Mortgage Mayhem: Second Liens Become Sticking Point

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NEW YORK (TheStreet) -- As banks are getting down in the trenches to help borrowers take mortgage debt down a notch, second liens are increasingly becoming a first priority.

Banks have begun to make long-awaited progress in resolving distressed primary mortgages -- even if it requires a principal cut, a short sale or an outright foreclosure. But non-primary loans have hindered progress as the industry continues to work through hundreds of billions of dollars' worth of first-mortgages that have fallen behind.

A healthy portion of the $10.7 trillion in outstanding U.S. mortgage debt is made up of non-primary loans. There are no federal data to indicate the breakdown of primary vs. junior mortgages. But using the four largest mortgage servicers as a proxy, 61% of their outstanding residential debt is tied up in non-primary loans.

There are home-equity lines of credit that were extended when home values soared past the initial purchase price. There are also so-called "piggyback" mortgages - secondary, tertiary and even quaternary loans - that lenders extended to those who wanted to buy during the boom but lacked cash for down payments.

Banks had been kicking the can down the road for second liens, trying to make headway on first liens first. But the issue is now front and center for a simple reason: If a borrower can't afford to pay the first mortgage, there's no reason to think he will be able to pay other types of home-loan debt any better.

"The second-lien holders are going to be taking massive losses," says Greg Hebner, who provides loss-mitigation services for large mortgage companies as president of MOS Group.

Hebner explains that second-lien holders have little recourse for handling troubled borrowers other than taking "big haircuts" on principal. Even though some second-lien holders can pursue foreclosure, they won't get any money until the first mortgage is made whole. Home-equity lenders have even less recourse, since the debt is comparable to a credit-card line: Secured only by notional home values that have wasted away.

"All you can kinda do is look at those people and say, 'Boy, it sucks to be you right now,'" says Hebner, referring to holders of second-lien debt. "These folks are really in a bad way because very few of them have any equity."

The economics of a foreclosure -- or last-ditch tactics like short sales and deed-in-lieu transactions -- make less sense for a lenders and investors, the further one moves down the pecking order of subordination.

For instance, a borrower may have a $200,000 first mortgage and a $20,000 second mortgage on a home now valued at $250,000. After the costs of legal fees and the costs of processing a foreclosure or "foreclosure alternative," there's little chance that even the first lender will be made whole.

As a result, lenders and investors have been holding onto non-primary debt, hoping an eventual pickup in the economy will boost home values enough to bring some of that equity back. The loans have remained in relatively good shape for the time being, due to the extended low interest-rate environment.

"I know it's a shocking number ... but something like half of all ... the cases where the first is in default, the home equity's still paying," JPMorgan Chase CEO Jamie Dimon told investors in mid-July.

But Hebner points out a Catch 22: When the economy finally starts to pick up, sending home values higher, interest rates will follow.

"What's the borrower going to do when their Libor index sets in, or some second that they have tied to a T-bill or a federal yield goes from 2 or 3% to 5 or 6%?" he says, concluding that, "As a second-lien holder, I may be lucky to get any money back at all."

JPMorgan has more relative exposure to junior residential mortgage debt, with its $95 billion in junior liens representing 42% more than primary mortgage holdings. Bank of America has the most nominal exposure, with $146 billion in junior liens at June 30. Combined, JPMorgan, Bank of America, Wells Fargo and Citigroup held nearly $400 billion in such debt at June 30.

For the time being, many second-lien holders are still holding out to avoid getting wiped out completely. For instance, Dimon said losses will occur -- they just haven't all happened yet -- and that the bank has been preparing for the oncoming wave of write-downs and charge-offs within its $37 billion in loan-loss reserves.

But the delay in addressing non-primary housing debt has become a monkey wrench thrown into the gears of broader home-loan workout proceedings. As second-lien holders hold out for a recovery to boost values, their intransigence is hurting banks' ability to modify first mortgages successfully -- unless all of the debt is held by the same entity.

Says Lewis Ranieri, who laid the foundation for the mortgage-backed securities market at Salomon Brothers in the 1980s: "They can't even do short sales because the second is in the way...that's not accidental."

Ashley Adami, a counselor at ClearPoint Credit Counseling Solutions, says the issue of second-mortgage problems is "very prevalent" among the homeowners she advises. Many of them end up overwhelmed by the sheer scale of residential-mortgage debt.

"I come across this situation all the time," she says, "Even if the primary mortgage is adjusted, it's not putting the homeowner in a position to afford all of their expenses."

Eric Evenhuis, a 64-year-old family counselor in Southern California hasn't even gotten that far.

Evenhuis is so far underwater on his Rancho Cucamonga home that there's little chance his lender will be able to provide a profitable workout for the first mortgage, much less his home-equity line of credit. Home prices in the area have dropped about 35% since the peak in 2007, according to Zillow.com.

Evenhuis says he owes roughly $600,000 to OneWest Bank on the first mortgage and another $78,000 on the HELOC; the home is only worth about $360,000. On Friday, the Los Angeles-based lender denied his request for a modification and suggested he enter short sale proceedings. Evenhuis and his wife would like to get the issue resolved before February 2011, when the five-year mortgage term comes due, and before he retires next year to live on a fixed income.

"We don't want to lose our home, but we may have to," he explains.

The federal government has tried to address the issue by extending incentives through the Home Affordable Modification Program to mortgage servicers that address second mortgages in home-loan modifications.

But the program hasn't been very successful in addressing distressed loans, with banks turning to their own proprietary workouts instead. So few servicers have made progress within the program that just $27 billion of a potential $75 billion in incentive payments are now eligible for collection. Only seven servicers are participating in the second-lien program, dubbed "2MP."

The industry has been preparing for the delayed second-lien losses by building reserves, and also by cutting home-equity lines of credit like mad. Otherwise, banks would face the risk of borrowers drawing down on HELOCs to pay other types of debt.

"It happened to me," says Hebner, the MOS Group loan-loss specialist, who still sounds a bit shocked. "I obviously never missed a payment or anything like that, but they just said, 'Your line of X has now been cut to Y.' Everybody wants to reduce their exposure on home-equity lines because they're seeing the problems in their portfolio."

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