Matt Stoller: Some Observations on the Second Lien Problem

Matt Stoller is a fellow at the Roosevelt Institute.  You can follow him on twitter at http://www.twitter.com/matthewstoller

Over the past three years, the big four servicers have been keeping hundreds of billions of dollars of second mortgages on their books (mostly in the form of Home Equity Lines of Credit, or HELOCs).  Many of these mortgages would seem effectively worthless, because a home equity line of credit or second mortgage on top of an already deeply underwater first mortgage has no value.  You can’t use it to foreclose, because you’d get nothing out of the foreclosure – all of that would go to the first mortgage holder (usually some investor in a pension fund somewhere).  It has only “hostage value”, or the ability to stop a modification or write-down from happening.  The best way to clean up this situation is to have the regulators (FDIC, OCC, Federal Reserve) simply tell the banks that they must write down their second mortgages on collateral that has been impaired.  That way, the incentive problem goes away.  By forcing the bank to recognize the loss now, the bank will no longer stop a modification on a first mortgage.  And in fact, the regulators pretty much agreed that this is what their examiners should do, when they issued new rules earlier this year on accounting for second liens.

Only, the regulators haven’t done it, because the banks claim their seconds are performing.  Bank of America says that these loans are worth 93 cents on the dollar.  Several of the other banks don’t break out their loss reserves for seconds, so it’s hard to tell, but I think it’s clear they aren’t reserving enough.  We can tell that because the Federal Reserve itself is dramatically overvaluing these seconds.  In a stress test, the Fed said in its worst case scenario that the banks would lose only “$56 billion”.  These are low numbers.  According to their most recent investor report, Wells Fargo alone has $35 billion of second liens behind first mortgages that are underwater.

Rest here…

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