U.S. banks pay lip service to second mortgages

March 24, 2010

Cross-posted from today’s NYT.

JPMorgan this week became the latest in a trickle of big banks willing to modify second mortgages for some struggling U.S. borrowers. While it’s a baby step in the right direction, it won’t do much to fix America’s foreclosure woes.

Second-lien loans, essentially top-up mortgages, look like a good place to start addressing the problem of borrowers who can’t keep up with payments. After all, second liens are subordinate to first mortgages. So when it comes to cutting interest or principal payments, they should logically come first.

But the U.S. government has primarily tackled first mortgages — and hasn’t got that far even there. The Home Affordable Modification Program (HAMP), which is designed to facilitate mortgage payment reductions, is aimed at several million struggling borrowers. Of 1.4 million trial modifications offered so far, only 170,000 have resulted in adjustments that the program sees as “permanent”.

And even these look anything but permanent since they still leave borrowers paying an average of 60 percent of their before-tax income towards debt and house expenses (see slide 6). That’s not close to a sustainable level of debt, so defaults down the road look inevitable.

That ought to focus banks’ attention on their second-lien loans. There may be little or no chance many of them will ever be repaid. But banks have avoided writing down second liens because accounting rules allow them to consider the loans to be performing so long as borrowers make interest payments.

It’s easy to understand why the banks are kicking the issue down the road. According to Amherst Securities, of $1.05 trillion in outstanding second liens, commercial banks hold $767 billion. Bank of America, Citigroup, JPMorgan and Wells Fargo alone hold $442 billion of them.

A government modification program for second liens known as 2MP, a companion for the HAMP program, was first put forward a year ago. But Bank of America, Wells Fargo and now JPMorgan have only recently joined. Nor is it likely to reach many borrowers since it targets only those few who achieve “permanent” modifications under HAMP.

Assuming around half distressed homeowners have second mortgages, this would cover some 85,000 second liens, only scratching the surface of the 19 million junior liens — with an average principal balance of $57,000 — that First American CoreLogic estimates are outstanding.

It’s good news that banks are finally willing to discuss second lien modifications. But to keep more struggling U.S. borrowers in their homes — a better outcome for banks and borrowers alike than foreclosure — banks need to forgive loan principal on a much larger scale so that borrowers again have skin in the game.

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Who cares about second mortgages? I wonder how the vacation home market is faring? It can’t be good.

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