On Monday, Citigroup (C) announced first quarter earnings that beat consensus expectations thanks to cost cutting and better credit performance. Citigroup's $1.2 billion net release of credit reserves during the quarter boosted earnings, as a decline in reserves translates to a dollar-for-dollar increase in the accounting value of the loans the bank owns. Despite the overall good news on credit conditions, Citi did report a large increase in nonperforming second lien loans - such as a home equity loan or home equity line of credit (HELOC). According to the earnings release, Citi classified $800 million in second liens as nonperforming, including $700 million that were actually current but subordinate to a first mortgage that was seriously delinquent.
The graph below compares the nonperforming rate on first lien and second line closed-end mortgages (mortgages with a fixed principal balance). These data (from the FDIC), show that borrowers are 2.75-times more likely to go delinquent on their first mortgage than on their home equity loan, as delinquencies on the first liens are 9.61% relative to 3.49% for second liens. The share of HELOCs that are nonperforming is even lower, at 1.83% of all loans, according to the FDIC. This is anomalous because the second liens are subordinate to the first mortgage and should therefore be riskier and have a higher default rate. Instead, many households continue paying their home equity loans even as they stop making payments on their mortgage.
Ultimately, if the house goes into foreclosure in a situation where the unpaid balance on the first mortgage exceeds the market value of the property, the second lien would be worthless. In foreclosure, the proceeds generated from auctioning the property are used first to retire the senior loan with any money left over used to pay off the second mortgage. While there have been deviations from strict claims priority, as in the mortgage servicer settlement, the basic rules of foreclosure resemble a corporate bankruptcy where senior secured creditors get the proceeds from the sale of the collateral, while subordinated debt holders and equity holders get wiped out.
Concern that banks were not properly accounting for potential losses on second liens in foreclosure proceedings led regulators to issue a January 31 guidance that effectively requires banks to treat a second lien as nonperforming if it is subordinate to a first lien that is nonperforming. The result was that J.P. Morgan (JPM), Wells Fargo (WFC), and Citi combined to classify over $4.1 billion of second liens as nonperforming during the quarter. The largest holder of second liens is Bank of America, which is likely to report a large increase in nonperforming second lien loans when its data are released next week.
In total, more than $10 billion of second liens may be classified as nonperforming during the quarter. This is just 1.4% of the $723 billion of second liens held by insured depository institutions at the end of 2011, according to the FDIC. It is also not clear what loss severity is used for loan loss reserves. In many cases, the loss severity is likely to be 100% when the homeowner is underwater on the first mortgage. Yet, in the recent stress test the Fed estimated only $56 billion in potential losses on second liens, which suggests a maximum default rate of about 8% or recovery rates that are far above what is implied by house prices.
There are many hypotheses for why a homeowner would continue to pay his second lien even after going delinquent on his mortgage. The payment is lower, the loan is fully recourse to the borrower in 39 states, and revolving home equity lines provide the household with access to credit. However, it is also important to note that the servicer of the first loan is often the owner of the second lien. Given that the servicer has much greater exposure to the second lien, it makes sense to think the servicer would work harder to ensure the second lien is current. Part of the anomaly could therefore be explained by servicers exerting greater pressure on borrowers to pay their second liens. The new regulatory guidance seems to recognize this conflict of interest.
Honest accounting for second liens is critical to measure the stability of the large banks and to correctly evaluate the likely effectiveness of principal forgiveness programs. Although commentators continue to criticize the Federal Housing Finance Agency (FHFA) for refusing to write off outstanding principal balances of loans owned by Fannie Mae and Freddie Mac, such debt forgiveness will be largely meaningless if the second liens remain intact. According to FHFA, "well over half of the Enterprises' seriously delinquent, underwater mortgages have a third party that shares the credit risk, in the form of a subordinate lien, a credit enhancement, or both." In these cases, the holder of the second lien should write-off the value of its loan entirely before Fannie and Freddie are forced to incur losses.
An inability to resolve the problem of second liens has hamstrung government policy in this area for several years. The first quarter earnings reports suggest that, for the first time, banks have to recognize that second liens subordinate to a nonperforming first mortgage are impaired and have to be classified as such. Once the amount of reserves set aside to deal with the potential losses on these loans grows to a level consist with current house prices, then banks would finally be in a financial position to help resolve the mortgage crisis without requiring further assistance from taxpayers.