Felix Salmon

The second-mortgage underwriting failure

By Felix Salmon
February 8, 2010

In case you missed it on Friday, it’s worth checking out Tracy Alloway’s post about second mortgages in the US. She makes a very good point about how they’re making it a lot more difficult for mortgages to be modified — but we kinda knew that already. What I, at least, didn’t know was this:


All those second-mortgage-backed CDOs which have gone to zero, causing enormous losses? They’re in that tiny little purple wedge at the bottom. The overwhelming majority of second mortgages, it turns out, are held the old-fashioned way, on the books of banks, credit unions, and savings institutions.

Now this goes strongly against the dominant narrative of the subprime crisis, which is that the originate-to-distribute business model was largely responsible for the disastrous collapse in underwriting standards. Here, there was no originate-to-distribute business model, and clearly most of these seconds should never have been written — but they still were, and what’s more they were underwritten disproportionately by the big four commercial banks. (Actually, I’m not clear on if they were underwritten by the big four, of if the big four have just acquired them through the acquisition of companies like Countrywide and Wachovia.)

What explains the commercial-bank loan officers taking toxic second mortgages onto their own books? I think it’s a combination of factors. Firstly, they believed the hype. Secondly, they were reaching for yield in the Great Moderation just like everybody else. And thirdly, the originate-to-distribute model still existed in a smaller form: the banks were acquiring these loans from mortgage brokers who got paid at close, whether or not the loan was a good one.

None of that, of course, is remotely helpful in addressing the problem today, of what on earth to do with $1 trillion in second mortgages. It would be great if all the banks just wrote them down to zero, but you know that’s not going to happen. And first-lien mortgage holders are going to hate to give the second-lien holders anything at all — what Al Yoon calls “a principal reduction plan where losses are shared”. Some of the bondholders might be asking for that, but I’ll bet you they’re mainly the holders of triple-A-rated tranches, who don’t mind if the holders of lower-rated tranches get wiped out through a loss-sharing agreement. If this kind of plan does go through, expect holders of the lower-rated tranches of first-lien mortgage bonds to scream blue murder, and possibly go to the courts. They’re meant to be senior to the second liens, after all, yet they might well get nothing while the second-lien holders get something. What a mess.

4 comments so far | RSS Comments RSS

How did we get to a state where first lien holders are even considering sharing in the loss of principal before the second lien holders get wiped out? Never mind the gall it takes for a 2nd lien holder to think she’s owed anything. But what possible power does she have to pressure the primary mortgage holder to even entertain the notion?

Posted by Sandrew | Report as abusive

Rules are rules, and sometimes the rules do not wipe out junior debt to zero before starting to hit senior debt. If you are senior debt, you absolutely must know the rules inside and out, and if they bite you, it is your fault.

Not to put too fine a point on it, but neither the law nor the debt markets are or should be your mommy.

Posted by wcw | Report as abusive

At issue is that the first lien can’t be modified without paying off the second, or getting the second to agree to re-subordinate.

So, if the holder of the first thinks they will recover $100k in a foreclosure, but $150k in a modification or short sale, the junior lien holders threaten to refuse consent, and force foreclosure, unless they are kicked-back some of that $50k difference.

Posted by Brad9999 | Report as abusive

Sloppy post Felix. The chart above is post-writedown and/or post-runoff as of Q3 2009 and tells you nothing about the issuance model. Consider:

http://www2.standardandpoors.com/spf/pdf  /media/subprime_cm_dislocation_090308.p df

This S&P article puts second-lien ABS issuance between 2005 and 2007 at $150 billion (bottom p.7) – they were selling as fast as they could. Banks distributed a lot of product, some of which paid off investors after refinancing and much of which went to zero. Also any really bad 2005-2007 second lien is no longer on the books because it’s been through foreclosure. Banks currently hold such a high volume due to the near-complete shutdown of the ABS market, particularly for residential second liens. All the stuff that was in their pipelines in 2007/2008, which they probably would have loved to get rid of, was unsaleable. Some of the stuff written more recently in reasonable markets may actually be decent quality, if the income is well-documented and they charged a good premium. Think of someone with a good, stable job who waited to buy a nice California condo until 2008/2009 and took a lot of debt because rates were low and they didn’t want to liquidate stocks.

You are correct that much of the volume was acquired by BofA when they bought Countrywide, but of course this retention of credit risk was not a rational choice on the part of Countrywide but an unplanned disaster that would have wiped out their company if not for the acquisition. Anyone who was not a TBTF bank and was writing a lot of second-liens failed – mainly due to zero recoveries in defaults which erased these second liens – thus, it’s inevitable that a large fraction of remaining second liens will be held by large banks.

What will happen is the same thing always happens when you have a lot of bad debt that no one wants to recognize – it will be resolved in grinding, interminable fashion in bankruptcy court. Existing contract and bankruptcy law is our best effort to resolve debt problems fairly, and to imagine that politicians, lobbyists, and bankers are going to generate a better plan mid-crisis is a fantasy. A few smart people will make a lot of money and everyone else will feel lousy. In the long run the housing stock will be redistributed to people who can hold it, some banks will fail, and some new banks will arise. Nothing exciting to see here, move along.

Posted by najdorf | Report as abusive

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