Barney Frank's call for banks to forgive principal on second liens was music to the ears of mortgage bond investors who have been pushing the idea for about a year.

The House Financial Services chairman wrote in a letter to the four largest banking companies dated March 4 that their refusal to take hits on second mortgages has been "a principal obstacle" to preventing foreclosures.

"Large numbers of these second liens have no real economic value — the first liens are well underwater, and the prospect for any real return on the seconds is negligible," the Massachusetts Democrat wrote.

Yet the holders of the second liens "refuse to acknowledge the losses and write down the loans, which would allow willing first-lien holders to reduce principal and keep borrowers in their homes."
(The four recipients of the letter — Wells Fargo, JPMorgan Chase, Bank of America Corp. and Citigroup  — hold more than half of the roughly $660 billion in home equity loans, according to Lender Processing Services in Jacksonville, Fla.)

The Mortgage Investors Coalition, a group of 15 money management firms and hedge funds, wants the government to offer banks incentive payments to write down second liens. The group's members, which manage more than $100 billion in residential mortgage-backed securities, are willing to write down their first liens to 96.5% of the homes' current value, as long as second lienholders take a proportional writedown as well. Once the borrowers' debt was reduced, they would be refinanced into Federal Housing Administration loans.

"Bondholders are putting money on the table. They're not asking for a subsidy," said Micah Green, a partner at the law firm Patton Boggs who represents the coalition.

He said investors are increasingly concerned that the administration's Home Affordable Modification Program (HAMP) is not working, and that more borrowers will simply redefault and go into foreclosure.

When HAMP was introduced a year ago, second liens were famously left unaddressed. Banks would have to take further capital hits if they had to write down second liens.

In August, the government unveiled 2MP, a supplemental program to HAMP in which companies agree to reduce a borrower's second-lien payment if the first lien has also been reduced. But so far only BofA has signed for 2MP, compared with 106 servicers participating in HAMP.

"The blockade here is the second lien," Green said. "It's become increasingly clear that the back-end debt-to-income ratio on these loans is leading to redefaults. You cannot address the problem of the homeowner unless you reduce the second lien. The government needs to incentivize the banks."

Surprisingly, home equity loans on depository balance sheets are performing much better than first liens, further reducing banks' incentive to take writedowns.

"If homeowners are paying their credit card bills and home equity line of credit and they're not paying their first lien, it is a potentially devastating scenario for the future of the mortgage market," Green said.

 

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