One of the gross oversimplifications of the mortgage boom and bust is that banks were more inclined to make risky loans because they were able to get them off their books through securitization. In fact, one of the most troublesome categories of bubble-era lending has been sitting on banks' balance sheets all along.
At the end of 2010 the four largest banks owned 42% of the outstanding $950 billion in closed-end second mortgages and home equity lines of credit. All through the crisis, observers have wondered why banks have not written down these liens more aggressively given the obvious deterioration in collateral values. Second-lien holders have also been blamed for blocking loan resolutions like principal reductions and short sales.
Given the complexity and noise surrounding this issue, American Banker offers answers to the following frequently asked questions.
If the homeowner is upside down on the mortgage, isn't the second lien worthless?
Not exactly. Second mortgages are considered riskier because if there is a default and the property is underwater by more than the amount of the second lien, the second-lien holder receives nothing from the foreclosure sale.
However, second liens may have some recovery value because they are generally recourse loans and in all but 11 states, lenders have the option of chasing borrowers for the debt not covered by the foreclosure sale proceeds. The recovery on such debts is generally minimal, though.
Also, just because a loan is underwater, "that doesn't mean that it is a bad loan," said Tim Long, senior deputy comptroller and chief national bank examiner for the Office of the Comptroller of the Currency. "If a person has a job and they are working and they have good debt-to-income ratios," simply being underwater "doesn't mean that their loan is impaired and that the second is impaired."
In fact, a good number of borrowers whose first liens have gone into foreclosure have continued to make payments on the seconds.
Really? Why would they bother?
Typically the second in these cases is a home equity line rather than a closed-end loan, and the borrower wants to maintain access to credit. A study released in February by Amherst Securities Group found that only 59% of borrowers with a home equity line of credit turned delinquent when the first was in delinquency, compared with 78% of borrowers with closed-end seconds.
"In short, we believe the single most important reason borrowers who are delinquent on their 1st mortgage continue to pay on their 2nd is that it allows for continued access to credit," Amherst analysts wrote.
A study released by the Federal Reserve Bank of Philadelphia in December found that about a third of borrowers who defaulted on their first-lien mortgages kept their second-lien mortgages current. Even when borrowers were in the process of foreclosure due to defaults on their first-lien mortgages, about 20% of them kept their second-lien mortgage current. "Our results overall suggest that people default strategically as their home value falls below the mortgage value; they exercise the put option to default on their first mortgage," Fed economists Julapa Jagtiani and William Lang wrote. "However, they tend to keep their HELOCs current in order to maintain the credit line available to them, particularly for those who have already used their credit card lines."
So should bankers be worried about second liens?
Yes, because we're still talking about a lot of once-collateralized loans that have become unsecured.
From their peak in mid-2006 housing prices declined 31.8% through January 2011 as measured by the 20-city Case-Shiller composite index. And according to Zillow Inc., 15.7 million of single-family homeowners — 27% of homeowners with a mortgage — were underwater at the end of 2010.
That's why some say second-lien loan exposure has the potential to blow a hole in bank balance sheets. (See related story.) Adam Levitin, a law professor at Georgetown University, said banks are carrying their second-lien portfolios at overly optimistic values, which only postpones the pain.
"Second-lien loan exposure seems to be highly concentrated on the four largest banks," he said. "It is kind of a time bomb waiting to go off. They are not being carried at fair market value."
Why aren't they carried at fair value?
When the big banks acquired distressed institutions such as Washington Mutual, Countrywide and Wachovia, most of the second-lien portfolios that came with those institutions were marked down as credit-impaired.
However, most of the legacy second-lien loan portfolios on bank balance sheets are in held-to-maturity buckets as opposed to most first-lien loans, which were bundled into mortgage-backed securities and sold. This gives banks have a lot of latitude in how they calculate value.
Bank of America Corp., the only one of the top three banks to break out its reserves on home equity lines, appears to be optimistic about the prospects of getting paid back on second liens. Though credit allowances are not intended to cover an estimate of total lifetime loan losses — future provisions can replenish cushions depleted by chargeoffs — they can serve as something of a proxy for the carrying value of a portfolio on a company's books. Excluding impaired loans it acquired with its purchase of Countrywide, B of A's allowance for home equity losses was equal to 6.5% of its portfolio at March 31, suggesting a carrying value of more than 93 cents on the dollar. Meanwhile, the company said writedowns and allowances had put the carrying value of its entire consumer impaired portfolio — including first liens — at about 66 cents for every dollar of legal claim. Wells Fargo & Co. and JPMorgan Chase & Co. do not report the size of their allowances specifically for home equity loans.
What else don't we know?
A major challenge to evaluating the health of second-lien portfolios is the fact that "they are generally, especially home equity lines, negative-amortization products," said Josh Rosner, managing director of the consulting firm Graham Fisher & Co. "As long as you pay the minimum due, you are current, which makes the problem look significantly smaller than it is."
According to Equifax, the average outstanding balance on a HELOC has grown from $48,745 in March 2006 to $61,848 as of March 2011, and the average utilization rate has risen from 50.4% to 55.4% over the same period.
HELOCs generally are issued with draw down periods ranging from five to 10 years, during which the borrower can borrow as much as they would like on the line and make interest-only payments. So borrowers who obtained the lines of credit from 2005 to 2007, the tail end of the bubble, and who have been drawing on them heavily and making only minimum payments, could be in for a shock when their loans convert to amortizing (i.e. higher) monthly payments in the coming years.
Rosner said that banks' financial reporting does not fully address this risk.
"I want to know how many are current because the borrower is making full payment with principal and interest and how many are current because they are just getting the minimum payment due on an open end," he said.
Jerry Dubrowski, a spokesman for B of A, could not provide the number of HELOC borrowers making only minimum payments, but he said that the negative amortization features on HELOCs are a nonissue.
"If they are current, you are not going to reserve for them," he said. "Because why would you? That would be the equivalent of saying that 'There are people in your neighborhood that are not paying their mortgage — I need to reserve for you.' "
Has transparency improved?
Financial Accounting Standards Board rule updates that went into effect last December did require banks to disaggregate their data and to be more specific in their disclosures.
However, the FASB rule updates still leave banks with a lot of discretion as to how they break out their data on receivables such as second-lien loans.
"In general, we are seeing definitely better disclosure and more detailed disclosure," said Francene McKenna, president of the consultancy McKenna Partners LLC. "However, it looks like they are still to some extent being somewhat a little optimistic on what the future is going to hold," she said. "There are still missing pieces; you really wish for some kind of consistent disclosure."
Why are second liens considered an obstacle to loan mods and other workouts?
Because the second-lien holders are often the servicers of the first mortgages held by MBS investors. As such, they can stall or block a short sale or a loan mod that reduces principal, and they have an incentive to do so, because a sustainable loan modification or a short sale could require the second lien holder to take a significant haircut or even a writeoff. Further, to date, the federal government has not had much success implementing its 2MP program, which provides financial incentives to servicers for modifying second lien loans. The program was announced in August 2009; by February 2011 fewer than 17,000 second liens had been modified under it.
"There is a conflict of interest to servicing securitized first liens while holding the second," said Rep. Brad Miller, D-N.C. "There is an extortionist value of being able to mess up a short sale."
In August Miller introduced the Mortgage Servicing Conflict of Interest Elimination Act, which would prohibit servicers from owning second liens that are attached to first-lien loans held by an unrelated entity. The bill went nowhere.
It's important to note, however, that being a servicer of the first lien and the holder of the second can also be a disincentive to foreclose — since foreclosure also produces a loss for the second lien.
The same business imperatives preventing borrowers from getting sustainable workouts may also have allowed them to stay in their homes a little while longer. "If you are the servicer who services the first on behalf of an investor and the second on behalf of a related entity," Rosner said, "you have every incentive on the 89th day to call the borrower and say, 'We don't want to move your second to the default status. Make some payment so we can keep you current.' "
Where are the regulators in all this?
The OCC, which regulates the four largest banks, maintains that the banks it oversees are adequately reserved against losses on second-liens.
"Our banks are working through this. We have specific guidance out to our banks and to our examiners. They have to account for this stuff right," Long said. "We are aggressively reserving against current second liens and we are aggressively making them charge off second liens that are impaired."
The agency also insists that the vast majority of second liens are not performing markedly differently than first-lien loans in terms of defaults. In a December letter to Rep. Miller, acting comptroller of the currency John Walsh said the OCC matched more than 60% of second liens held by banks ($293 billion) to first liens and found that about 6%, less than $18 billion worth, were current but standing behind delinquent or modified first liens.
However, the OCC statistics miss the riskiest sector of the market. According to statistics compiled by National Mortgage News, the four largest banks service only 35% of the outstanding subprime loans.
Which are the riskiest second-liens?
According to many experts, subprime borrowers who borrowed near the peak of the housing boom were more likely than not to have second liens. "Any loan that is 80% [loan-to-value] on the first and it's subprime or alt-A, then you know it is 90% sure that there is a 20% piggyback on the second," said Thomas Borgers, a managing director at Mesirow Financial Consulting.
And although they were able to unload mortgage-backed securities of first liens for big profits, "the banks would hold the seconds because they couldn't get a good price for them; that is the key point," said Borgers, who worked as an investigator for the Financial Crisis Inquiry Commission. At their peak in early 2007, there were only $87 billion of securitized seconds outstanding, and these dwindled to less than $22 billion by the end of last year.
Some say that many of the piggyback loans issued to subprimeborrowers may have already been charged off. "I think that the vast majority of those would have been washed out of the system," said Keith Gumbinger, vice president of the mortgage research firm HSH Associates.
What does the future hold?
If the foreclosure crisis continues, banks stand to take heavy losses on HELOCs and closed-end loans that are attached to underwater homes. But B of A is taking only modest reserves against future losses and it is unclear what specific reserves Wells has against losses on second liens.
Excluding its impaired portfolio, 40% of Bank of America's second liens are underwater. Including the impaired Countrywide portfolio, the bank has $12.9 billion reserved against further losses on its home equity line and closed-end loan portfolio — a ratio of approximately 9.6%.
At Wells Fargo, 38% of HELOCs and closed-end loans are attached to homes that are underwater. Wells, whose second-lien loan portfolio is approximately 133% of its Tier 1 common capital, does not break out reserves against future losses on its junior-lien portfolio. "We don't break that number out for home equity specifically," said Wells Fargo spokeswoman Natalie Brown. Among Wells' junior-lien borrowers, "the majority of folks are making their payments on time," she said.
The question is how much more will banks have to write down in the future if the housing market does not make a significant enough recovery to let underwater borrowers refinance or sell, and what happens if borrowers strategically default in greater numbers.
"Could lenders still be exposed to losses relative to the stuff they wrote yesterday?" Gumbinger said. "Absolutely. Not all of those properties have come through any sort of disposition cycle. Even a borrower who has been making payments all along on both his first and his second may come to a point where he says, 'Hey, I have to sell my home, I lost my job and my home is underwater.' "