Mortgage investors push for banks to write down second liens

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A group of investors in mortgage-backed bonds dubbed the Mortgage Investors Coalition (MIC) recently submitted to Congress a plan to overhaul the refinancing of underwater borrowers by writing down the principal balances of both first and second mortgages. The confederation of insurers, asset managers and hedge funds hope to break a logjam between Washington DC and the four megabanks with the most exposure to writedowns on second lien mortgages, including home equity lines of credit.

The private sector initiative coincides with House Financial Services Committee Chairman Barney Frank’s open letter dated 4 March to the CEOs of the banks in question – Bank of America, Citigroup, JP Morgan Chase and Wells Fargo – urging them to start forgiving principal on the second lien loans they hold.

But the banks are unlikely to take action until they get new accounting guidance from regulators that would ease the impact of such significant principal reductions on their capitalization ratios, sources with knowledge of the situation told Debtwire.

The four banks in question collectively own more than USD 400bn of the USD 1trn in second lien mortgages outstanding. BofA holds USD 149bn, Citi holds USD 54bn, JP Morgan holds USD 101bn and Wells Fargo holds USD 115bn, according to fourth quarter 2009 10Q filings with the Securities & Exchange Commission.

As proposed, the MIC’s plan entails haircuts to the first and second lien loans to reduce underwater borrowers’ loan to value ratios to 96.5% of current real estate market prices, according to two sources close.

The downsized first lien mortgages would subsequently be refinanced into new loans from the Federal Housing Administration, allowing RMBS holders to clean the non-performing loans out of their trusts. Such a “short-refinancing” approach is the only way to allow restructuring on a massive scale by employing the existing refinancing infrastructure in the mortgage industry, said Jeffrey Gundlach, formerly of TCW and now CEO of DoubleLine Capital LP.

“If you wanted to modify a lot of people fast enough you need to refinance using the existing machinery,” Gundlach said. Just as US banks refinanced trillions in mortgage debt during the housing boom, the banks could refinance once again – but this time to lower loan-to-value ratios, he said. “The refi mechanism, in my view, is the only way to get there with the size we’re dealing with.”

UnHAMPering restructurings

Amherst Mortgage analysts estimate that about half of non-agency homeowners with a securitized first mortgage hold a second lien mortgage, and many of them pay the second liens routinely because the payments are lower and the creditors more aggressive. Treasury estimates that about half of at-risk borrowers have a second lien.

So far, implementation of the government’s Home Affordable Modification Program (HAMP) has focused on interest rate cuts rather than principal forgiveness, owing largely to banks’ resistance to principal write downs, the sources said. The results haven’t been pretty, according to one hedge fund investor.

The median debt-to-income burden carried by borrowers modified through HAMP is 59.7% -- 31%-41% of which can be attributed to second lien payments, the investor estimated. The remaining expenses are a combination of auto, credit card and student loan debt, the investor estimates, not accounting for variables such as household expenses and medical bills.

In order to reduce that debt burden and unwind the loan-to-value ratios of the roughly 25% of US homeowners underwater on their mortgages, second lien mortgage debt must be reduced, Amherst Securities Group analysts wrote in a 29 January report.

In the case of short refis, a borrower would have to be eligible for HAMP and owe more on their mortgage than their home’s appraised value, according to the sources close. The borrower would be refinanced into a 30-year fixed rate Federal Housing Administration mortgage through the Hope for Homeowners program.

For the program to work, HAMP would place principal balance forgiveness first in the modification waterfall. The associated second lien would take a principal balance reduction but remain intact through the process - ultimately to be re-subordinated to the first lien, the sources close said.

A systemic program to modify second lien mortgages called 2MP does exist but Treasury has stalled on implementation because the banks that hold them can’t afford it, six buyside investors said. The sources all said implementation of the program, called 2MP, would result in “catastrophic” losses for the nation’s four largest banks, which collectively hold more than USD 400bn of the USD 1trn in second lien mortgages outstanding.

“The party line continues to be they are a week away, two weeks away,” the hedge fund source said. “Treasury continues to tell investors that any day now they will be out with a final program and they will be signed up. The joke is really on us because they haven’t done anything.”

Treasury first introduced the 2MP on 29 April. Since then, Bank of America is the only institution to announce it will implement the program. Fellow banks JPMorgan Chase, Citigroup and Wells Fargo, meanwhile, say they need more guidance from Treasury before agreeing to it.

Wells Fargo spokesperson Mary Berg said the bank supports the “spirit of the program” but is not willing to commit before it has more guidance from Treasury.

Chase spokesperson Tom Kelly said the bank believes principal forbearance ”has the same payment impact as principal forgiveness.”

Treasury estimates that 1m-1.5m homeowners could be helped by the 2MP. Per 2MP guidelines, second lien holders would have the option to accept either modification or a lump sum pay-out to extinguish second lien debt under the program, a source of resistance from the banking community. Those borrowers qualified for a first lien modification under HAMP would automatically qualify for a second lien modification.

Banks have modified second lien mortgages using in-house programs. Bank of America, for example, has modified 57,000, according to spokesperson Rick Simon. Simon said he believed Treasury was working on accounting guidance that would help banks implement the program. Office of the Comptroller of the Currency spokesperson Kevin Mukri said “all our banks have to follow GAAP and there is no exception to that. From time-to-time banks ask us to interpret GAAP, but there is no real change here.”

”Treasury expects to release updated guidelines for the second lien program very soon,” Treasury spokesperson Meg Reilly said.

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