at the edge of our understanding of this crisis. They find:

Consistent with the idea that securitization induces agency conflicts, we confirm that the likelihood of modification of securitized loans is up to 70% lower relative to portfolio loans. Finally, we find evidence that affordability (as opposed to strategic default due to negative equity) is the prime reason for redefault following modifications….In terms of magnitudes of the estimated coefficients, second lien loans are the least likely to be modified, controlling for all other loan characteristics. This is hardly surprising, as junior liens likely suffer most severe losses in modifications….In a similar flavor to this result, we find that loans which are second lien (piggybacks) are less likely to become modified. Again, the magnitude is large: -0.113. We attribute this result to the conflict of interest between lenders.

Second-liens are a major driver of what is causing fewer modifications.   The presence of a second-lien causing conflicts between lenders as well as reducing the number of modifications shows up as a major driver in aggregate data.

Third, there’s some pretty serious statements floating out there that the servicers are making sure the second liens get paid even when the first doesn’t.  Check out Mr. David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at House committee on “Second Liens and Other Barriers to Principal Reduction as an Effective Foreclosure Mitigation Program”:

It is important not to confuse payment priority with lien priority. In almost all scenarios, second lien holders have rights equal to a first lien holder with respect to a borrower’s cash flow. The same is true with respect to other secured or unsecured debt, such as credit cards or car loans. Generally, consumers can decide how they want to manage their monthly payments. In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.

So what you see is a lot of people, almost 64%, who have stopped paying the first trying to make some sort of payment and paying the much smaller second. It’s tough to justify why a financially literate person would do this – the first is the one that is going to drag him into foreclosure. That servicers could keep mortgages in delinquency limbo while they hope to earn out enough of the second rather than get down to business and re-modify the loan in question is a the type of conflict very specific to this situation, and one that any best practices for servicers need to address.

Fourth, I don’t think investors in the first lien have enough information to actually challenge this.  Last December Zach Carter reported, House Democrats Push For New Foreclosure Regulations, explains how a new letter from Representative Miller is being signed by House Democrats which joins and references a letter from 52 economists, financial experts and activists.   I found these servicer regulations, organized by Chris Walen and Josh Rosner, quite strong. What did these new servicing regulations call for in terms of seconds?

– Mitigate losses on residential mortgages by taking appropriate action to maximize the net present value of the mortgages for the benefit of all investors in a securitization rather than the benefit of any particular class of investors.

– Disclose any ownership interest of the servicer or any affiliate of the servicer in other whole loans secured by the same real property that secures a loan included in a given pool of mortgages used in a securitization.

– Eliminate the regulatory incentives that motivate banks to keep troubled portfolio loans in “limbo,” without permanent modification or remediation, merely because the bank is successful in obtaining a marginal payment that avoids classifying a loan as non-accrual.

– Establish a pre-defined process to address any subordinate lien owned by the servicer or any affiliate of the servicer, if the first mortgage is seriously delinquent (i.e., 90 days or more past due) to eliminate any potential conflicts of interest.

Less than making sure that the 2nds take the full brunt of the second wave of losses (after homeowners), it’s more about making sure there’s a good process in place to not abuse the servicing of these loans through “limbo” states, and to realize the business is maximizing the value of all investors, not just a single one.  That’s really important to get down on paper.  Because…

Fifth, remember, this conflict is by design. Here is a paper by Charles Calomiris and Joseph R. Mason for the American Enterprise Institute back in 1999, High Loan-to-Value Mortgage Lending: Problem or Cure? This is the cramdown debate in 1999:

Misplaced concerns about the riskiness of HLTV lending and the destabilizing effects of reloading and churning have led some in Congress to advocate altering personal bankruptcy law to allow cram-down—or bifur- cation—of mortgage debt exceeding 100 percent of home value. Under such a scenario a borrower filing under Chapter 13 would avoid foreclosure. Mortgage lenders would retain senior claims on the borrower up to the amount of the fair market value of the underlying property at the time of bankruptcy. The HLTV loan would thus be second in line as a claim on borrower wealth up to a maximum of the value of the mortgaged property. The amount of the HLTV loan greater than the value of the underlying property at the time of bank ruptcy would be treated as unsecured debt and placed on an equal footing in the bankruptcy process with other unsecured debt.

Such a fundamental change in the nature of the HLTV debt contract would undoubtedly undermine the special advantages of HLTV loans. By limiting the re- sources that stand behind the loan to the value of the mortgaged property itself, the law would transform HLTV lending from its current form—a relatively senior, collateralized claim on the consumer’s wealth—to essentially a junior claim on the amount of housing wealth (but not the actual house) of the consumer….

Cram-down would essentially eliminate that special bargaining power of the HLTV lender.

People knew back then than junior claims on debt would give those junior-lien holders a “special bargaining power” in terms of working out bad debt.  The idea is that it would screw up the ability to work out bad debt, and as such that debt would be a bit cheaper than if there was a sensible mechanism in there, and then we could all max out our homes a little bit easier.   Little did we value how important solid rules, procedures and mechanisms for running our consumer debt system would be, and that they wouldn’t magically appear through some sort of Economics 101.

Notice we would never set up any other market this way. If I put my car on a roulette table in Vegas I can’t turn around and say to the auto loan company “oh you are going to have to work out my debt to you with my gambling bookie.  He has a claim to your collateral.” The idea that you could issue junior liens on the same collateral without contacting or seeking permission of the primary collateral holder is, to the corporate finance part of my brain, b-a-n-a-n-a-s. I couldn’t imagine our corporate market working this way with junior liens being issued with senior creditors unaware and not having to grant permission; I’m surprised we allowed it to happen in our residential mortgage market. Right now first-lien holders can’t even be sure that they are the only claim on their collateral.  How are you even suppose to do risk modeling that way?

And I’m even more surprised we’ve taken no steps to fix it. Ok, I’m less surprised by that. The largest four banks are quite powerful.