Loan Mods and the Preferential Treatment of Banks: FAQ

FAQ: Who’s on first? And what's a second?

The folks in the Executive Branch of the US government run the:

• Treasury; and the
• Bureau of Alcohol, Tobacco, and Firearms.

I've just read the Guidelines for the Home Affordable Modification Program (“HAMP”).

If the Executive shows as much respect for the Constitution as it did for private contracts, then only the First Lady will have the right to bare arms.

What's a second?

A second mortgage is a mortgage on real estate that has previously been pledged as collateral for another mortgage. The second mortgage typically carries rights that are “subordinate” to those of the first.

Second mortgages are called “subordinate” because, if the borrower defaults, the first mortgage gets paid off first, before the second mortgage. Until 4 Mar 2009, second mortgages were riskier for lenders and generally sported higher interest rates than first mortgages.

What happened on March 4, 2009?

The Treasury released the HAMP guidelines. They describe how HAMP will help “3 to 4 million at-risk homeowners” reduce their monthly first mortgage payments to avoid foreclosure. The borrowers’ contractual payments will be reduced by:

• Temporarily lowering the interest rate to as low as 2.00%; and
• Possibly extending the term to as long as 40 years; so that
• Borrowers’ monthly home payments (including principal, interest, taxes, and insurance) do not exceed 31% of their gross monthly income.

Taxpayers, mortgage lenders, and mortgage investors will “share the cost” and pay for these modifications.

What about the second mortgage investors? Why aren't they putting up a few shekels? They're supposed to be subordinate to the firsts, right?

Good question. Why indeed? Laurie Goodman and Roger Ashworth of Amherst Securities took a look at HAMP in First Lien RMBS Holders – Beware!, 9 Mar 2009. They observed that the Program could:

• Disproportionately benefit the four largest mortgage servicers who are also the largest holders of closed-end second mortgages and revolving home equity lines; and
• Violate the time-honored priority of claims in which the second lien is written off before the first lien suffers any diminution of cash flow.

If so, the Program would probably destroy what remains of the securitized mortgage market (i.e., the conforming piece), in much the same way that the bailout has already destroyed the market for preferred stocks (See my Gentlemen Prefer Bland.)

Did anyone see this coming and propose a better solution?

Actually, yes. In the fall of 2008, analyst David Bernstein reviewed US Census American Housing Survey data. He found that:

• About 78% of households with mortgaged properties have only one lien on their home;
• Only 22% of indebted households have more than one lien on their home; and
• More than 70% of all homeowners with payment problems have more than one lien on their home.

Since second liens are so closely associated with payment problems, Bernstein proposed a focused and efficient mortgage rescue plan emphasizing the restructuring of second mortgages, rather than the more widespread modification of first liens.

(Bernstein’s complete presentation - Seconds First: The Role of Second Liens in the Mortgage Crisis and Rescue, 10 Nov 2008 – is available at SSRN, which does not provide his affiliation.)

What's wrong with modifying seconds?

One “problem” with Bernstein’s approach is that – by focusing on the restructuring of second mortgages – he focuses precisely on the assets typically held in portfolio by the large banks identified by Amherst.

To the extent that the seconds are restructured – and their value lowered – this will more directly and painfully impact large banks than would a first mortgage-restructuring plan, like HAMP.

This is because second mortgages are NOT as widely distributed as firsts. Firsts have been securitized and distributed across a broad investment base, including both non-banks and banks.

It would seem that despite the talk of “change,” the current Administration has NOT really budged from the prior Administration’s policy of “save the big banks.”

A first mortgage modification program (like HAMP) that leaves the second mortgage untouched is not bailing out the borrower.

It is protecting the big banks (with their large second lien portfolios), at the expense of the rest of the financial sector (i.e., smaller banks, credit unions, insurance companies, mutual funds, and pension funds.)

Okay, maybe you convinced me. What about the takings clause, isn't this unconstitutional?

You are referring to the Fifth Amendment of the US Constitution, which reads, in part:

• No person shall … be deprived of … property, without due process of law; nor shall private property be taken for public use, without just compensation.

Neither you nor I are Supreme Court Justices. Mortgage investors might attempt to assert their rights under the Fifth Amendment, suggesting that they have been deprived of property (i.e., cashflows) as a result of HAMP.

But if the quarter-century of legal action following the repudiation of S&L’s Supervisory Goodwill is any guide, (see my Thing One and Thing Two) litigious investors will need to be long-lived and well funded.

See Edward J. Sullivan's A Brief History of the Takings Clause for more on “takings.”

So: Who's on first?

The government will always defer to, and preferentially treat, the interests of large banks. The Fed Chairman has said as much, and why, in sworn Congressional testimony:

• [The]…Federal Reserve has also used its … authority to … stabilize systemically critical financial institutions. The Federal Reserve collaborated with the Treasury to facilitate the acquisition, … prevent the failure, …[or] stabilize [Bear Stearns, AIG], Citigroup and the Bank of America… The actions … taken to stabilize systemically critical firms were essential to protect the financial system as a whole… -Chairman Ben Bernanke, Testimony: Federal Reserve programs to strengthen credit markets and the economy, 10 Feb 2009.

This government, like the one that preceded it, must provide large banks with special consideration and first-class treatment. It will do this despite the banks’ contractual standing or status – even if, for example, the banks have a secondary (rather than a primary) property claim.

It would be foolish to expect them to do anything else, since the government’s hands are tied.

Who’s on first? Large US banks! If you don’t believe me, read the HAMP guidelines.