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The Second Mortgage Problem – Banks Holding Out

The biggest obstacle to reducing principal and effectively working out home mortgages in trouble is the fact that half the homes in foreclosure may have second mortgages or home equity lines of credit.  The investors holding first mortgages understandably object to any debt reduction scheme that would not require the junior lien holders to take the hit first.  The junior mortgage holders are unwilling to recognize the reality that many of their loans are worthless. Why are second mortgage holders in denial?  Because unlike first mortgages, which are mostly held by investors in mortgage-backed securities, second mortgages are still held by banks on their own balance sheets.  If the major banks were honest about the value of their home equity debt, their capital would take a huge hit.  At a time when the banks are repaying Treasury’s equity investments, they do not want to expose this fundamental weakness in their balance sheets.  Bloomberg reports that the four big banks, who are also the largest servicers of investor-owned first mortgages, have a combined total of $450 billion in home equity debt on their own books. Bank of America, for example, has $150 billion in home equity debt, and 50% of it is underwater, or nearly, although most borrowers are still making payments, so far.  BofA estimates that half of the home equity debt is on homes with total first and second mortgage debt exceeding 90% of the home value. This at a point when its tier I capital was $191 billion.  Total loss provisioning for this portfolio was 6.4%, or about $10 billion, a figure that is clearly inadequate.   Large write-offs of BofA’s $150 billion home equity assets would take a big bite out of its capital base.

Thus, the essential first step in deleveraging American homeowners, namely big write-downs in second mortgage debt, is stalled by banks in denial.  As a result, the $1 trillion home equity tail is wagging the $10 trillion first mortgage dog.  Treasury is working on a plan to entice second mortgage holders to accept 15 cents on the dollar voluntarily, but banks are unlikely to play ball. Ironically, the present Bankruptcy Code allows homeowners to get rid of underwater second mortgages and home equity debt, if the first mortgage eats up all the equity.  Apparently, few homeowners who could benefit from stripping off second mortgages are using bankruptcy, perhaps because of the high costs to hire a lawyer and file a case.  In the absence of better use of bankruptcy stripdowns, or an alternative means to compel write-downs of second mortgage debt, the present stalemate, and the foreclosure crisis, will continue.