Why the AGs are right to leave second liens alone

By Felix Salmon
March 17, 2011

Jesse Eisinger has a conspiracy theory about the way that second liens are treated in the proposed mortgage settlement:

The proposed agreement — which is preliminary and subject to intense negotiations being led by Tom Miller, the attorney general of Iowa — would allow banks to treat second mortgages, like home equity lines of credit, just like the first mortgages. Under the proposal, when a bank writes the principal down on the first mortgage, the second should be written down “at least proportionately to the first.”

Suddenly, the banks would be given license to subvert the rules of payment hierarchy, as Gretchen Morgenson pointed out in The New York Times on Sunday. Yes, the clause says the other alternative is to wipe out the second’s value entirely, but given a choice, the banks would be extremely unlikely to do that…

When the principal on the first mortgage is reduced, the second lien is typically wiped out…

The proposal “seems astonishingly generous to the second-lien holders,” said Arthur Wilmarth, a law professor at George Washington University. “And who are those? Of course, they are the big mortgage servicers.”

I don’t understand this at all — especially not the “suddenly” bit. 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.

So the banks will always push as hard for the second lien to be written down as much as possible, except perhaps when the owner of the second lien is the same as the owner of the first. Jesse’s contention that the banks would be “extremely unlikely” to wipe out the second entirely makes no sense to me — that’s exactly what they’re going to want to do, in pretty much every case when they don’t own the second lien themselves. And in any case the settlement doesn’t allow the banks to do anything they haven’t been able to do all along.

Morgenson says that the proposal is “turning upside down centuries-old law requiring creditors at the head of the line to be paid before i.o.u.’s signed later” — but what we’re talking about here is a voluntary loan modification, not a foreclosure liquidation. The law determines what happens to the proceeds of a foreclosure sale; it says nothing about what banks can or can’t do of their own volition. If I lend you money, I have every legal right to forgive the loan entirely if I want, no matter how many creditors junior to me end up getting paid in full.

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.

Let the banks dance this way: the outcome is normally fine, and no one is being unfairly taken advantage of. The AGs’ settlement seeks to enforce basic decency in mortgage servicing; it shouldn’t also try to enforce dubious policy on second liens.

Update: In the comments, ErnieD and Jesse Eisinger explain what the issue is here. The banks securitized the first liens, but they own the second liens. So modifying a first lien costs them much less than writing down a second lien. In that situation, there’s a big conflict of interest at servicers, which are owned by banks, and have a financial interest in transferring too much value from the first lien holders to the second lien holders.

This is a good point, but I’m still not convinced that the AGs’ settlement is the right and proper place to address it. Servicers are treating borrowers badly, and the settlement addresses that. On top of that, they may or may not be treating bondholders badly, too. Trying to address that issue simultaneously I think makes an already-complex agreement so hard to construct that it would never see the light of day.

Comments
16 comments so far

Here is my limited understanding of the issues here:

1. First mortgages were securitized when they were originated. Often the originators became the serciers, now mainly owned tby the large banks (BoA buying Countrywide etc.)

2. Neither the banks nor the servicers own the bulk of the MBS’s created from the securitized mortgages. Instead, they are generally held by institutional investors (insurance companies, pension funds etc.).

3. The investors in the MBS’s are relatively passive by design. The day-to-day decisions on foreclosures etc. are undertaken by the servicers.

4. The servicers used their relationships with the borrowers to sell them HELOCs. These HELOCs were generally not securitized and so are still on the books of the serviers or their parent banks.

5. The servicers receive substantial fee and penalty income from defaulting borrowers who go into foreclosure. They still need to remit principle+interest payments to the MBS until the foreclosure is complete but get to keep the fees and penalties.

6. The servicers sell the foreclosed property, get their fees and penalties from the foreclosure process, send the rest of the first mortgage principal recouped to the MBS investors, and can keep the rest to cover their HELOC if anything is left.

7. Since the MBS is the first lien in precedence, a principal mod theoretically should apply first to the HELOC and then to the first mortgage. Traditional lien precedence would mean that the servicers would need to wipe out their own equity before they could ask the MBS investors to share the pain. Doing anything other than this would require a very disparate group of investors to approve an alternative structure allowing the servicer to keep a bunch of principal.

It appears that the system is replete in conflicts of interest for the servicers. It is hard to see how they can make equitable decisions when the law says that they should be the first to take major write-offs and their primary mode for recouping those losses is to delay foreclosures, thereby maximizing fees and penalties that they get instead of the investors. The executives in these organizations should be nominated for sainthood if they can actually go through these processes and not get dragged to the dark side.

It is unclear to me if the servicers have a fiduciary duty to the MBS investors. If they do, there would be lots of incentives to breach it.

All in all, I think the US has created a mortgage and foreclosure system over the past decade that makes a Rube Goldberg Machine look simple and rational. It has clearly failed on so many levels, that it needs to be reworked from scratch.

Posted by ErnieD | Report as abusive

My complaint about this post is that the third-to-last paragraph should have been more prominent; I think this is the most salient response to what you’re responding to.

But, yes, exactly what you said.

Posted by dWj | Report as abusive

Felix,

You misunderstand the situation. This is confused:

“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.”

“ErnieD” has it right. Banks don’t own a lot of these 1sts. The servicers’ parent banks generally have the 2nd liens on their books, but the firsts are largely now nestled in RMBSs. Generally, the 2nd lien holders have to agree to a modification of the 1sts. Therefore, there is a conflict of interest. And since the ownership of the 1sts is diffused throughout the institutional investment world, they can’t easily organize to resist this.

Many participants believe that the servicers, which own the 2nd liens, are a major impediment to speedy modifications. Why? Because they would have to take a hit on the 2nds that they own.

This AG clause therefore seems to me like a carrot to the banks, to get them to agree to principal modifications. It creates the possibility that the owners of the 2nd liens (again, the big banks) would only have to write-down in “proportion” with the 1st, instead of taking the hit until the amount equal to their loan is exhausted.

Posted by JesseEisinger | Report as abusive

@dWj

However, I believe the problem here is that the banks are typically the junior creditor and the non-bank MBS investors are typically the senior creditor.

This settlement is heading in the direction of expecting the junior creditor to make the decision on how much of a write-off the senior creditor should take so that the junior creditor can minimze its losses when the law says it should be the other way around.

Posted by ErnieD | Report as abusive

Your “Update” reveals what a sham journalist you really are. You post an article about an agreement you don’t even understand, and with such a seemingly strong point of view for someone so ignorant of the subject matter. Someone at Reuters needs to yank your credentials. I guess it is true – even a monkey can type.

Posted by npsent | Report as abusive

And here is another thing that catches my eye. Even after being exposed as ignorant of the subject matter to the point where you couldn’t even understand the agreement you are writing about, you still put forth your “opinion” as to the agreement’s value. Why should anyone care what you think concerning a subject you can’t fathom? Your are exposed as a fraud. Please quit it.

Posted by npsent | Report as abusive

I just read your article entitled “Don’t Donate to Japan.” My regard for your abilities and judgement have been confirmed. You are a full-on-moron.

Posted by npsent | Report as abusive

duh. it’s even worse – both the linked post and the NYT article talk about exactly the point brought up by the ErniedD and Jesse. So Felix clearly didn’t even read the articles he’s commenting on.

Posted by niveditas | Report as abusive

I can tell you first hand that the conflict between first and 2nd lean holders is real. Customers try and refinances their first mortgages all the time when my small bank owns the 2nd.

We’ve been saying no alot lately because people are trying to take cash out on the re-fi or roll their closing costs into the new loan. The problem is that my bank is much less interested in the 2nd loan business so in many cases we’re asking to be paid off in full prior to allowing the 1st loan (owned by another bank) to be refinanced by another bank.

It really ticks off the customers but we try to explain to them that in the last two years the median recovery on a 2nd lean loan has been ZERO.

Posted by y2kurtus | Report as abusive

ErnieD, not sure your understanding is correct:

1) Originators are different legal entities from servicers with different management. They may or may not be part of the same group. They also have different legal obligations. If you think being part of the same group means you march in tune you need to have a quick look at what is happening between BlackRock and the old Merrils.

2) Servicers don’t own anything. They SERVICE the loans.

3) Investors are not “passive by design” when it comes to foreclosures. Rather if the MBS is agency – which the vast majority are – then they don’t care because of the credit wrap and if it is not then underlying credit risk on the loan is part and parcel of their investment process. I am sure alot of buyside were careless about this but that is because they were incompetent. The servicers are typically required to maximise the return to the investor.

4) Servicers didn’t anything to anyone. You mean the originators.

5) Er no. When the home goes into foreclosure then AFTER the home is sold, the servicer gets to deduct its **costs** before distributing the remaining cash. Back in the go go days when you could sell for above the loan amounts then obviously the investor doesn’t care but nowdays the servicer has to justify the costs which is now eating into the investors cut. If the investor is not bothering to check this then they deserve to get screwed. Also typically the servicer typically passes on the mortgage payments for up to 90 days after the default. Thereafter they typically are not required. So to summarise the servicer gets it’s fees AFTER the home is sold and AFTER the investor signs off on those fees.

6) See above. Did it never occur to you why there was a race to the bottom for people doing the legal process? Surely if all that money would magically go back to the servicer no one would care.

7) They are completely separate loans. A principal mod for the first loan makes it MORE likely the HELOC will see some cash as it is less likely the borrower will default. Typically before the second-lien would be wiped out before the first-lien feels the pain.

Imagine you got 100,000USD first lien, 20,000 second lien. If the house if sold for 120,000 then everyone gets paid, 110,000 then the second lien is worth 10k and first lien at par, then 100k wipes out the second lien and it needs to be sold at below that to hurt the first lien. If the first lien is modified then if the 2nd lien is more likely to see some cashflow. What this agreement is trying to prevent is the situation where having agreed to principal mod on the first lien the second lien refuses to modify. The Agreement says this can no longer happen. Basically if a principal mod on the first lien is 50% then the 2nd HAS to agree to having AT LEAST 50%.

That is now 4 articles you have quoted from the same idiot, every single one whinny self-righteous toss who also happens to completely and utterly wrong and showing him to be hopelessly clueless on the subjects he pontificates on.

Posted by Danny_Black | Report as abusive

ErnieD, not sure your understanding is correct:

1) Originators are different legal entities from servicers with different management. They may or may not be part of the same group. They also have different legal obligations. If you think being part of the same group means you march in tune you need to have a quick look at what is happening between BlackRock and the old Merrils.

2) Servicers don’t own anything. They SERVICE the loans.

3) Investors are not “passive by design” when it comes to foreclosures. Rather if the MBS is agency – which the vast majority are – then they don’t care because of the credit wrap and if it is not then underlying credit risk on the loan is part and parcel of their investment process. I am sure alot of buyside were careless about this but that is because they were incompetent. The servicers are typically required to maximise the return to the investor.

4) Servicers didn’t anything to anyone. You mean the originators.

5) Er no. When the home goes into foreclosure then AFTER the home is sold, the servicer gets to deduct its **costs** before distributing the remaining cash. Back in the go go days when you could sell for above the loan amounts then obviously the investor doesn’t care but nowdays the servicer has to justify the costs which is now eating into the investors cut. If the investor is not bothering to check this then they deserve to get screwed. Also typically the servicer typically passes on the mortgage payments for up to 90 days after the default. Thereafter they typically are not required. So to summarise the servicer gets it’s fees AFTER the home is sold and AFTER the investor signs off on those fees.

6) See above. Did it never occur to you why there was a race to the bottom for people doing the legal process? Surely if all that money would magically go back to the servicer no one would care.

7) They are completely separate loans. A principal mod for the first loan makes it MORE likely the HELOC will see some cash as it is less likely the borrower will default. Typically before the second-lien would be wiped out before the first-lien feels the pain.

Imagine you got 100,000USD first lien, 20,000 second lien. If the house if sold for 120,000 then everyone gets paid, 110,000 then the second lien is worth 10k and first lien at par, then 100k wipes out the second lien and it needs to be sold at below that to hurt the first lien. If the first lien is modified then if the 2nd lien is more likely to see some cashflow. What this agreement is trying to prevent is the situation where having agreed to principal mod on the first lien the second lien refuses to modify. The Agreement says this can no longer happen. Basically if a principal mod on the first lien is 50% then the 2nd HAS to agree to having AT LEAST 50%.

That is now 4 articles you have quoted from the same guy, every single one shows him to be hopelessly clueless on the subjects he pontificates on.

Posted by Danny_Black | Report as abusive

ok double posted… toned it down a bit, take your pick

Posted by Danny_Black | Report as abusive

again to be clear. Both loans are secured. I can be fully up to date on the first and if i default on the second i can be foreclosed on. The difference is then when there is cash – ie AFTER the foreclosure and AFTER the cash is in the bank. Then the first has the right to get paid in full and then whatever is left goes to the second. This agreement says nothing about that. This is about a principal mod on a non-foreclosed loan so the seniority is not an issue then.

Posted by Danny_Black | Report as abusive

anyone with at least two braincells would work out that Morgensen – i don’t put Eisinger in this category – is saying is insane. If 2nd liens are automatically written down to zero whenever there is a mod then they will simply not agree to mods. End of story. If you have a choice between a guaranteed zero and non-guaranteed zero which are you going to choose? I believe even Basic Finance for Absolute Idiots doesn’t have a section where it explains you should never chose the option where your payout that is **guaranteed** to be zero and as such is obviously far too advanced for Mr Eisinger. Remember you are only compliant if you are not in default on ALL your obligations.

The agreement says that the mod for the 2nd has to be AT LEAST as much as the mod for the first or extinguished all together, so the idea that somehow the second is taking money from the first is exactly the opposite of what it actually says.

Even the idiotic post defending his moronic article shows how little he understands. Most RMBSes are credit wrapped by Frannie. They take the hit on the mods, not the “diffuse” investors and you bet your bottom dollar they are not acting to maximise the returns for the holders of more junior debt. Even if they are not agency debt, the servicer is required by law to maximise the NPV to the loans being serviced.

Here is betting this useless churnalist didn’t even bother reading the original document. If he did then he needs to go back to have remedial first grade reading lessons. That you, most the NYT and some of the people at the FT have paid jobs just goes to show how unfair the recession truly has been.

ErnieD, the actual clause says the exact polar opposite of what you say. When the first agrees a mod the second has to agree to take at least as large a hit or get wiped out altogether.

Felix, in future, rest assured if mr Eisinger says X then Not(X) is true.

Posted by Danny_Black | Report as abusive

PS in previous post you=Eisinger.

Posted by Danny_Black | Report as abusive

It is acceptable, but sad, that the stupid and blind can’t see or understand the implications of a Naked Emperor riding an Elephant indoors.

As intelligent sighted people it is amazing that Americans are still missing the implications and continue to allow it to happen without comment while the guy cleaning up the poop left behind is arrested for having contraband elephant poop (MARS FTC Rules)…

Hopefully Americans will see the truth and ask why the emperor is naked and riding an elephant in the first place…

Continue to call a Naked Emperor, naked, and have the due diligence done to make the banks pay one poopy loan at a time… Negotiated private settlements are here! Do not expect the system will produce a just settlement by itself. We must all fight individually to compel a fair outcome for ourselves. Educate and arm yourself then please step into the ring! The Banks may have unlimited resources but Americans have an unlimited will to fight for justice!

http://diligencegroupllc.net/

http://diligencegroupllc.net/

American Homeowner

-AH

Posted by ahouse1 | Report as abusive
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