More on the Role of Second Liens and the Mortgage Settlement as Stealth Bank Bailout

Readers who missed the post over the weekend entitled, “Schneiderman MERS Suit and HUD’s Donovan Remarks Confirm That Mortgage “Settlement” is a Stealth Bank Bailout,” since it provides important background and context for this piece, which clarifies some issues I skipped over.

To give a brief recap of the post: both a small group discussion with Shaun Donovan (reported by Dave Dayen of Firedoglake and separately by Shahien Nasirpour of the Financial Times) and the Schneiderman MERS lawsuit on Friday confirm our previously-stated hypothesis that the settlement is really a transfer from mortgage investors to banks. That is why the banks remain willing to participate as the release has been whittled down to appease the formerly dissenting attorneys general (remember, the old reason for the banks to go along was that it was a cash for release deal: the banks were willing to pay hard money to get a significant waiver of liability).

The reason this settlement amounts to a transfer is the banks will be given credit towards the total reported value of the settlement for modifying mortgages that they do not own, meaning that economic loss will be borne by investors. Servicers have an obvious incentive to shift losses onto other parties whenever possible, and so the only principal mods they are likely to do of loans they own are one they would have done anyhow.

In addition, default rates are higher among borrowers with second liens, and second liens are almost entirely held on bank balance sheets. Which banks? Oh, the ones that happen to be the four biggest servicers: Bank of America, Citigroup, JP Morgan, and Wells. And those second lien holdings are collectively in the hundreds of billions. Were they written down to the degree that some mortgage investors argue is warranted, it would reveal that these banks were seriously undercapitalized.

As we stressed, this plan is a serious violation of property rights (not that that should be any surprise at this point). The creditor hierarchy is clear: second liens should be written off in their entirety before first liens are touched. Yet we also linked to evidence in the post from top mortgage analyst Laurie Goodman that servicers were already doing everything they could to favor their second liens over firsts. This settlement would give official sanction to this practice.

I also want to flag, a second time, an appalling throwaway comment in a New York Times update tonight:

The settlement, if all states participate, will also include $3 billion to lower the rates of mortgage holders who are current.

Huh? The banks have an explicit obligation to service the loans for the benefit of the certificate holders, meaning the investors. There is NO economic rationale, none, for reducing interest charges to borrowers who are current (unless they are under financial duress and at risk of delinquency/default). This is a bribe to prevent complaints by borrowers who pay on time and are in “beggar thy neighbor” mode.

I did want to clarify a possible misimpression I suspect I created in my Sunday post. By inveighing against a transfer from first lienholders (investors in mortgage bonds not owned by banks) I may have left reader thinking the Powers That Be will not touch second liens at all in the agreement. That isn’t true. We highlighted in an earlier post on Nevada attorney general Catherine Cortez Masto’s letter which raised questions about the pact that there were some provisions about second liens. I didn’t discuss them in detail because it is a bit of a Plato’s cave exercise. But as we indicated, anything short of wiping out the seconds before the firsts is simply not defensible (the second liens, which are overwhelmingly home equity lines of credit, got higher interest rates precisely because they were higher risk). And from what we can infer, the provisions in the agreement, at least at the time of the Masto letter, are smokescreens to cover the goring of investor oxen.

Let’s look at the questions Masto asked related to second liens:

This suggests that there is a requirement to modify (note modify rather than extinguish) a second lien when a first is modified. Given the desire to assist banks while trying to maintain a fiction of “fairness,” I’d expect this provision to set forth some sort of parallel treatment, for instance, that a 10% principal mod on a first mortgage must be accompanied by a 10% reduction on a second. Since the dollar amounts involved in first mortgages considerably exceed those in seconds, the first lienholder would still take the bigger writedown in dollar terms, and the second lienholder will benefit by the borrower having greater ability to pay.

I’d assume the answer to be “yes” unless the provisions regarding second liens meant to be a joke. Virtually all of the bank-owned second liens are home equity lines of credit.

I can’t infer the implications of 34.2, so if you have any good guesses, please pipe up in comments.

On 33.2, the point in the settlement, of writing off second liens more than 180 days delinquent, is largely meaningless. As we indicated, banks keep insisting that their seconds are current, and that’s because they can make them so.

First, as we have recounted, these liens actually have a lot in common with credit cards, in that banks will allow stressed borrowers to pay only the interest due and amortize the loan. We’ve even been told banks will reduced the payment on a loan about to go delinquent, take a token payment, and deem the loan to be current. Banks can also increase the home equity credit line, which means borrowers can simply borrow more to make their payments.

The result is that the banks report a much larger portion of their second liens are current than would actually be categorized as current if they were required to define current on a fully amortized basis. Moreover, they are not required to write down these loans, which are mostly held in their “held to maturity” books even when the first lien is defaulted or in a significant negative equity condition (remember, unless there is equity in the house, an uncured default on the first means foreclosure, which means the second is wiped out. One of the reasons bank foreclosure timelines have become so attenuated is to avoid taking losses on seconds). Not surprisingly, the supine OCC contends there is nothing it can should do, to force the banks to behave otherwise.

Before you say, “Gee, is all this so unreasonable?” let’s contrast this conduct with how regulators treated small bank commercial second liens recently. Bank expert Josh Rosner tells us that during the height of the crisis, certain primary prudential regulators forced the other regulators to make sure that the community banks with large commercial exposures had to have those loans reappraised and written down those exposures to fair value. This took place even when the loans were held in the held to maturity books of the banks. Keep in mind that the accounting rules were that loans in these books did not have to be revalued unless there was a credit event (such as a delinquency). Even then, they would normally be required to test the loans to see if the impairment was temporary or whether a writedown was warranted. Yet even in cases when these loans were paying on a fully amortized basis, the regulators forced these small banks to write them down.

A final point: some readers questioned my comment that the current version amounted to a transfer from retirement accounts to banks. That was overly broad, but more refinement (I hope to get to when I can get my hands on market share and expected loss data) does not make the picture much prettier.

I focused on private label securities, since they have and still continue to experience a much level of defaults than prime (Fannie and Freddie) mortgages. The latest data I have seen (which was a while ago) was 40% expected defaults, which would produce losses of 30% (as in you’d get 25% recovery form the foreclosure). The 75% loss on foreclosure is a valid number historically, but I expect loss severities to rise to much closer to 100%, between servicer delays, greater scrutiny by some judges in judicial foreclosure states, and more borrowers fighting foreclosures.

While not all deals were total turkeys, on most deals, the lower tranches are already wiped out, and the top 3 AAA tranches are also gone due to refis. So what is left are the fourth and 5th once-rated AAA tranches and some of the lower tranches. While foreclosures distribute losses to the lowest-credit-rated borrowers first, mods are distributed pro rata across all tranches, and with the bulk of the value of the deal originally and still in what were originally AAA tranches, they will take a hit. Mind you, most investors are not opposed to mods IF any second liens were wiped out first; they are still better off taking a 25% to 50% hit than a 80% loss.

So the investors that will be most affected are AAA investors, if nothing else because originally and now they represented the bulk of the value of the securitization. I’m not certain precisely who were the targets for AAA RMBS, but in general, AAA bond buyers are pension funds (particularly defined benefit funds, but bond funds that marketed themselves as “AAA” or high credit quality would also be targets, and those are often an option in 401 (k) plans, either offered directly as an investment option or bundled into a “balanced” fund) as well as insurers, who for regulatory reasons also tend to hold some of their portfolios in AAA rated assets. The appeal of private label MBS was investors got a better yield than for corporate or government bonds, supposedly in return for bearing some prepayment risk (no one thought they were eating credit risk too).

But….I managed to miss the biggest investors in the former AAA private label MBS: Fannie and Freddie, which hold large exposures to private label securities. So it is both taxpayers and investors that will pay for this stealth bailout.

So even with this hopefully helpful clarification, the overall picture remains the same: the deal as now constituted is a victory for the banks, shamelessly marketed as a win for repeatedly victimized ordinary citizens.

- the OCC has taken the position that there is nothing they can do, or should do, to force the banks to behave otherwise.