Why the AGs are right to leave second liens alone

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.


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