In Proposed Mortgage Fraud Settlement, a Gift to Big Banks
By JESSE EISINGER, ProPublica
Lurking in a proposed mortgage fraud settlement with the state attorneys general is a clause that could be worth billions for the big banks.
Yes, I mean the settlement that might extract the supposedly large sum of $20 billion from the banks to settle foreclosure fraud. The one denounced as a “shakedown” by Senator Richard Shelby of Alabama.
Despite such rhetoric, the settlement might let the banks avoid tens of billions of write-downs, thanks to a clause with a biblical flavor: the last shall be first.
The proposed agreement — which is preliminary and subject to intense negotiations being led by Tom Miller, the attorney general of Iowa — would allow banks to treat second mortgages, like home equity lines of credit, just like the first mortgages. Under the proposal, when a bank writes the principal down on the first mortgage, the second should be written down “at least proportionately to the first.”
Suddenly, the banks would be given license to subvert the rules of payment hierarchy, as Gretchen Morgenson pointed out in The New York Times on Sunday. Yes, the clause says the other alternative is to wipe out the second’s value entirely, but given a choice, the banks would be extremely unlikely to do that.
So how is this a gift? Because when the principal on the first mortgage is reduced, the second lien is typically wiped out. The first lien holder has the first right to any money recovered, and the second lien holder has to wait its turn.
The proposal “seems astonishingly generous to the second-lien holders,” said Arthur Wilmarth, a law professor at George Washington University. “And who are those? Of course, they are the big mortgage servicers.”
And who owns the big mortgage servicers? The biggest banks.
Throughout the financial crisis, we have heard plenty of intoning about the sanc y of contracts. But this suggests that the banks, with the authorities’ tacit approval, think contracts are for thee and not for me. The price to get the banks to do the right thing contractually with mortgage modifications and foreclosure is to allow them to not do the right thing elsewhere.
To understand the significance of this issue, cast your mind back to the height of the housing bubble. People used their homes as A.T.M.’s, withdrawing billions from their equity to finance motorboats and meals at Applebee’s.
The top four banks now have about $408 billion worth of second liens on their balance sheets, according to Portales Partners, an independent research firm specializing in financial companies. Wells Fargo, for instance, has more money in second liens than it has tangible common equity, or the most solid form of capital. If banks had to write these loans down substantially, acknowledging the true extent of their losses, they would have to raise capital — and might even teeter on the brink of insolvency.
The performance of second liens is among the biggest puzzles in banking today: why are they doing better than the firsts? When Wells Fargo disclosed its earnings, for instance, it classified 5.3 percent of its first mortgages as nonperforming, but put only 2.4 percent of its second liens in that category. That seems very odd because it’s much easier to lose your home if you don’t pay your mortgage than if you don’t pay your home equity line.
Investors are deeply skeptical about the value in these loans, bidding about 50 cents on the dollar for them these days. Even allowing that banks probably hawk the least attractive loans and that investors bid low to generate a high return for the risk, many of these loans are still probably not worth 100 cents on the dollar.
Yet banks have taken relatively few write-downs on second loans so far. In fact, even when the first clearly is in trouble, sometimes the banks appear to resist writing loans down. Bill Frey, who runs Greenwich Financial Services, has instigated lawsuits to try to recoup the value of mortgage securities by getting the banks to buy back faulty mortgages that were in the pools he examined. He analyzed mortgage securities made up of loans by Countrywide Financial, which is now owned by Bank of America, looking for instances when the second lien was still extant, even though the first lien attached to the same property had been modified. Such a situation would suggest that a bank was not marking down a second lien even when the underlying, more senior first lien was impaired. He says he found multiple instances in every one of the 200 pools he examined.
Mr. Frey argues that the banks should charge off those seconds. “That’s the concept of subordination,” he said. “It’s been around since the Magna Carta. Maybe we should get on the bandwagon.”
This is not simply a fight between hedge funds, which own the securities that contain the first liens, and banks that house the seconds. Many mortgage securities are held by small banks, life insurance companies and pension funds. “I can see little reason why a pensioner should take the loss instead of Bank of America, when it’s Bank of America’s bad loan,” Mr. Frey said.
A Bank of America spokesman said that it charges off second loans when borrowers haven’t made payments for 180 days. The bank doesn’t, nor is it required to, charge them off just because the first lien has been modified, he says. But if a first mortgage is modified, the bank will increase its reserve because it’s more likely that the second will sour.
Since the fall, the Office of the Comptroller of the Currency has been examining how banks across the industry are treating their second liens, according to two people familiar with the review. The O.C.C. declined to comment.
But so far, the agency has evinced a rather blasé at ude about the potential problem on banks’ balance sheet. Don’t expect forceful action any time soon.
In this case, making the last first may mean that weak banks continue to inherit the earth.
What? no criminal fraudsters, no whoring lawyers, in jail? Not even investigated? Man, I'm so surprised.
However, the kid who bid on govt leases with no money to protect the environment from predatory corps is going to jail, and NYC spends $1B in 5 years arresting marijuana possessors.
Thanks for your non-sequitur.
This article and Stockman's article are simply more proof from a long-time Repug establishment insider about how the financial sector/VRWC has rigged the financial sector, and polluted/compromised govt with people from the financial sector who are only interested in abusing govt to protect/enrich the financial sector, no matter how much that injures the non-financial sector.
Amuse yourselves by impotently, academically debating the fine points and credibility of his article and economics/finance.
Thanks for your content-less hand waving. It's much appreciated.
I'm confused. How is writing off a loan (whether first or second) a gift to a bank? I get that the author is saying that the terms of the proposed settlement allow banks to avoid writing down home equity loans. But the article also says:
Under the proposal, when a bank writes the principal down on the first mortgage, the second should be written down “at least proportionately to the first.”
If you're writing down principal, you're writing down the money owed to both the primary and secondary lien holder. How is that a benefit to the banks?
The OP seems to be saying the usual order of business is for the second lien to get wiped out if the first is written down.
"How is that a benefit to the banks"
because it's USUALLY "first-lien, first-served", with non-first liens sometimes getting completely cut off. Above, the non-first liens would be marked down same as first-liens, rather than zeroed.
Similarly, that's why Goldman-Sacks got the govt to bail out AIG because if AIG went down, Goldman would have gotten in line with all, and sometimes behind, the other creditors to collect pennies on the dollar. When taxpayers send $100B+ to AIG, Goldman immediately got back 100% of their $12B in AIG, IIRC, and Warren Buffet's $5B investment in Goldman during the bottom of the crisis jumped up to $8B in a very short time for a 60% gain.
The banks don't want to write down their losses. This deal ostensibly help them to continue to hide their true financial condition.
I just don't see the relationship between the two loans. Assuming they're two seperate banks, if the primary lien holder decides to reduce its loan, that's its choice. I'm just curious as to why the secondary lien would have to be wiped out in the event of a primary loan write-down? Is that some bank policy or what?
From a legal perspective, this makes no sense. In the event of a foreclosure, the primary loan is to be paid in full before a penny is applied to the secondary lien. The article even acknowledges this. I don't see why the write-down context should make a difference.
It's not very clear to me either.
The article implies that writing the down first lien causes the non-first liens to be zeroed. yes, there's something more going on that's not explained.
The problem is that the article seems to assume that what in reality is discretionary is becoming a law under this proposed settlement.
You write down principal when there's a negative relationship between equity and outstanding principal on a loan. For a secondary loan, this is really bad because that lien has no chance of being repaid in the event of foreclosure. I think, as a result, second loans are completely written down in recognition of this fact -- if the first mortgage (the one with priority) isn't going to be repaid, all junior liens (with secondary priority) have no chance of being repaid.
However, all mortgage write downs are discretionary matters of negotiation between creditor and debtor. There is nothing obligating the secondary lien holder to write off the entirety of its loan in the event the primary lien is written down.
In fact, the settlement's requirement of a proportional reduction between lien 1 and lien 2 could conceivably benefit the mortgagor by requiring the second mortgagee to reduce its lien -- which currently is not required.
That being said, this isn't my area of expertise, so I could be wrong.
Right. I think that assumption is incorrect - and therefore dooms the point the article is trying to make.
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