Save your house by not paying your mortgage. Sounds crazy, doesn’t it? But for more than a million homeowners, this might be the right answer. Those homeowners, for whatever reason, have defaulted on their first mortgage but continue to pay their second mortgage on time. This has created a crazy situation in which the lender holding the second lien is reporting a performing loan while the lender holding the first lien is reporting a delinquent loan. The majority of these second liens are held in the loan portfolios of just four banks - Bank of America, Citibank, J.P. Morgan Chase and Wells Fargo. These same four banks service most of the first mortgages owned by bondholders or other banks. When Joe Homeowner defaults on his first mortgage but continues to pay his second mortgage and then seeks relief from the Home Affordable Modification Program (HAMP) or his first lender, he often is unable to obtain relief because the holder of the second lien refuses to take a loss on the lien. This upsets the whole priority of claimants in the event of default. The second lien holder is supposed to get wiped out before the first lien holder suffers a dollar of damage, but that isn’t happening in this bizarre world.
What is the solution? Stop paying your second mortgage. This will work because of the way bank regulators treat delinquent loans. So long as Joe Homeowner remains current on his second mortgage, the big bank has to hold just 8 cents in capital for each dollar outstanding. However, if Joe stops paying, the big bank must classify the loan as delinquent and allocate funds to a reserve for loan losses.
The longer it has been since Joe stopped paying, the more loan-loss reserves the bank must hold. After 30 days, the bank typically should allocate 20 cents in reserves for each dollar outstanding, maxing out at 100 cents on the dollar after 180 days. Now the big bank has a totally different set of incentives when it comes to negotiating the restructuring of Joe’s first mortgage. Now the big bank will want to get this deadbeat loan off its balance sheet and will take virtually anything offered. Voila! Holdup problem solved.
The critical role of second liens in hamstringing the HAMP and other foreclosure-mitigation programs has been almost universally acknowledged. The majority of delinquent mortgages and mortgages in the process of foreclosure also involve second liens on the same properties, and many borrowers have been paying their second liens while defaulting on their first liens. Consequently, second-lien holders have been unwilling to “play ball” by taking large write-downs on their investments as part of efforts to avoid foreclosure on the delinquent first liens, even though the second liens are, in most cases, virtually worthless once the property reaches the end of the foreclosure process and is sold at sheriff’s auction, typically for less than the outstanding amount on the first lien.
Bank regulators (the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency) have the power to end this second-lien holdup problem, but, instead, they are complicit in this scam by not requiring the second lien to be classified at least as severely delinquent as the first lien. Were regulators to act in a consistent manner, banks would be facing large write-downs on much of their second-lien portfolios and would be far more willing to negotiate with borrowers and first-lien holders on loan restructurings to keep properties out of foreclosure.
Why would regulators behave this way? The four largest banks in the country hold more than $400 billion in second liens and would take massive hits to their already-thin capital were regulators to act. For example, Wells Fargo holds more than $120 billion in home equity loans but less than $80 billion in tangible common equity. Were Wells Fargo forced to make appropriate provisions for its second liens, it would have to transfer a large portion of its tangible common equity to its allowance for loan losses, forcing it into an undercapitalized or even insolvent status.
So much for the vaunted stress test trumpeted by regulators last year. Of course, that is another reason for regulators not to use this power; it would make them look bad for failing to account for this problem in the stress tests.
Rebel A. Cole is professor of real estate and finance at DePaul University.