A Lien-Stripping Argument in Two Paragraphs.

Josh Rosner just released a follow-up note on the current foreclosure crisis, Why “Blank Name” Matters and Trustee Obligations, which takes a balanced but worried stance on how the the assignment of notes in “blank” name can cause problems on the legal chain of mortgage backed-securities.

Speaking of Rosner and securitizations, here is Rosner’s presentation for the Roosevelt Institute’s recent financial reform conference, The Future of Financial Reform, on securitization reform. Here is his chapter, Securitization: Will the Wild West Become a Ghost Town or a Thriving Metropolis?, and here is his summary on reform:

I wanted to also highlight the following two paragraphs from his chapter, which is a perfect summary of the debate for lien-stripping (or what is often called “cramdown”) and how it relates to our current crisis. We’ll need this in our policy and theoretical toolbox for the for the next couple of posts.

Priority of Lien

As noted, the priority of a first-lien obligation over a second lien remains questionable. Currently, it is almost impossible for the holder of a first lien to know if a second lien exists on the same collateral. Without first-lien-holders and second-lien-holders knowing of the other’s existence or the terms of their contracts, it becomes very difficult to assess their credit, liquidity and contractual risks or the risks to the borrower’s ability to meet obligations under their contracts.

This problem must be addressed, but doing so would likely require legislation. The problem is all but unique to consumer lending. In corporate lending a borrower must generally receive approval of senior creditors before being able to issue a second lien on the same collateral. The same should exist in mortgage lending. If the first lien is expected to be underwritten based on a borrower’s ability to repay, it does not make sense to allow another lender to underwrite a loan to the borrower in excess of that first obligation without either an explicit prioritization of payments to the first lien ahead of the second or without prior approval of the first-lien-holder.

The financial markets would never let the twisted way we let set up multiple mortgages exist in the corporate market. With mortgages people can take out junior liens, like a home equity line of credit, without permission of the first mortgage and often without even informing the first mortgage.  Since they are secured on the home, this completely changes the risks the first mortgage holder has.

The only way to do this system and not have it cause major problems when distress hits is to have an explicit prioritization of payments and an explicit prioritization of rewriting the debt in bankruptcy, which is all that lien-stripping is. This is even more crucial in the world of securitization where it isn’t clear if the people who would rework debt are either incentivized, legally capable or have the expertise and resources to carry the reworking of debt. Not having this in place years ago has made it very difficult to rework debt, which has just kept the foreclosure and economic crisis going longer than it needs to be going.

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