An idea for how to deal with second liens

By Felix Salmon
March 22, 2011
Jesse Eisinger today on the subject of second liens and the proposed mortgage settlement from the state attorneys general.

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I had a long conversation with Jesse Eisinger today on the subject of second liens and the proposed mortgage settlement from the state attorneys general.

Second liens are clearly causing a huge problem in both the mortgage market and the banking market, as Mike Konczal clearly explains. They’re being held on banks’ books at what looks like extremely inflated values, and those banks are also overwhelmingly the entities servicing first-lien mortgages. As such, the banks are quite happy when homeowners default on their mortgage — that frees up cashflow to continue paying the second-lien loan.

It’s not at all obvious why homeowners would continue to pay their second mortgage even when they’re delinquent on their first, but that seems to be exactly what’s going on: the CEO of JP Morgan Chase Home Lending has said that some 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. This is unfair to investors in first liens, who are senior to the banks with the second liens but who are in many cases more likely to be asked to take a haircut on their loan.

The AGs seek to deal with this problem by saying that if a first-lien mortgage is modified, then the second lien must be marked down at least as much. That seems sensible to me, but it’s insufficient to Jesse, who reckons that treating the two liens equally is going to become some kind of de facto standard.

That said, the proposal is clearly an advance on what we have now, where the best-case scenario for second-lien holders is to see the first lien modified while the second lien gets paid off in full and on time. And it’s not at all obvious what would improve on the AGs’ proposal. Writing second liens down to zero is too harsh: it would unnecessarily damage the banks, and it would render pointless all of the underwriting they did to ensure that there was some kind of debt-repayment capacity beyond just collateral.

Jesse thinks that if the banks are forced to write down their second liens to something a bit more realistic, or if at least they’re required to increase the reserves they have to hold against them, then they will be more likely to accept write-downs on those loans. He might be right: I’d love to see some research on that front. In principle, banks have every incentive to fight to extract as much money as possible out of every loan that they own, whether they’ve written it down on their books or not. But here’s the difference: if they’ve written it down they’re chasing profits when they do that, and if they’re holding it at par then they’re trying to avoid losses. If banks fight harder to avoid losses than to chase profits, then forcing write-downs might do some good. Certainly humans feel that way, so it’s not impossible.

I also had one idea of my own. It’s probably not original, but I haven’t seen it anywhere else, so I don’t know what the objections are. In any case, how about this: any time a first lien is modified, the second-lien holder loses their security interest in the home. The debt outstanding remains just as payable as it ever was — it just remains unsecured. So if the first-lien holder writes down the mortgage to less than the value of the house, the second-lien holder can’t then swoop in and foreclose if there are payment difficulties.

In most of these cases, the second lien is de facto unsecured anyway: this rule would turn secured debt into unsecured debt, which would force the banks to make more sensible reserves against it — and would also allow homeowners to only fear foreclosure if they default on their modified mortgage, rather than on either the modified mortgage or their second mortgage/Heloc. Meanwhile, the banks which own the second loans wouldn’t have to write them down if they felt that the homeowner was a good credit.

It’s not going to happen, of course: anything along these lines would require new legislation, and there’s no chance of that. But I’d still be interested in what people thinking about how to deal with second liens react to the idea. It might at least help clarify some of the issues involved.

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Comments
16 comments so far

I quite like your idea.

As for the difference between chasing profit and avoiding loss, there’s also a timing-based accounting motivation here; if you can postpone having to realize your loss, you gain a great deal in terms of flexibility of capital use / staying technically solvent, while you would generally realize the profit as it accrues. The regulatory pressure therefore is higher, especially in the short term, not to realize losses than to realize profits, so that even rational bank managers would work harder for the former than the latter.

Posted by dWj | Report as abusive

A nice idea, but why would it require new legislation?

I’m under the impression that loan modifications already require the consent of all parties (first lien, second lien, borrower). Why could they not additionally agree that the second lien be waived (leaving the loan unsecured)?

Posted by TFF | Report as abusive

You’re not seriously asking a banker to give up a secured loan if he has any choice in the matter, are you?

heh.

==RED

Posted by REDruin | Report as abusive

“Why could they not additionally agree that the second lien be waived (leaving the loan unsecured)?”

That’s exactly the way we roll if we have the 1st lien. If a borrower is in a bad enough position that we need to write down our interest on a 1st than the 2nd lien is by definition TOAST.

Any payments that are currently flowing to the 2nd lien holder should be comming to us if the borrower is behind on the 1st. If the 2nd lien holder gets frisky we generally resolve it on the courthouse steps. The house gets sold at auction, we bid what we are owed… the 2nd lien holders name drops off the title and that’s that.

We’re still in a position to work with the original borrower at that point if we think it’s in the best interest of the bank. I can assure you that we have no interest whatsoever in taking on the hassle and cost of maintaining and marketing the property. If there is any way to keep the borrower in the house we’ll do it.

The bottom line is when banks were offering 2nd loans at prime -.50 or prime -1.00 they were badly mispricing the risk.

Posted by y2kurtus | Report as abusive

@RED, no, I wasn’t proposing to give the second lien holder any choice in the matter.

@y2kurtus, if you sell the house at auction and you bid what you are owed, do you still manage (in at least some cases) to keep the borrower in the house?

Posted by FelixSalmon | Report as abusive

RED, if the first lien is worth 20% more than the property, the “security” backing the second lien is completely worthless.

If I were negotiating that one, I would ask the second lien holder whether they would rather have an unsecured loan with payments that possibly continue or foreclosure proceedings in which they receive nothing.

Only benefit to the banker of keeping the loan secured is if the property value rises substantially before the foreclosure.

Posted by TFF | Report as abusive

@felix, I am deeply suspicious of any “forced” actions. Once you start retroactively changing the rules, you open yourself to a host of abuses. Eventually people lose faith in the system and are reluctant to initiate any new deals whatsoever.

Constitutional government is superior to authoritarian rule.

Posted by TFF | Report as abusive

This is one place where modifying the bankruptcy code could be useful. In similar situations in the corporate world, if the seniors have to take a haircut, typically the juniors are either wiped out or get some sort of warrant that if things turn around, they will be made close to whole.

Something like that would be ideal. Equitable.

Alternatively, after a modification, cash paid to the junior claimant is trapped and sent to pay down the senior, after the senior is paid off, the junior becomes the senior until the junior loan is paid off. Junior can accrue while it is in forced deferral.

Posted by DavidMerkel | Report as abusive

@y2kurtus, sounds like you have some interesting experiences. I’d love to hear more, if you are interested. I can be reached at jesse@propublica,org or on the Twitter at @eisingerj.

Indeed, I’d love to hear from anyone who has firsthand experience negotiating with 2nd lien holders.

Posted by JesseEisinger | Report as abusive

@y2tkurtus, I’m confused by your comment.

If you make a successful credit bid for the house, then all liens are extinguished. The bank becomes the owner of the property and the current occupants, former homeowner, no longer has any equitable interest in the property.

How then do you work with that party? Are you then approaching them to continue their occupancy as renters? If so, then it seems the bank has merely exchanged the headache of managing and marketing the property for the headaches of renting and managing the property. More to the point, the bank would have to account for the property as REO, something most are loathe to do.

Perhaps I am missing something. Are you suggesting that you undertake a sale of the property back to the homeowner that you foreclosed upon? Is the bank creating a new loan to finance a circular transaction? Clearly, the act of foreclosure creates an asset for the bank in lieu of the loan it originally carried on its books. How then are you transferring this asset to another party if indeed that is what is transpiring?

I really would like to hear how you are keeping borrowers in the house and what legal status defines their occupancy.

Posted by TomLindmark | Report as abusive

@Felix Yes there have been cases where my bank has assumed ownership at a forclosure auction and kept the original borrower in the home. This is a very small minority of cases.

TomLindmark is exactly right that the previous owner no longer has any equitable interest in the property from that moment our credit bid wins. If they have not been evicted yet if there is any way to work it out with them and get them back on track that’s always the best outcome for the bank.

We are driven to defend our 1st lien status when the borrower who is behind with us and behind on a 2nd is being persued more agressively by the 2nd lien holder than by us. The 2nd lien holder knows that they are in a desperate position at that point and are trying to bully the borrower into paying them something, ANYTHING immediatly in order to stop late payment fees and peanlty interest and the collections calls.

I doubt very much that other local banks don’t do exactly the same thing if they can realize more money by keeping a person in their home than they can get for that home on the open market.

I can say definitively that we would never outbid a 3rd party if we thought that 3rd party was offering our bank more value than we could expect to recover from the original borrower.

To clarify further, when I said “we bid what we are owed” that is the maximum we would ever bid. At most auctions we are the only party present. Some times there are several “vulture’s” who will bid .20cents on the dollar but we’ll outbid those. If a 3rd party is bidding 80% or 90% of what we are owed we’re very likely to step asside in those cases if we think that is the best outcome for the bank.

Posted by y2kurtus | Report as abusive

Things we have done to keep people in their home’s.

Extend the remaining terms out to 30 years.

Agree to modify the loan for as many as 2 years to go interest only.

Agree to temporarialy accept payments lower than interest for a period up to 6 months… without accruing the additional interest.

Our bank (and any sane bank) will do anything possible to keep a borrower who has the capicity to stay in the home in the home.

In Maine though real estate prices never exploded upward in the same way they did in the hotspots. We see people who are 25% underwater… in some states you see people 50% underwater.

Posted by y2kurtus | Report as abusive

Obvious reason why they would pay the second lien and not the first is because the monthly payments are typically far less and they probably don’t realise they can still be foreclosed on by the 1st holder.

Also as i pointed out in the previous post the issue about seniority only matters AFTER the house is sold and cash realised. Mr Konczal apparently doesn’t know this. He apparently also thinks it is somehow outrageous that you can have two tiers of secured loans and claims this is something that could never happen in the corporate world. Apparently in his time working as a “financial engineer” – whatever that means and whereever he worked – he never came across common stock and corporate bonds. For god’s sake, he has been pontificating about MBS for ages where this is the entire model!

Also the second is not “de facto unsecured”, it is secured just like the firsts are and if the customer doesn’t pay then there is a cost-benefit analysis to whether it is worth paying the fees to foreclose vs the amount you are likely to get. At the bare minimum it pays to threaten to take the home away.

Long talk with Eisinger, you realise that is time you’ll never ever get back. Did he ever work out that the proposed settlement says the opposite of what he claimed?

Posted by Danny_Black | Report as abusive

My loan modification has been approved . I have finished my trial period and am on my second payment under my modification agreement. I have my court date tomorrow that my mortgage bank has scheduled to vacate judgement, dismiss the action without prejudice, dissolve lis pendens and cancel sale scheduled . What may happen with my 2nd liens? I have equity loan with Regions bank and SBA loan. Will they have opportunity to contest, will I need to set up payment with them still, will they drop what I owe them…what kinds of choices will I have?
Also, should I incur any attorney expenses from any of them as they are included under defendants as well as myself? My association is included under defendants as well and the association has had the attorney office send me their bill. I am current with all payments toward my association and never ever was advised they were doing this. They threaten to put a lien on the house if I do not pay this…am I supposed to pay their attorney fees??? I had advised them that I was working out the modification . I feel they jumped the gun. Need advise…..

Posted by cew56 | Report as abusive

My loan modification has been approved . I have finished my trial period and am on my second payment under my modification agreement. I have my court date tomorrow that my mortgage bank has scheduled to vacate judgement, dismiss the action without prejudice, dissolve lis pendens and cancel sale scheduled . What may happen with my 2nd liens? I have equity loan with Regions bank and SBA loan. Will they have opportunity to contest, will I need to set up payment with them still, will they drop what I owe them…what kinds of choices will I have?
Also, should I incur any attorney expenses from any of them as they are included under defendants as well as myself? My association is included under defendants as well and the association has had the attorney office send me their bill. I am current with all payments toward my association and never ever was advised they were doing this. They threaten to put a lien on the house if I do not pay this…am I supposed to pay their attorney fees??? I had advised them that I was working out the modification . I feel they jumped the gun. Need advise…..

Posted by cew56 | Report as abusive

Chapter 7 BK in 2009. Primary home exemption put 2nd HELOC mtg into a unsecured gray area. Both mortgages discharged. Since then House value since BK dropped further. Due to condition of roof and basement and general condition of house it is worth less than the payoff of the first. Would like to stay Modification of first is just out of reach and haven’t paid anything on second since bk in 2009. Would like to know statue of Limitation for the second lien. or if it was wiped in bk and they are trying to collect on a discharged unsecured debt. Made an offer in 2010 of 10% on 2nd. and they said no We want it all plus late fees ect. They have since then called me once a year to see what I am doing with the house. They know it it underwater. I told them if I sell it would be a short sale and they would get nothing, If I walk away they would get nothing and if the 2nd could force a foreclosure they would still get nothing and I still have an option of a chapter 13 BK and have the lien stripped. Shouldn’t have the 2nd been stripped during charpter 7 in the first place. The uncertainty of this lien is driving me crazy. Can the first mortgage holder make they 2nd go away.

Posted by green1260 | Report as abusive
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