I had a long conversation with Jesse Eisinger 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.
