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.