If a home is underwater but the borrower keeps paying the second mortgage (though maybe not the first), can that junior lien be worth anywhere near face value?
The question is more than academic. If the answer is "yes," as banks have indicated in their valuations, government attempts to help distressed borrowers may be destined to flounder as second liens continue to stymie loan modifications and short sales.
If the answer is "no" — as many critics contend — and banks were forced to acknowledge it by writing down more of their second liens, their capital could take a serious hit.
"Home equity is the giant elephant in the room and everybody knows it," said Anthony Sanders, a finance professor and director of the Center for Real Estate Entrepreneurship at George Mason University.
Observers said fallen home prices and evaporated equity mean that those borrowers who today are still paying their second mortgages on underwater properties may soon join the ranks of those who aren't.
And if house prices fall further — as many economists are predicting — more borrowers will slip into negative equity, making defaults even more likely, all other things being equal.
Roughly 23% of mortgage borrowers owed more than their homes were worth in the second quarter, and another 28% had "near negative equity" in their homes of 5% or less, according to CoreLogic, an analytics firm.
"If 25% of mortgages are underwater, [the second liens on those homes] should be classified as nonperforming loans, which would require a 50% reserve," said Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist.
Yet losses taken to date have not been as severe.
Since 2008 the top four banking companies — Bank of America Corp., Citigroup, JPMorgan Chase, and Wells Fargo — have charged off 19.9% of $79.7 billion in junior liens, and 8% of $353.9 billion in home equity lines, according to call report data.
The four institutions now hold at least $423 billion of home equity loans, including $151 billion of loans to borrowers who are either underwater or close to it, according to data provided to the House Financial Services Committee in April.
Banks point out that a good chunk of borrowers who have already defaulted on their first mortgage are still paying their second mortgage or home equity line.
One reason, bankers said, is that the balances, and therefore the monthly payments, tend to be small.
"In half of all cases where the first is in default, the home equity is still paying," Michael Cavanagh, JPMorgan Chase's chief executive of treasury and security services, said on its second quarter conference call.
"It is a shocking number. … [but] remember the home equity is a loan secured by real estate. It is supposed to pay. You are not supposed to walk away from a loan because the collateral is worth less."
In the second quarter the delinquency rate on second liens with combined loan-to-value ratios above 100 was just 6% for B of A, and 5.04% for Wells.
Citigroup's overall delinquency rate was 2.4% in the second quarter and 47% of its second liens were "underwater," with loan-to-value ratios above 100% in the quarter. JPMorgan Chase did not break out delinquency data on second liens apart from Cavanagh's remarks.
Bank of America, which has $40.6 billion of second liens with loan-to-value ratios above 100%, estimated in its second-quarter report that it would be able to collect 85 cents for every dollar loaned, even if all such loans defaulted. It based this estimate on current housing market prices, a spokesman, Jerry Dubrowski, said.
Banks are required by regulators to charge off loans after 180 days of nonperformance, according to the Fed and the Office of the Comptroller of the Currency (OCC), which supervises large banks that service 65% of all mortgages.
A bank does not have to classify a home equity loan if the value of the property has dropped, said Bryan Hubbard, an OCC spokesman.
But Cole and others argue that banks ought to reassess the underlying credit quality of loans and account for problem credits if the collateral has changed. "Regulators have the power to force the banks to reserve against these loans, but choose not to do so," he said.
Gerald Hanweck Sr., a finance professor at George Mason and a former visiting scholar at the Federal Deposit Insurance Corp., agreed that banks are loath to take losses on performing loans even if the value of the home has dropped 30% or more and a default is likely.
Regulators are complicit in looking the other way, he said.
"The banks have been accounting for [home equity loans] at par and the reason is that supervisors won't force the writedowns," Hanweck said. "If the loan is performing, that's their fallback, but the underlying value of the property is still less and is insufficient to support the valuation."
But forcing writedowns would have negative consequences for capital positions, which banks have spent the last few years rebuilding and will have to further buttress in coming years under the new Basel III standards.
"We don't have the money in the economy to successfully write down these loans," Sanders said. "If we force the banks to write them down, the banks will become insolvent and come back to the federal government for additional bailout money, which means the taxpayers get stuck."
Timothy Long, a senior deputy controller at the OCC, said in an interview last week that banks have taken "massive losses" already on home equity loans.
"We have been very focused on the second-lien issue," he said. "The at-risk population of seconds is not nearly as big as what people who are doing an oversimplified analysis of bank balance sheets think."
The OCC is doing an analysis of the risk associated with second liens if the first is delinquent and is notifying banks to take action on problem loans.
"They don't get to sit there as if nothing has happened," Long said.
Second-lien holders' reluctance to take losses has been widely cited as one of the main impediments to the government's Home Affordable Modification Program or HAMP.
"Were regulators to act in a consistent manner, banks would be facing large write-downs on much of their second-lien portfolios and would be far more willing to negotiate with borrowers and first-lien holders on loan restructurings to keep properties out of foreclosure," Cole said.
Borrowers with second liens have higher loan-to-value ratios and, with little or no equity giving them an incentive to stay in their homes, redefault on modified first mortgages in higher numbers, according to Laurie Goodman, a senior managing director at Amherst Securities Group.
Greg Hebner, the president of MOS Group, an Irvine, Calif., company that contacts troubled borrowers on behalf of lenders and servicers, said that as many as 60% to 70% of borrowers in distressed markets like Las Vegas and Phoenix are underwater, yet the banks have taken no writedowns to reflect such losses.
"If you're at 210% LTV and showing the loan as performing on your books, you are ultimately going to have to give a huge principal concession," Hebner said. "Once these borrowers get their first lien sorted out, the only thing that's keeping the seconds performing are ultralow interest rates."
Modification can be a setup for failure, Hebner said, because when delinquent borrowers who have not paid their mortgage for six to nine months get loan mods, they often end up with an even higher combined loan-to-value ratio since unpaid payments are added to the principal balance.
That, Hebner said, puts second liens even further "out of the money," making a default more probable down the road.
More than a year ago 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.
Sanders said the lack of any discernible results from the program signals an impasse between second-lien holders (which often service the first mortgage), investors in the senior debt and mortgage insurers over how much of the cost each party should eat.
"There's not a lot of incentive for all of these parties to work together, because the losses are so extreme," Sanders said.
Data on the number of mods completed under 2MP will not be released until the end of December, said Mark Paustenbach, a Treasury Department spokesman.
Second-lien holders have also been blamed for discouraging short sales, in which the borrower avoids foreclosure by selling the home for less than is owed on the mortgage and the lender accepts a discounted payoff.
Banks holding second mortgages have scuppered such transactions by insisting on the right to chase after the borrower for the amount of debt not covered by the home sale, short sale experts have said.
Some in the industry fear that even if regulators do not make banks write down second liens to reflect collateral values, accounting changes will.
The Financial Accounting Standards Board has proposed a rule that would force banks to mark-to-market nearly all assets and liabilities.
"If the banks are forced to write down to market or reserve down to the market value of the loans, it could hurt them from a capital perspective, and likely unnecessarily so," said Jeffrey Naimon, a partner at the law firm BuckleySandler.
Naimon said some additional reserves have already been taken and no one knows what the ultimate losses will be.
" 'Underwater' and 'nonperforming' are very different," he said.
Even if a second-lien defaults and the sale of the home is not enough to cover even the first mortgage, banks can pursue deficiency judgments against borrowers in all but 12 states. However, recoveries are minimal since most borrowers are unable to pay because of a loss of income, banking attorneys said.
Michael Lacour-Little, a finance professor at California State University at Fullerton, said banks are more likely to sell their impaired home equity portfolios to third-party collection agents rather than go after the borrowers themselves.
"A good operating assumption would be that recoveries are 5% to 10% of the balance in a best-case scenario," Lacour-Little said. "It would be prudent to increase loss reserves to reflect management's best judgment on what will ultimately be recovered."