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Second liens an intractable roadblock in foreclosure prevention [ClearOnMoney]
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Second liens an intractable roadblock in foreclosure prevention

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Commentary

Second liens an intractable roadblock in foreclosure prevention

10 Mar 2010 by Jim Fickett

A fundamental conflict between first and second lien holders makes mortgage modifications (especially principal reductions) and short sales very difficult. None of the three attempted solutions proposed so far looks promising.

As mentioned earlier, on current trends only 2% of seriously delinquent mortgages are likely to be saved from default by HAMP, the main mortgage modification program. Why so few?

The conflict between first and second lien holders

It seems that second-lien loans (e.g. home equity loans) are a primary problem. The root of the issue (see the reference page Multiple lender issues in foreclosure mitigation for further details) is this:

  • Modification of the primary, or first-lien, mortgage always involves some loss for the lender
  • The first lien has the primary claim, and first lien holders normally feel they should not have to give up any value until after second lien holders are wiped out
  • In a modification or refinancing the first lien may lose senior status – the legal situation is somewhat ambiguous, but to avoid risk the first lien holder typically asks the second lien holder to explicitly re-subordinate
  • In many cases a second lien holder sees a chance to extract some value in exchange for re-subordination; sometimes some relatively small compensation will gain cooperation; sometimes the second lien holder blocks changes in the first lien, on the hope the borrower will pay them off completely

That is the basic conflict. It is exacerbated by three further facts:

  • Four banks that own over half of the servicing market also hold over half of all home equity lines of credit, suggesting some conflict of interest
  • A modification involving principal reduction cannot be completed unless any second lien is settled
  • First liens are typically non-recourse, meaning that in default, foreclosure proceeds are the best the lender can hope for; second liens are often recourse, meaning that even after foreclosure, a lender can try to recover some recompense from other income or assets

Attempted solutions

Second lien modification program

In April 2009 the Treasury announced 2MP, the second lien modification program, the first main attempt to cut through this difficulty. The main idea was to break the deadlock by requiring participating servicers to modify second liens in a parallel manner with first, or accept an extinguishment payment of between 4 and 12 cents on the dollar. Participation was voluntary, and Bank of America has been (as far as I can tell) the only bank to join the program (in Jan 2010). It seems 2MP is going nowhere.

Home affordable foreclosure alternatives program

In Nov 2009 the Treasury announced the Home Affordable Foreclosure Alternatives (HAFA) program. The Treasury sees short sales as a second-best solution, compared to loan modification, but still better than foreclosure. HAFA is aimed at short sales and deed-in-lieu-of-foreclosure transactions. Second liens present the same roadblock for short sales that they do for principal reducing modifications, so HAFA offers incentives to the second lien holder to write off the loan. Calculated Risk gives a good summary:

on a $50,000 2nd lien, the holder of the lien will be offered up to $1,500 to sign off on the deal and release the borrower from personal liability. The HAFA program will reimburse the 1st lien holder one third of that amount, or up to $500. …

I expect that most 1st lien holders will be willing to pay this amount to the 2nd lien holder. But would a $50,000 2nd lien holder be willing to sign off for only $1,500?

It really depends on the financial situation of the borrower, and probably on the likelihood of personal bankruptcy. In most cases the 2nd lien holder can probably do much better by selling the lien to a collection agency.

Although I think the HAFA program will help with short sales (and deed-in-lieu transactions), this will not solve the 2nd lien problem. Foreclosure may still be the servicers' option of choice for borrowers with subordinate liens.

Barney Frank

In what may or may not turn out to be a serious attempt to get past the second lien roadblock, Barney Frank, chairman of the House Financial Services Committee, recently sent a letter to Bank of America, JP Morgan, Citigroup, and Wells Fargo, in which he demanded action:

To save homes on a large scale, we must … focus on permanent principal reductions …

Many investors in first-lien mortgages have indicated that they are willing to accept the fact of significant losses … With the interests of homeowners and investors aligned in this way, it should follow that large numbers of principal-reduction modifications could be made relatively quickly. That is not happening. According to investors, Administration officials, and other experts I have consulted, holders of second-lien mortgages are now a principal obstacle to many modifications. … requires immediate attention from your institutions.

Large numbers of these second liens have no real economic value … Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loands, which would allow willing first-lien holders to reduce principal

But Tracy Alloway, on the FT Alphaville blog, notes that the top four commercial banks hold $442 billion in second-lien loans, a large fraction of which are probably worth very little. So at the same time that other parts of the government are still hard at work trying to stabilize the banking system, Frank is asking for a hit to capital that is probably in the hundreds of billions. It does not seem very likely to happen right away.

All in all, it seems that the second lien problem will be slow to clear, and that we can expect limited success in government programs aimed at foreclosure mitigation.