Viewpoint: Discovering Second Liens
Read the Wall Street Journal today, and you'd think that regulators and financial markets just now figured out that second liens are a real problem in attempting to put together criteria for cookie-cutter loan modifications. The story says that the Obama administration's Making Home Afforable program has "hit a stumbling block" and that the Treasury is "scrambling to address the problem" of second liens. The reason? Second lien holders aren't required to participate in the loan modification plan the administration outlined in early March. (Oops.) But the suggestion that this is a new problem that nobody saw coming is absolutely horrible reporting -- worse yet, it does a disservice to the analysts that did great work to highlight the very problems with the plan that now have investors in a lather. One group of analysts comes particularly to mind for both their great work and their glaring lack of mention in the Journal: that would be uber-mortgage analyst Laurie Goodman and her team over at Amherst Securities. How the Journal failed to mention perhaps the best-known analyst in the mortgage space in a story about mortgages, a story borne from research she did, is absolutely beyond me. On March 5 and again on March 9, Goodman and Roger Ashworth published a research note criticizing the Obama plan for its "inherent conflict of interest between servicers and investors." Beyond more generic criticisms of the plan -- the idea that the plan produces an incentive for a homeowner to 'rent' their home for 5 years -- Goodman zeroed specifically in on the issue of second liens. "The plan, in combination with the servicer safe harbor, leaves the current 1st lien holders with no protection," the Amherst analyst wrote in their March 9 note. "It is the equivalent of having the fox guard the hen house, with the fox in possession of the only set of keys. And it potentially corrupts the integrity of the securitizaton market." This research is what has set investors -- people like Jeffrey Gundlach, chief investment officer of TCW Group Inc., who is quoted in the story -- off into the press with pronouncements that the plan does a disservice to any first-lien RMBS holder, and they'd likely not participate as a result. But the story mentions nothing of the research team that first called attention to the problem, and suggests that administration officials have been caught off guard by a problem they didn't see coming. While it's clearly true they didn't see it coming, it's probably far more accurate to suggest that the current spat is the latest proof of two seemingly immutable facts surrounding efforts to 'solve' the nation's mortgage crisis: first, that regulators and financial authorities don't understand all that well what they are trying to fix; and second, that as a result, any fixes that are offered up have the very real potential to do more harm than good. Treasury officials told the Journal they're now trying to come up with a fix, essentially, something they hope will bring second lien holders into the fold to share in losses via the bulk loan modification plan; the idea being floated apparently would "require lenders to cap monthly payments on second loans at a set percentage of the borrower's gross income," the paper said. In plain English, the idea here is to force down the value of any second lien, too, perhaps in line with the first, perhaps not. But devaluing a second lien is a very different thing from seeing that lien rendered altogether worthless. And as it stands now, any bank holding second liens doesn't just take a haircut when a borrower goes delinquent; it generally gets scalped. Non-performing seconds are essentially worthless, something that can be seen in the fact that many second lien holders are actually not even foreclosing when a borrower stops paying (according to at least one distressed note purchaser I spoke with recently). There's nothing to recover in so doing. Some of the largest banks (and, not coincidentally, the largest servicers as well) would be more than happy to see that dynamic change to one where those losses -- the kind of losses that are currently wiping out their second liens at a rapid clip -- are instead shared among first and second lien holders. The Amherst team made the point in March that the top 4 servicers hold 52 percent of residential revolving lines of credit held by all FDIC-insured institutions -- add in closed-end seconds on the balance sheet, and you're talking about $441 billion in second liens with the Big 4. Aggregate holdings of non-agency MBS at the same Big 4 are only a fraction of that total, at $117.5 billion, in comparison. In other words, protecting even some of the value of outstanding second liens delivers far more protection to the collective balance sheet here, versus the alternative. No wonder a banking executive deadpanned to Journal that they're willing to negotiate on taking a hit on seconds, but "don't think we should get wiped out." (You don't have to wonder if that executive worked at a large versus a small bank.) But the question of what appears to essentially be a 'loss sharing' proposal that asks first lien holders to share in the losses that would traditionally be ascribed to second lien holders -- if that is indeed what the Obama administration is set to propose here -- does little to remove the underlying concerns that generated the spate in the first place: aren't second liens supposed to bear first loss, and all of the first loss? Editor's note: The April issue of HousingWire Magazine, out now, takes an exclusive and in-depth look at the Obama Administration's Making Home Affordable program for loan modifications. It's insight you can't find anywhere else, and the sort of insight you'll read months from now in other publications. Don't subscribe? Click here, or call 817-745-4671. Write to Paul Jackson at email@example.com.