With millions of American homes in immediate danger of foreclosure and bank solvency still an issue, time is running out to resolve two incompatible agendas that the Obama administration has pursued since it took office.
On the one hand, regulators are allowing “too big to fail” banks to conceal losses, which might reveal that they are insolvent, by allowing these institutions to keep large portfolios of second-lien mortgages on their books at close to pre-bubble values. (Second-lien loans include home equity lines of credit as well as piggyback mortgages—the high-interest loans that were typically used to finance 15–20 percent of a home’s cost.) On the other hand, the administration is trying to save homeowners from foreclosure through its troubled Home Affordable Modification Program (HAMP), which has focused almost exclusively on first-lien loans—more than 90 percent of which are owned by Fannie Mae and Freddie Mac (and thus backed by taxpayers) and by smaller banks and investors in mortgage-backed securities.
These two competing agendas form one of the major knots standing in the way of a housing recovery. A December 2010 Congressional Oversight Committee report criticized the Obama administration for not implementing accounting rules that would require banks to adopt so-called Fair Value standards, which would have changed the ways that mortgages are carried on bank balance sheets and eliminated disincentives standing in the way of loan modifications. As the report states, “There continues to be tension between Treasury’s goal of mitigating foreclosures and its goal of maintaining adequate capital levels at large banks.”
Unfortunately for struggling homeowners, the Fair Value accounting provision was gutted in January after the banking industry vigorously lobbied against it. But allowing banks to stay alive because of questionable accounting practices, even as many American homeowners are drowning in debt, only postpones the day of reckoning, not just for banks and homeowners but also for the broader economy. One of the biggest holes in HAMP and other loan modification programs is their failure to address second-lien loans significantly. And what makes inaction on second-lien loans especially troubling is that the Treasury Department estimates that 50 percent of at-risk mortgages involve these kinds of loans.
The administration’s trepidation is understandable, and may be heightened when it sees the results of a new round of stress tests—due in late March but not expected to be made public—on the country’s largest financial institutions that Treasury launched in early January. Second-lien loan portfolios are among the largest and most precarious liabilities on bank balance sheets today. The four largest banks hold approximately $420 billion of these loans on their books—more than 40 percent of the approximately $1 trillion in outstanding second-lien loans. Housing prices have plunged 32 percent since 2006, and many of the second-lien portfolios will be worthless if the foreclosure crisis continues. That is because, according to the established legal concept of lien priority, in which the first-lien holder must be fully compensated in a foreclosure before subordinate holders, if the property is underwater by more than the amount of the second-lien loan—as is the case with millions of homes—the institution holding the second-lien loan does not get any money.
The Obama administration is pinning its hopes for resolving this seemingly intractable issue on its long-awaited second-lien modification program, HAMP 2 MP. Originally announced in August 2009, HAMP 2 MP officially became a requirement for mortgage servicers as of January 1. Although major financial institutions such as Bank of America signed on to HAMP 2 MP with great fanfare last spring, it has been a failure thus far. As of December 31 only 3,257 loans have been canceled or modified under the program.
Second-lien loans figured prominently in a proposed settlement that state attorneys general sent to the nation’s five largest banks in early March. The proposal, which could cost the banks some $20 billion, seeks to overhaul shady mortgage-servicing practices that have been the subject of investigations and lawsuits [see Ulam, “The BofA Mortgage Settlement Fiasco,” November 1, 2010]. But the AGs face major hurdles in their attempt to resolve conflicts of interest regarding second liens. For one thing, the proposal is already receiving heavy pushback from the banks. For another, adequately addressing the second-lien problem would cost far more than $20 billion.
Leading economists, investors and members of Congress are clamoring for the administration to take more comprehensive action, including a regulatory overhaul that would address the conflicts of interest the big banks have as both the country’s largest owners of second-lien loans and the largest mortgage servicers. Servicers like Bank of America actually have a disincentive to write down or modify the second-lien loan they own when the first lien on the same property is packaged into a mortgage-backed security owned by other parties, such as pension funds or private investors. In these cases, modifying a first-lien loan under a program like HAMP functions as just another bank bailout. It enables the bank to postpone foreclosure, which in the case of an underwater property would wipe out the bank’s second-lien loans. Further, a homeowner who has received a first-lien loan modification under HAMP now has more money to pay off her second-lien mortgage. This situation allows banks to defer losses—a maneuver known as “extend and pretend”—even as it generally leaves the borrower with unsustainable debt loads.
This past December several dozen investors, analysts and prominent economists—including Nouriel Roubini, James Galbraith, Joshua Rosner and Christopher Whalen—signed an open letter to regulators requesting that national loan servicing standards be developed to combat “widely reported servicer fraud” and to address servicer conflicts of interest. According to the letter, reform of the mortgage-servicing industry is critical to reviving the mortgage securitization market and enabling potential homeowners to get credit.
On the legislative front, this past August Representative Brad Miller introduced HR 4953, the Mortgage Conflict of Interest Servicing Act, which would prohibit mortgage servicers from owning second-lien loans that are attached to first-lien loans they service but don’t own. Miller acknowledged that his bill, now languishing in committee, has the potential to break up some of the country’s biggest banks. “It would not cause them to be insolvent; it might reveal them to be insolvent,” he said, adding, “they could not possibly sell $450 billion in second mortgages—they could not begin to get anything like the value that they have been carrying them at on their books.”
But if the housing market is to recover, many of these second-lien loans must be written down or written off. About 27 percent of mortgaged homes are underwater, a bigger predictor of foreclosure than unemployment, according to an in-depth study by the Amherst Securities Group. That represents an estimated $975 billion in debt that could not be recouped if the homes were sold today. Underwater borrowers with second-lien loans are in a major jam: they cannot take what would be the most logical route for someone drowning in debt—selling their home at current market value—because the holder of the second-lien loan in many cases will object to, and prevent, a sale price that will not pay off both loans. Nobel Prize–winning economist Joseph Stiglitz describes the dilemma in his book Freefall: “If there had been a single mortgage for 95 percent of the value of the house, and if house prices fell by 20 percent, it might make sense to write down the mortgage to reflect this—to give the borrower a fresh start. But with two separate mortgages, doing so would typically wipe out the holder of the second mortgage. For him, it might be preferable to refuse to restructure the loan; there might be an admittedly small chance that the market would recover and that he would at least get back some of what he lent.”
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Many underwater borrowers with second-lien loans need a fresh start, or they will end up in foreclosure. So far 3.5 million homeowners have lost their homes since the beginning of 2007. Another 5.7 million are at immediate risk of foreclosure. The December Congressional Oversight Panel report predicts that by the time the crisis has abated, 13 million additional foreclosures will have occurred. The main reason HAMP has been such an unmitigated disaster is that it requires banks to bring overleveraged consumers down only to the point where they are paying 31 percent of their income to service the first-lien loan. This arrangement fails to address the borrower’s overall debt picture, which often includes second-lien, credit card and auto loans. Because of this glaring defect, many of these modifications result in redefault or leave borrowers on the verge of it. The average HAMP modification leaves homeowners with a pre-tax debt-to-income ratio of about 63 percent, which consumes approximately 80 percent of their after-tax income.
The HAMP 2 MP program requires servicers to take write-downs on second-lien loans that are proportional to the first-lien loans they have modified. But it is not clear the government incentives will be enough to enable banks to absorb the extent of write-downs and outright losses they need to concede in order to allow modifications that are truly sustainable for borrowers. Why? Because, experts say, second-lien loans are a major threat to bank solvency. “Second-lien loans can make these banks toast very quickly,” says Tomasz Piskorski, a Columbia University Business School professor. According to Piskorski, the unresolved situation could develop into a banking crisis larger than the one linked to subprime mortgage-backed securities, which almost put the banks out of business in 2008.
The defeat of the proposed Fair Value accounting rule was critical to bank survival. According to the Oversight Panel report, Bank of America has more than $137 billion worth of second-lien loans on its books. This represents 83 percent of its Tier 1 Capital, the principal measure used by regulators to determine bank solvency. The situation at Wells Fargo is even worse. Its second-lien portfolio is 116 percent of its Tier 1 Capital.
During the Treasury’s first round of stress tests, in 2009, second-lien portfolios were valued at 86 cents on the dollar under an “adverse scenario.” Today, banks are carrying their second-lien portfolios at 85 cents to 93 cents on the dollar, according to Joshua Rosner, managing director of the consulting company Graham Fisher & Co. Rosner says the current accounting standards allow banks to greatly overinflate the value of these portfolios and argues that, depending on their date of issue and other attributes, open-end second-lien loans are actually worth 40 to 60 cents on the dollar.
The conflict of interest inherent in “too big to fail” banks is no secret to administration officials. “We don’t want to have a program that throws all of these servicers into huge red ink—where we have modified second-lien loans and at the same time crippled the bank industry,” says Laurie Maggiano, director of policy for Treasury’s Homeownership Protection Preservation Office in regard to the HAMP 2 MP program. “We do need to be careful that we balance the good work that we are doing for borrowers against the big picture, which is stabilizing the mortgage market and the credit market.”
There don’t appear to be many viable solutions in the current political climate. But if strong action is not taken to write down mortgage principal and regulate mortgage servicers, underwater homeowners who do stay in their homes will be paying an absurd—and for many, probably unbearable—amount of their income to banks for many years to come. Another proposal from Congressman Miller is that the government use eminent domain to buy second-lien mortgages from banks at market value. Although this could put some of the largest banks out of business, Miller notes that the 2010 Dodd-Frank Act has a mechanism to wind down large financial institutions in an orderly way, so as to not cause too much damage to the economy. At least with the government in the driver’s seat, millions of homeowners would have a much better chance of staying in their homes.
It is time to get real about the value of these toxic assets— aside from the “too big to fail” agenda, the only argument for not forcing banks to take serious write-downs on second-lien loans is the assumption that housing prices are going to return to pre-2007 prices. And that is not going to happen unless we have another real estate bubble.