Second Lien Writedowns, II

R.A. (Ryan Avent!) writes in response to my previous entry:

[Mike’s thesis] places the government in a bind. If it forces banks to write down worthless second mortgages to clear the way for new modifications, then the banks suddenly look shaky again. If it doesn’t, then lots of homeowners are stuck in loans they can’t modify and may not be able to afford.

I think that he may be overstating the potential pain to banks, however. It is the case that troubled borrowers are very likely to have second liens. But is it the case that second liens are likely to belong to troubled borrowers?

We see that the four big banks hold $477 billion in second lien mortgages. Losses on those mortgages attached to underwater properties with borrowers seeking modifications are likely to be very high—significantly higher than 13%. But 75% of mortgage borrowers in America are not underwater. We would expect second liens to be far less common among borrowers with positive equity, but because there are so many more borrowers with positive equity, it’s not at all clear that most second liens fall into the category Mr Frank describes. And of those homeowners who are underwater and have second liens, not all need a modification.

Let’s get a little bit of data in here I should have opened with. I’m going to go to a paper by Laurie Goodman from Amherst Securities Group, “2nd Liens—How Important? “, covered here by Alphaville, and reproduce some text and a chart:

Exhibit 7 (below) contains this information. For prime loans, on average, the simultaneous 2nd is 19% of the mark-to-market value of the house, which raises the prime loan CLTV (total liens/market value of the home) from 105 to 124. Subsequent higher liens are 26% of the mark-to-market value of the house, raising that CLTV from 83 to 109. For properties that have both a simultaneous 2nd and a subsequent 2nd, the increase in CLTV is 29% of the market value of the house (from 94 to 123). For Alt-A loans, the simultaneous 2nd is now 26% of the value of the house (from 121 to 147), while it is 30% for subsequent higher liens (from 99 to 129) and 36% when both are present.

That chart has a lot going on, but the last two columns are the first place to start. The second to last column is the current loan-to-value, LTV, of the first lien. If it is greater than 100, it is underwater on the first mortgage by itself – the loan is greater than the value of the house. (Note the third to last column, which is the original LTV; there goes the bubble, eating 20% since origination.) The last column is the current CLTV, or combined-loan-to-value, which is the loan to value on all the debt of the property. For properties with a single lien, or with the second lien paid off, they are necessarily the same. These are averages – the data sources aren’t more specific. (I believe this data consists solely of loans originated since 2003).

As you can see, on average the loans with second liens are underwater; they are both underwater if there was a subsequent higher lien (they got an additional mortgage at some point, perhaps to get equity out of their home), or if they got a simultaneous second lien (where they got a first mortgage for 90% of the LTV, and then a second mortgage to get the rest of the balance). If it is greater than 120, that’s a danger zone for strategic defaults and vulnerability to unemployment (areas with high unemployment and an LTV greater than 120 are significantly at risk for large scale foreclosures). The simultaneous second liens are particularly brutal.

This is good advice, and advice I’ll be taking from now on – when people discuss housing statistics and LTV, keep an eye if they are talking about LTV or CLTV – it makes a massive difference, as you can see above.

The simultaneous second lien CLTV for option ARM, on average, is 169. My god.

And a quote from Goodman’s House testimony about this research:

Third, any principal reduction program requires the Administration to address the second lien problem head on. The solution is clear — the banks that own the second liens will have to write them down. The treasury may choose to pay an “extinguishment fee”; it may make sense to allow the banks to take the losses over time. But for the sake of giving homeowners the best chance to stay in their home, the second lien will have to be extinguished. It should be noted that second liens have thus far, under HAMP, been treated with kid gloves.

Ah, Treasury paying an extinguishment fee. Fantastic! Note that if the stress test was updated quarterly and assets had to be marked consistently in some manner, the banks would be forced to writedown these second liens. Instead it looks like taxpayers will bribe nudge the banks to let go of their second liens through TARP money so that mortgage modifications between the primary lien holder and the resident can continue. Odds that we’ll get a value-added-tax next year but not a financial transaction tax or TARP recipient tax?

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10 Responses to Second Lien Writedowns, II

  1. BAM says:

    So should I hurry up and get a 2nd mortgage on my house before they write everything down? Seriously, was it greed that drove banks/lenders to encourage people to do this? “Sure the shallow end of the pool is nice, but try the deep end! It’s a fun place to be” says the lender all while the swimmer is slowly drowning.

    What a joke all of this is. There are two sides here really: taxpayers and government/lobbyists/banks/financials. Guess which side is going to get screwed in the long run no matter what happens. I’ll give you two guesses.

  2. csissoko says:

    One other dimension that you probably need to consider is the difference between securitized HELOCs and HELOCs held on a bank’s books. According to the ABA less than 2% of the HELOCs on banks books are 90 days overdue or non-accruing — that is they’re performing much better than prime mortgages.

    • njnnja says:

      Laurie’s piece makes this exact same point, and has some interesting observations re: portfolio vs. securitized seconds. I recommend reading the entire document.

  3. csissoko says:

    A commenter over at Bruce Krasting ( may have the explanation for the outperformance of HELOCs. Whereas many prime mortgages are non-recourse, HELOCs are usually full recourse loans — so there is a strong incentive for people who don’t want their wages garnished to pay them. No wonder the mortgage market is a mess.

  4. Mike says:

    Re: puzzling well 2nd/junior performances, from the Amherst Report, should have mentioned it in the body:

    So here is the puzzle—Why are delinquencies on bank-owned 2nd liens lower than on bank-owned 1sts? We have two theories. First, some borrowers are paying their 2nd mortgage without paying the 1st. Remember, banks own many 2nds on which they do not own the 1sts. It could be that if a bank owns and services the 2nd and the 1st is in a securitization, and if the borrower is not in a financial position to make two payments, he is “encouraged” to pay the 2nd, and told the 1st can be modified.
    Another set of circumstances that will generate the same outcome: if there are two different creditors knocking; the creditor with the 2nd lien is more aggressive and the payment is lower. The borrower will pay the bill with the more aggressive creditor and lower payment, to make one creditor go away. That is, the borrower does not
    recognize that the 2nd lien servicers’ threats of foreclosure are hollow: the recovery, if the home is sold, is usually insufficient to both pay off the 1st and allow for a
    substantial recovery of the junior lien. Second, many borrowers are not paying their 2nd, but most of those are unpaid 2nds are home equity lines of credit. The unpaid interest is simply added to the balance, and the loan technically remains current.

  5. fresno dan says:

    Wish I had started reading this blog earlier.
    Your commentor made a reasonable supposition, and your response addressed the issue in detail, and shows a very comprehesive knowledge of the issue and the data that is available.
    thank you for sharing your knowledge and insights.

  6. Todd says:

    Fantastic research and post Mike. Even with all the backstops, guarantees, bailouts, etc. it seems the banks are still in dire shape and may still be exposed. I was under the impression much of this had been reserved for since it is easily foreseeable. But I guess that is naive.

    It makes me wonder what the opportunity cost of all these efforts is? Clearly enormous and, sadly, mostly unknowable.

  7. Pingback: Underwater Second Liens « The Baseline Scenario

  8. Sprizouse says:

    Just thinking out loud here Mike, maybe you can help me (and tell me if I’m right, wrong or lost somewhere).

    I examined the 10K filings of the Big Four to look at their current 2nd liens. It appears they’ve written down almost $43 Billion on the 2nd liens between the government’s stress tests in April and their end of year filings.

    What I did next was take the percentage change in 2nd liens after the writedowns, and subtract that percentage from 60% (which was your worst-case adverse scenario) to see how much further the writedowns have to go. I came up with $220 Billion still left.

    So at the current annualized pace of writedowns (I assumed the annual pace was $65 Billion because they wrote off $43 Billion in the 8-months between the stress tests and their filings) and assuming 60% losses on the 2nd liens, it will still take them another 3.3 years to remove it all.

    But can you see any chance for the current spread scheme (which Tyler Cowen called gruesome) to last another 3.3 years, thereby enabling them to ‘drag themselves to solvency’ (as you put it)?

    Further, if this gruesome spread scheme is contributing, let’s say, 20% to their writedown abilities, that means it will have to be responsible for $44 Billion of the remaining $260 Billion in writedowns. Further if the banks are borrowing at exactly zero percent, the current spread on the 3-year is still only 1.47%, so with a compounded rate I still see that the ‘Big Four’ alone will have to buy almost $1 Trillion of treasuries in the next three years to remove those holes using this scheme (which seems like an AWFUL lot!). And all this is assuming short-term rates don’t rise in the next three years.

    Well anyway, I’m guessing some of my assumptions don’t add up properly in places, but perhaps they do. Maybe you can correct me or run this scenario on your own.

  9. Pingback: Business Items :: Not All Is Well

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