naked capitalism

A fairly long discussion, by blogosphere standards, has broken out over second liens. For those comparatively new to the topic, a recap is in order.

Second liens are either second mortgages or home equity lines of credit on homes. The bone of contention is that mortgage servicers, which also happen to units within the biggest US banks, have not been playing nicely at all with stressed borrowers out of an interest in preserving the value of their parent banks’ second liens. And the reason for that is that writing down second liens to anything within hailing distance of reality, given how badly underwater a lot of borrowers in the US are, would blow a very big hole in the equity of major banks and force a revival of the TARP. That is one of the very last things Team Obama would like to see happen, hence its eagerness to promote various extend and pretend policies.

The mortgage settlement proposal includes a provision that would call for second liens to be reduced pro-rata with the firsts. That, as Gretchen Morgenson noted, and Jesse Eisinger amplified, is contrary to long-standing principles of priority of creditor payments. Felix Salmon then argued that the banks were within their rights to try to extract some value from the seconds, which led to further rebuttals by Adam Levitin and Mike Konczal. Levitin’s realpolitik argument was that given that TARP is closed for new business and Dodd Frank resolution isn’t operationally or politically attractive, the regulators are locked in forbearance strategies. Konczal points out a deranged aspect of the second mortgage market: that unlike any other type of credit, borrowers are allowed to take out second liens out without obtaining the consent of the first lienholder. This feature, BTW, dates to the Garn-St. Germain Depositary Institutions Act of 1982

Now let us remember: if an underwater house is foreclosed upon, the first mortgage comes up short and the second gets wiped out. In theory, both lienholders can try to get a deficiency judgment. In practice, no one does; if someone is so broke they will give up their homes, it’s pretty unlikely that trying to extract more from them will be a profitable exercise.

Here is Felix’s argument to the contrary:

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….

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.

Um, I wouldn’t call this a “sophisticated dance”, I’d call this baldfaced abuse by an agent with a clear conflict of interest. Banks get paid inadequately to service troubled portfolios; the pricing models result in them taking big losses. Pushing for foreclosure wipes out the second, so it’s hardly an option they want to exercise. But first mortgage investors are disenfranchised; the bondholder agreements required that 25% need to band up to sue (and even then they need to sue the trustee to get them to prod the servicer). That’s a high enough threshold to make the servicers unaccountable. Put it another way: if the first lien investors had decent access to the courts (and weren’t afraid of annoying big banks, yet another deterrent to litigation), or the second lien holders had nothing to do with servicing, I think you be hard pressed to argue that you’d see outcomes like the ones we are witnessing. The second lienholder advantage results from deliberate negligence of their duties to the investors (and if you don’t think they abuse investors in lots of other ways, I have a bridge I’d like to sell you). Therefore I have very little sympathy with the banks on this one.

A second mystery, raised both by Eisenger and Konczal, on why borrowers are defaulting on firsts and not seconds, is actually not that hard to clear up. Eisinger wonders:

The performance of second liens is among the biggest puzzles in banking today: why are they doing better than the firsts? When Wells Fargo disclosed its earnings, for instance, it classified 5.3 percent of its first mortgages as nonperforming, but put only 2.4 percent of its second liens in that category. That seems very odd because it’s much easier to lose your home if you don’t pay your mortgage than if you don’t pay your home equity line.

Konczal’s answer is partly right:

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.

Some of it, as he suggests, is ignorance: borrowers realize that making less than the minimum gets them nowhere, so they try to stay current on as many debts as possible. But is the fact that the payment on the first is smaller than the second really the driver? It might be, but there is good reason to think other factors are involved.

Anecdotally, it appears that banks use a very aggressive carrot and stick to keep seconds current. They threaten borrowers with aggressive debt collection on seconds. And on home equity lines, which are the overwhelming majority of second liens (see this spreadsheet courtesy Josh Rosner for details of the results from the five biggest servicers, click to enlarge), negative amortization is kosher.

For data junkies, 1 is Citi, 2 is JPM, 3 is BofA, 4 is Wells and 5 is GMAC

So what does a bank do? On day 89, before the HELOC is about to go delinquent, it tells the borrower to pay anything on it. A trivial payment is treated as keeping the HELOC current. So this explains Eisenger’s question: it’s easy for the Wells of this world to pretend that these second loans are doing fine if you will go through all sorts of hoops to make them look current, including if needed by lending them the money to make part of their interest payment. So even though a lot of commentators argue that it’s hard to argue that banks should write down their seconds if borrowers are current, what “current” really means deserves a lot more scrutiny than it has gotten.

Finally, Konczal (presumably in the interest of giving the devil his due) cited a pretty remarkable 1999 American Enterprise Institute study by Charles Calomiris and Joe Mason which argued that the second and first mortgage conflict was by design. The excerpt was not consistent with the way I’ve heard investors discuss these liens. I pinged a buy-side contact who wrote back:

Regarding investor expectations of seconds – I’d like to say that the Mason article cited by Konczal is an astonishing piece of shill work. I was active in high LTV 2nd lending going back to 1995 with a select group of lenders. The lenders, the rating agencies, the investors and the insurers all knew that making 2nd lien loans currently with negative equity, (or the potential to have negative equity), meant the loan could be crammed down.

The Supreme Court’s early 1990s decision on cramdowns specifically excluded investor properties and second liens [this is the decision that disallowed bankruptcy judges from writing down first mortgages on primary residences in Chapter 13 bankrupticies to the current market value of the collateral, which is the practice in all other types of secured liens, and treating the balance as unsecured]. We discussed these types of loans as being semi-secured – the lien provided some leverage but could be written down if challenged. Obviously, this means they were high risk loans when made (or invested in). As a result, the lender had to be very careful when making the loan. The lenders I worked with only extended these types of loans if they put the borrower in a better financial position by lowering his overall debt level and also made sure that they had a minimum of $3-4 k of unencumbered cash flow every month.

Believe or not, when lenders are concerned about the risk in their loans and careful about their exposure, they can make good loans. These high LTV second liens have performed better than first lien Alt A and subprime deals from the same era. When I checked a few months ago, most of my company’s 2004-2006 high LTV second lien deals had not been downgraded despite this housing blow up.

Mason’s argument about how awful it would be to make high LTV seconds unsecured is total BS – the risk of this happening is what made the lenders do their jobs well.

So the banks’ arguments in favor of not writing down seconds don’t stand up to much scrutiny. But given the reality that many commentators have stresses, that realistic values of the second mortgages would reveal the biggest US banks to be insolvent, we’ll continue to see both theatrics and borrower abuses continue in the interest of shoring up miscreant and incompetent lenders.