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R.A. (Ryan Avent!) writes in response to my previous entry:

[Mike's thesis] places the government in a bind. If it forces banks to write down worthless second mortgages to clear the way for new modifications, then the banks suddenly look shaky again. If it doesn’t, then lots of homeowners are stuck in loans they can’t modify and may not be able to afford.

I think that he may be overstating the potential pain to banks, however. It is the case that troubled borrowers are very likely to have second liens. But is it the case that second liens are likely to belong to troubled borrowers?

We see that the four big banks hold $477 billion in second lien mortgages. Losses on those mortgages attached to underwater properties with borrowers seeking modifications are likely to be very high—significantly higher than 13%. But 75% of mortgage borrowers in America are not underwater. We would expect second liens to be far less common among borrowers with positive equity, but because there are so many more borrowers with positive equity, it’s not at all clear that most second liens fall into the category Mr. Frank describes. And of those homeowners who are underwater and have second liens, not all need a modification.

Let’s get a little bit of data in here that I should have opened with. I’m going to go to a paper by Laurie Goodman from Amherst Securities Group, “2nd Liens—How Important? “, covered here by Alphaville, and reproduce some text and a chart:

Exhibit 7 (below) contains this information. For prime loans, on average, the simultaneous 2nd is 19% of the mark-to-market value of the house, which raises the prime loan CLTV (total liens/market value of the home) from 105 to 124. Subsequent higher liens are 26% of the mark-to-market value of the house, raising that CLTV from 83 to 109. For properties that have both a simultaneous 2nd and a subsequent 2nd, the increase in CLTV is 29% of the market value of the house (from 94 to 123). For Alt-A loans, the simultaneous 2nd is now 26% of the value of the house (from 121 to 147), while it is 30% for subsequent higher liens (from 99 to 129) and 36% when both are present.

That chart (click to enlarge) has a lot going on, but the last two columns are the first place to start. The second to last column is the current loan-to-value, LTV, of the first lien. If it is greater than 100, it is underwater on the first mortgage by itself – the loan is greater than the value of the house. (Note the third to last column, which is the original LTV; there goes the bubble, eating 20% since origination.) The last column is the current CLTV, or combined-loan-to-value, which is the loan to value on all the debt of the property. For properties with a single lien, or with the second lien paid off, they are necessarily the same. These are averages – the data sources aren’t more specific. (I believe this data consists solely of loans originated since 2003).

As you can see, on average the loans with second liens are underwater; they are both underwater if there was a subsequent higher lien (they got an additional mortgage at some point, perhaps to get equity out of their home), or if they got a simultaneous second lien (where they got a first mortgage for 90% of the LTV, and then a second mortgage to get the rest of the balance). If it is greater than 120, that’s a danger zone for strategic defaults and vulnerability to unemployment (areas with high unemployment and an LTV greater than 120 are significantly at risk for large scale foreclosures). The simultaneous second liens are particularly brutal.

This is good advice, and advice I’ll be taking from now on – when people discuss housing statistics and LTV, keep an eye out to see if they are talking about LTV or CLTV – it makes a massive difference, as you can see above.

The simultaneous second lien CLTV for option ARM, on average, is 169. My god.

And a quote from Goodman’s House testimony about this research:

Third, any principal reduction program requires the Administration to address the second lien problem head on. The solution is clear — the banks that own the second liens will have to write them down. The treasury may choose to pay an “extinguishment fee”; it may make sense to allow the banks to take the losses over time. But for the sake of giving homeowners the best chance to stay in their home, the second lien will have to be extinguished. It should be noted that second liens have thus far, under HAMP, been treated with kid gloves.

Ah, Treasury paying an extinguishment fee. Fantastic! Note that if the stress test was updated quarterly and assets had to be marked consistently in some manner, the banks would be forced to writedown these second liens. Instead it looks like taxpayers will bribe nudge the banks to let go of their second liens through TARP money so that mortgage modifications between the primary lien holder and the resident can continue. Odds that we’ll get a value-added-tax next year but not a financial transaction tax or TARP recipient tax?