after the housing crisis - second liens and contractual inefficiencies
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After the Housing Crisis: Second Liens and Contractual Inefficiencies
Chris Mayer, Ed Morrison, and Tomek PiskorskiColumbia UniversityMay 2012
1. IntroductionSecond liens are thought to be an important problem for banks, consumers,
and mortgage modification policies targeting the housing crisis. For banks, the
problem is that they appear to be overexposed to the risks attendant to second liens.
These liens account for about $870 billion of U.S. household debt (Equifax Credit
Trends, August 2011) and ninety percent of this second lien debt is carried on the
balance sheets of commercial banks (FDIC 2012). As property values decline and
foreclosure rates increase, second liens are particularly vulnerable due to their
junior priority relative to first mortgages. This vulnerability appears to put
commercial banks at substantial risk because second liens account for over half of
bank capital (Lee, et al. 2012).
For consumers and policymakers, the problem is that second liens may
undermine mortgage modification efforts (Mayer, et al. 2009).1In particular, it is not
uncommon for the first and second liens to be serviced by different parties. When
different parties service the different liens, there is the potential that the second lien
servicer may hold up efforts to modify the mortgages. Effective modification could
require a substantial write-down or even elimination of the second lien. Instead of
agreeing to that kind of modification, servicers of second liens may prefer to play a
wait-and-see strategy, hoping the homeowner continues paying and housing values
recover. So a policy of providing a modest payment for the second lien to get out of
the way when writing down the first lien might be efficient (Mayer, et al. 2009).
Most analysts agree that the existence of second liens gets in the way of efficient
1We note that there are compelling arguments that in times of significant adverse macroshocks, debt forgiveness and loan renegotiation can create value for both borrowers andlenders (see for example Bolton and Rosenthal, 2002; and Piskorski and Tchistyi, 2008).
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mortgage modification and thus may be contributing to the foreclosure crisis in the
country (Amherst Mortgage Securities, 2010).
To illustrate the hold-up problem, suppose that a home is encumbered by
two liens, a first lien equal to $110 and a second equal to $30, each serviced by two
different servicers. Suppose as well that the homes current market value is $100,
but that lenders would receive $90 in a foreclosure due to the administrative costs
and other frictions generated by the foreclosure process. In some circumstances
when the homeowner refuses or is unable to pay, modificationreducing the
homeowners current cumulative loan-to-value (CCLTV) to $100is economically
efficient. Lenders will receive a greater overall recovery from a modification of the
mortgage debt than from a foreclosure.2
But the fragmented ownership of themortgage debt could prevent this efficient outcome. Modification requires that the
homeowners CCLTV be reduced by $40. The first lien lender is highly unlikely to
reduce its lien by this amount (from $110 to $70) because its recovery would fall
below what it could expect from foreclosure. The second lien lender is also unlikely
to write down its lien, absent some compensation. Because its lien is worthless in
foreclosure, the second lien lender has nothing to lose from holding up any
modification effort. Indeed, it can credibly refuse to modify its lien unless the first
lien lender shares some or all of its gains from modification (relative to foreclosure).
Efficient modification, therefore, requires first lien investors either to (i) write down
their lien to $70 or (ii) pay the second lien lender a bribe that could be as large as
the first lien lenders gains from modification. The bribe effectively taxes the
modification and thereby reduces its likelihood of happening.
But hold-up is not the only challenge posed by second liens. Even when both
liens are serviced by the same entity, problems arise when the first is securitized
2To keep this example simple we abstract from possible incentive issues and asymmetricinformation between borrower and lender (or servicer), such as the likelihood that aprogram modifying mortgages may encourage some borrowers to default who would nototherwise do so. See Mayer et al. (2011) for discussion of these issues.
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and the second is a portfolio loan on the servicers balance sheet. This is a frequent
occurrence. More than half of second liens are held on the balance sheets of the
largest banks, and these same banks service more than two-thirds of securitized
first liens. When a bank services both liens, but only owns one of them, a potential
conflict of interest arises. The servicer may delay or prevent modification of the first
lien in order to delay recognition of losses on the second, and to prolong payments
on the second. Conflicted servicers may also service the two liens in a way that
prioritize payments to second liens, held on their own balance sheet, over first liens,
held by outside investors. This reversal in the contractual priority of the liens is
sometimes called lien shifting (Frey, 2011).Additionally, accounting and other
regulatory rules may require a write-down of the second lien when the first is
modified. If second liens represent an important part of a banks capital
requirements, it may be reluctant to take actions (with respect to first mortgages)
that tend to reduce its capital base.
Government policies have attempted to address problems with outstanding
second liens, without success. HAMP (Home Affordable Mortgage Program) offers to
pay second lien holders a nominal amount to cover costs of modifying or writing-off
second liens, but has resulted in only 76,218 such modifications as of April, 2012,
with fewer than 17,000 of them involving write-offs.3
In this essay, we assess the gravity of problems posed by second liens and
propose legal and contractual responses. We begin our analysis in Section 2 by
quantifying the importance of second liens and discussing evidence that second
liens adversely impact mortgage modification efforts. We note that it is important
not to overstate the problems posed by second liens. Although homeowners owe
$717.2 billion in second lien debt, about $570 billion of that arises from home equity
lines of credit (HELOCs). Most of the remaining debt ($148 billion) arises from
3Treasury Department, March 2012 Making Home Affordable Report.
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closed-end second liens (CES).4As Lee, et al. (2012) show, most HELOCs were given
to borrowers with a conforming/prime first mortgage and relatively strong credit
scores, while CES were often given to borrowers with nonprime mortgages and
much weaker credit.5 In fact, CES balances are down more than 40 percent from
their peak, often due to defaults and subsequent write-offs by lenders. Thus only a
relatively small fraction of all second liensworth about $150 billionare in the
riskiest category of mortgages. As Lee, et al. note that HELOC performance might
deteriorate in the future if defaults grow again for underwater borrowers with
HELOCs, although that has not yet occurred.6Nonetheless, CES might still be worthy
of policy concern because of risks the pose for more than $600 billion of outstanding
first mortgages with which they are associated.
We then turn, in Sections 3 and 4, to potential legal and contractual
responses. While temporary policies have been proposed to alleviate problems
posed by second liens during economic crises, as noted above, such policies have
had only a limited impact on modification efforts. With most underwater borrowers
today still making payments on both first and second liens, we think it is important,
therefore, that policymakers and market participants design a durable framework
today for resolving the problems posed by second liens in the future. We therefore
propose (i) federal legislation and (ii) call for contract standardization that would
mitigate, if not eliminate, coordination and conflict of interest problems going
4Based on Equifax Credit Trends (March, 2012).5Additionally, to the extent that second liens are being carried at inflated values on bankbalance sheets, recent FDIC guidance is now forcing more realistic valuations(http://www.federalreserve.gov/newsevents/press/bcreg/20120131a.htm).In April 2012,Wells Fargo and JPMorgan reclassified $3.3 billion in second liens as nonperforming assets(http://www.bloomberg.com/news/2012-04-13/wells-fargo-jpmorgan-label-more-junior-home-loans-as-bad-assets.html). Further write-downs by other banks, such as Bank of
America, are expected soon.6One striking fact: According to a recent Zillow report, While a third of homeowners withmortgages is underwater, 90 percent of underwater homeowners are current on theirmortgage and continue to make payments.(http://www.zillow.com/blog/research/2012/05/24/despite-home-value-gains-underwater-homeowners-owe-1-2-trillion-more-than-homes-worth/)
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forward. In particular we propose, that federal law require all second mortgages to
include a provision that automatically eliminates the second lien (but not the
personal debt of the borrower) when associated first mortgage is underwater and
the first mortgage lender has committed to reduce the principal balance. This
proposal mitigates coordination problems because it permits unilateral
modification of the first mortgage, without consent or resistance from the second
lien lender. We discuss legal protections that would prevent first mortgage lenders
from using this power to disadvantage second lien lenders. We also propose that
banks and investors adopt standardized pooling and servicing agreements (PSAs)
that prohibit servicers of securitized first mortgages from owning associated second
liens. Such standardized PSAs would mitigate conflict of interest problems.
2. Evidence2.1 Quantifying the Extent of Exposure
According to data from Equifax Credit Trends (March, 2012), consumers owe
about $10.93 trillion to various lenders. Of that total, first mortgages represent
about $7.93 trillion and second liens are another $717.2 billion. Among the
outstanding second liens, the bulk ($569.1 billion) are home equity lines of credit
(HELOCs), which are revolving credit lines backed by the collateral in a home as well
as consumers personal credit. In total, HELOCs are about the same size as all other
types of revolving credit: Credit lines such as bankcards and retail credit cards
represent $583.7 billion. Closed end second liens (CES) are much smaller,
representing about $148.1 billion, less than 10% of all other non-revolving debt
such as auto, student and various loans ($1.69 trillion).
The distinction between HELOCs and CES is important. Banks argue that
HELOCs were given to borrowers with relatively high credit worthiness and were
underwritten to a great extent based on the credit quality of the borrower, not just
home value. Lee, et. al. (2012) provide evidence consistent with this claim, showing
that origination FICO scores and subsequent default rates for HELOCs are similar to
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those for prime first mortgages. Moreover, because HELOCS were often used to
finance home improvements, homeowners who took on HELOCS likely occupy
homes that have improved in value, reducing the probability that these borrowers
will default. By contrast, the origination characteristics and subsequent
performance of CES are much closer to those of subprime first mortgages. In terms
of payments, default rates on CES remain more than twice as high as for HELOCs.
When the first mortgage defaults, 20 percent of CES borrowers and 30 percent of
HELOC borrowers continue to pay their second lien for more than a year while
remaining seriously delinquent on their first mortgage.7These observations suggest
that HELOCS are less likely than CES to have an adverse impact on mortgage
modification efforts.
In light of these differences between CES and HELOCs, it is instructive to
examine second lien holdings by commercial banks. Table 1 shows these holdings
for the four largest banks in the U.S. For three of the four banks (Bank of America,
Wells Fargo, and JPMorgan Chase), the total value of second liensCES and
HELOCsexceeds the value of tangible common equity, and by a substantial
amount for Wells Fargo. But the second liens at highest risk of defaultCES
represent a relatively small fraction (no more than 18 percent) of overall second
lien holdings by these banks. The bank with largest exposure to CES is Walls Fargo,
for whom holdings of these liens represents about 24 percent of tangible common
equity.
These observations suggest that the risks posed by second liens may be
primarily associated with CES, which represent a relatively small proportion of all
second liens. This is not to say, however, that CES are not worthy of policy concern.
To the contrary, they may create obstacles to modification for hundreds of billions
of dollars of first mortgages. Recent data suggest that outstanding CES balances total
7By comparison, about 40 percent of credit card borrowers and 70 percent of auto loanborrowers will continue making payments a year after defaulting on their first mortgage.
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held in the servicers portfolio or is securitized.In addition these data have
comprehensive information on loan renegotiation actions performed by the
servicers.
The authors compare two cases: those in which the first and second
mortgages are portfolio loans held by a single bank, and those in which the first is
securitized and the second is a portfolio loan held by the same bank that services
the first mortgage. They find that securitized first liens with seconds are less likely
to be liquidated or modified than portfolio first liens with seconds. Put differently,
when ownership of the first and second liens is fragmented, the first lien tends to sit
in limbo: it is neither modified nor foreclosed upon- a situation that persists even
when the liens are serviced by the same bank.
Overall, the evidence provided by Agarwal, et al. (2011a) is consistent with
presence of both coordination problems and conflicts of interests between the
owners of first and second liens. It is also in line with prior research providing
evidence that securitization affects servicing and renegotiation of first lien
mortgages (see Piskorski et al (2010), Agarwal et al (2011b), and Zhang (2011)).
3. A Policy ProposalThe hold-up power of second liens is no surprise, and was likely anticipated
by first mortgage investors when they invested in the first mortgages. But the
primary concern of first mortgage investors appears to have been the possibility
that first mortgage servicersusually the originating bankswould modify the first
mortgages in ways that benefit second liens on the same properties (Frey, 2011).
First mortgage servicers might do that because they often carry the second liens on
their balance sheets and therefore face a conflict of interest in servicing the first
mortgage. But this response to potential conflicts of interest has two key defects,
which have loomed large in the financial crisis: when modifications are in the best
interests of first lien lenders, the PSAs (i) create severe roadblocks to modification
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(see Mayer, et al. 2009) and (ii) do nothing to remedy the hold-up power of second
lien lenders.
To be sure, its unclear how PSAs and first mortgages could have been
drafted to remedy the hold-up power of second lien lenders. First mortgages could
have included provision prohibiting homeowners from taking on second liens
without the consent of the first lien investors or the servicing agent (so-called
negative pledge clauses) and imposing penalties when homeowners violate the
prohibition (such as fees or higher interest rates). First mortgages might also have
included provisions stating that, in the event that a homeowner receives consent to
take on a second mortgage, the second mortgage lender must enter an inter-creditor
agreement that minimizes the risk of hold-up in the event that the homeownersuffers distress. These kinds of inter-creditor agreements are commonly observed in
corporate lending. Indeed, the term silent second lien has a radically different
meaning in the corporate lending sector: instead of describing a lurking lien that
first lien lenders are unaware of (as it does in residential lending), it describes a lien
subject to an inter-creditor agreement that requires second lien lenders to give their
automatic consent (and remain silent) to negotiations between the borrower and
first lien lenders.
But these contractual solutions to the hold-up problem are costly to deploy,
particularly because they require close monitoring of the debtors balance sheet. If
first mortgage lenders do not monitor homeowners, lenders might only discover the
existence of second mortgages after the homeowner is distressed (or in
bankruptcy). At that point, there is little gain to imposing fees or other penalties,
which will only deepen the homeowners distress and make mortgage modification
even more difficult. But the cost of monitoring likely outweighs the benefit in most
cases: The value of a first mortgage is typically too small to justify the careful
monitoring that is necessary.
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We are describing a complex contracting problem. It could be hard for
homeowners to credibly commit themselves not to take on second mortgages, and
first mortgage lenders may be unable to monitor homeowners in a cost-effective
way. Put differently, it appears that private contractual solutions may not prevent
ex-post hold-up by second lien lenders in a cost-effective way.
We believe this justifies a regulatory response to the hold-up problem, at
least during housing crises. When housing prices suddenly experience large
declines, the hold-up problem creates an important externality: because it prevents
efficient modifications, it contributes to widespread foreclosures, damages
communities, and prolongs the crisis.
We propose the following solution to the hold-up problem: Federal (or state)
law should require that every second mortgage include a provision that
automatically eliminates the second lien, thereby converting the second mortgage
into unsecured debt, upon the occurrence of two conditions: (i) the first mortgage
lender (or servicer acting on behalf of investors) agrees to reduce the principal
balance of the first lien and (ii) the appraised value of the home indicates that it is
worth less than the first lien (i.e., LTV>100). This solution would permit automatic
stripdown of second liens when those liens are worthless in foreclosure
(requirement ii) and threaten to hold-up efficient modifications that have been
proposed by the first lien lender (requirement i). Because second liens can be
stripped down only when the first lien lenders agree to modify their own liens, our
proposal deters first lien lenders from using our policy strategically to divert value
from second lien lenders. If second lien lenders nonetheless believe that their liens
were stripped down unnecessarily, they would have the right to bring suit against
first lien lenders. The suit, however, could only ask a court either to (i) assess
whether the first lien exceeded the appraised value of the home at the time the
second lien was stripped down or (ii) verify that first lien lenders modified their
own liens.
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The primary virtue of this solution is that it facilitates principal reductions
without requiring a bankruptcy filing. Under current law, summarized by Levitin
(2009), a homeowner can generally strip down a second lien in bankruptcy,
provided the home value is less than the first lien (LTV>100). But a bankruptcy
filing is very costly to the homeowner and creditors: it damages the homeowners
credit score, forces the homeowner to submit to a multi-year plan of repayment that
is sufficiently onerous that nearly two-thirds of homeowners are unable to complete
the plan, and discharges unsecured claims, including stripped down second liens.
Moreover, bankruptcy is an overly aggressive solution to the hold-up problem.
Many homeowners default on their mortgages simply because their homes are
worth far less than the combined mortgage balance. The homeowners have
sufficient liquidity to pay the mortgage balances, but conclude that it makes no
sense to continue paying a debt that far exceeds the value of the home it secures.
These homeowners dont need bankruptcy, which potentially readjusts all of their
debts. They need a simpler solution that adjusts only their mortgage debts.
Although our solution strips down second mortgages, it does not delete the
underlying debts. Homeowners will remain liable for the entire remaining balance
of the second mortgage. That balance, however, will become an unsecured debt,
much like a credit card balance. If that balance is too large for a homeowner to pay,
she will still have the option to file for bankruptcy to discharge the debt. If she does
that, the outcome will be the same as if our proposed solution did not exist: the
second mortgage debt will be discharged. What our proposed solution permits,
however, is the possibility that the homeowner can modify her first mortgage, pay
her unsecured debts (including the second lien) in full, and keep her homeall
without incurring the costs of a bankruptcy filing.
This solution shares much in common with the bail-in proposal for
systemically important institutions (Duffie 2009) and Adlers longstanding
chameleon equity proposal for corporations(Adler 1997). Under each of these
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proposals, senior claims convert to junior claims when the institution suffers
distress, thereby achieving a restructuring without a costly bankruptcy or other
resolution process.
We do not believe our proposal presents meaningful constitutional
questions. Assuming it was implemented via federal legislation, our proposal would
invoke Congresss power to regulate commerce (here, mortgage markets) and
would not violate the Takings Clause because it would apply prospectively to
mortgages originated in the future. If a state were to implement our policy, we do
not believe it run afoul of the Constitution. There is precedent for states taking
aggressive steps to limit the kinds of mortgages supplied to their residents. Until
1997, for example, Texas prohibited homeowners from taking on home equity loansunless the loans were to finance home improvements or tax payments. Since then,
certain kinds of home equity loans have been permitted, but only if they do not
increase CCLTV above 80 (see Forrester 2002).
One potential weakness of our proposal is that it depends heavily on the
discretion of the first mortgage servicer, which must decide whether to invoke the
procedure for writing-down second liens. If the first mortgages are securitized and
the servicer owns second liens associated with those first mortgages, the servicer
will labor under precisely the same conflict of interest that has long concerned first
mortgage investors. A solution to this problempreviously proposed by Frey
(2011)is to prohibit servicers from owning second liens while servicing
associated first liens for others. That solution, however, can be implemented by
contract. We therefore do not propose regulation to implement it.
Our proposal would undoubtedly affect the price of credit. Second lien debt
will almost surely become more expensive because our proposal limits recoveries in
the event that home values decline substantially. The price of first mortgage debt
could decline because our proposal eliminates ex post holdup problems.
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4. Alternative ProposalsAn alternative policy, favored by scholars such as Levitin (1999), is to revise
consumer bankruptcy law (especially Chapter 13) to permit homeowners to
reduce (cramdown) the principal balance of their residential mortgages to equalthe current values of their homes. Current bankruptcy law forbids cramdown with
respect to first mortgages and above-water second liens: if a homeowner wants to
retain a primary residence, the homeowner must pay the existing principal balance,
or any lower balance to which the lender agrees during a consensual modification.
Proposed reforms would change this: An underwater homeowner could enter
bankruptcy and, by invoking cramdown, exit with a mortgage balance that is no
greater than the homes value.
This proposalto permit cramdown in bankruptcycould alleviate the
hold-up problem created by second liens. Current law does permit cramdown with
respect to underwater second liens: If the value of the home is less than the first
mortgage, an underwater second mortgage can be converted into unsecured debt,
which can then be discharged by the bankruptcy process. Thus, current bankruptcy
law gives homeowners and first mortgage lenders power to overcome second lien
hold-up. But this power can be invoked only if the homeowner files for bankruptcy.Not only is bankruptcy itself a costly process, but the benefit from filing is limited
because homeowners cannot restructure first mortgage debt in bankruptcy. If the
bankruptcy code were revised to permit cramdown of first mortgages, homeowners
would have leverage to restructure all mortgage debts and would likely be more
willing to use the bankruptcy process to address hold-up problems created by
second liens.
In our view, proposals to revise the bankruptcy code are unwise because
cramdown is an overly aggressive remedy for a problem that is amenable to tailored
solutions, such as the one we propose.
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It is said that homeowners need to be given leverage or a stick in
negotiations with mortgage servicers and that cramdown is the appropriate stick.
We agree that a stick may be necessary when mortgage modification requires
negotiation with multiple lenders, some of whom may hold-up modification efforts.
Our proposal creates such a stick by automatically writing down underwater second
liens when the associated first lien is being modified. Unlike bankruptcy cramdown,
our proposal does not require a borrower to bear the monetary and reputational
costs of filing for bankruptcy, does not lead to a potentially unnecessary
restructuring of other debts (such as credit cards and auto loans), and does not
expose first lien lenders to the possibility that a bankruptcy judge will mandate
overly aggressive modification. We say that a modification is overly aggressive if it
extends greater concessions to the borrower than a modification that the borrower
and lender would have privately negotiated on their own, in the absence of frictions
such as hold-up problems and conflicts of interest. Our proposal fosters private
negotiation by reducing these frictions. Bankruptcy cramdown gives homeowners
the option to bypass private negotiation and seek more aggressive modification in
bankruptcy court.
There are several reasons why judicially-administered cramdowns could be
overly aggressive. Perhaps the most important is judicial error. Judges may
undervalue homes: The lower the assessed home value, the greater the cramdown
of the first lien. Judges might also select an inappropriately low interest rate for
future payments by the debtor: If the debtors risk of default is high, but the interest
rate fails to account for this, the expected value of future payments to the lender will
be less than the judicially determined (and potentially erroneous) value of the
home.9The risk of judicial error is non-trivial because bankruptcy judges have
9A number of courts have selected an interest rate equal to the prime rate plus a riskpremium equal to one to three percent, as noted by the Supreme Court in Till v. SCS CreditCorp., 541 U.S. 465, 480 (2004). This formula likely produces an interest rate that isinappropriately low when the risk of default is high. Currently, for example, the prime rate
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extremely large caseloads during non-crisis periods and would have even larger
caseloads during a crisis period if cramdown were permitted.10Likewise, it is not
clear that bankruptcy judges are generally sufficiently knowledgeable to choose the
right course of action, particularly during a crisis. Lack expertise could result in less
effective modifications, potentially increasing the risk of re-default and subsequent
foreclosure. Moreover, while the number of bankruptcy judges could be increased
during crises, it is unlikely that Congress can act sufficiently quickly to do this. This
delay could prolong a housing crisis and exacerbate associated losses.
We are assuming that judicial error is harmful to lenders. It might be thought
that, if judges are unbiased, their errors are equally likely to benefit and harm
lenders. That is likely untrue. First, when faced with uncertainty, judges may preferto err in favor of households, resulting in overly aggressive modifications. Second, it
is unclear whether judicial error would ever benefit lenders. If judicial error yields
insufficientlyaggressive modification, the lender has incentive to make it more
aggressive in order to avoid re-default or foreclosure. If the error results in overly
aggressive modification, the lender is harmed. An overly aggressive modification
could reduce lender liens by too much, but it could also offer benefits to
homeowners who not be offered them in private negotiation. Either way, lenders
are harmed by cramdown relative to the privately negotiated outcomes. Finally,
even assuming errors could benefit lenders, these errors tend to increase the overall
risk of mortgage financing by increasing uncertainty regarding future cash flows.
Because bankruptcy cramdown likely reduces lender recoveriesand
increases uncertainty regarding future cash flowsrelative to privately negotiated
is 3.25%. Yields on high-yield corporate bonds are about 7.68%, more than four percentagepoints higher than the prime rate. Data are taken from Bloomberg.com.10During the 12-month period ending June 30, 2008, for example, there were 368bankruptcy judges and 967,831 bankruptcy filings, implying a caseload of 2,630 bankruptcyfilings per judge (Mayer 2009). That caseload will rise substantially if cramdown ispermitted, and will rise dramatically during a crisis if homeowners view cramdown as aprincipal avenue for achieving mortgage modification.
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modifications, it will likely affect the price of credit. The magnitude of this effect is
unclear, but studies such as Pence (2006) show that the supply of credit is adversely
affected by laws that reduce creditor recoveries. A cramdown-induced increase in
the price of credit will likely harm borrowers and reduce overall welfare.
For these reasons, we believe that bankruptcy cramdown is an overly blunt
tool for dealing with problems arising from second liens. Our proposal is more
tailored and avoids imposing unnecessary costs of first mortgage lenders. Indeed,
our proposal can be seen as simply taking rules that currently apply in bankruptcy
(permitting cramdown of wholly underwater second liens) and applying them to
second liens generally, facilitating private negotiation between borrowers and their
first mortgage lenders.
5. ConclusionThe results in this paper suggest that the second lien problem, while quite large,
may not serve as a major impediment for a recovering housing market. Most
outstanding second liens are HELOCs, which were given to higher credit quality
borrowers who are current on their first and second liens. Of the lower quality
closed end second liens, more than 40 percent are already burned off. Theremaining CES balances are large, but would likely not threaten the capital position
of a major bank without large increases in HELOC losses as well. Furthermore, the
potential problems with conflicts of interest for second lien holders being more
willing to modify securitized first liens to preserve second lien recoveries that are
on their own balance sheet have been mitigated by new FDIC rules that require the
second lien holder to write off their second lien balance when the first lien becomes
delinquent.
However, existing evidence suggests that problems with second liens
nonetheless have contributed to the slow housing recovery and excessive
foreclosures. Coordination problems may have led to some additional foreclosures
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The research and conclusions expressed in this paper are those of the author(s) and do not necessarily
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as lenders were unable to pursue principal modifications on the first lien, even if
such modifications were relatively rare in the crisis. As well, the ability to hold up
the process and collect additional payments might have encouraged second lien
holders to provide cheaper credit to borrowers, exacerbating excessive homeowner
leverage in the period leading up to the crisis.
Our proposal provides a road map to a new solution to help prevent second lien
hold-up problems from interfering with modifications in the future. We believe that
this proposal would provide a simple contractual solution to the second lien
problem, reducing the current situation that encourages lenders to provide second
liens over unsecured credit or larger first liens. Of course, homeowners might also
be worse off taking out second liens relative to a larger first lien or unsecured creditin a downturn, but consumers may not be as well as equipped as lenders to choose
credit fully anticipating future potential problems. Thus our contractual solution
allows first lien holders to more easily convert second liens to unsecured credit
when they want to undertake a principal modification without the need to enter
bankruptcy.
Finally, we believe that future contractual solutions would be justified to try to
prevent other frictions that have exacerbated the impact of the crisis on
homeowners, servicers, and investors. For example, mortgages might contain
provisions that allow for automatic modification if home prices fall below some level
or household incomes fall (Piskorski and Tchistyi, 2010). Borrowers might be
allowed to use an underwater mortgage finance the purchase of a new home in a
different market (where unemployment might be lower) if that homeowner
purchased a new home for at least as much money as their current home was
wortha so called portable mortgage. Automatic refinancing when interest rates
fall would also help homeowners by encouraging refinancing without large
origination costs. The crisis has exposed many appreciable frictions in the mortgage
market that made it more difficult for the economy to recover and surely harmed
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The research and conclusions expressed in this paper are those of the author(s) and do not necessarily
reflect the views of Pew, its management or its Board.
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homeowners and investors. We have an opportunity to develop new structures in
the future to address these issues.
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The research and conclusions expressed in this paper are those of the author(s) and do not necessarily
reflect the views of Pew, its management or its Board.
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Mayer, Christopher, Edward Morrison, Tomasz Piskorski, and Arpit Gupta, 2011,Mortgage Modification and Strategic Behavior: Evidence from a Legal Settlementwith Countrywide, Working paper.
Pence, Karen, 2006, Foreclosing on Opportunity: State Laws and Mortgage Credit,
Review of Economics and Statistics88, 177-82.
Piskorski, Tomasz, and Alexei Tchistyi, 2010,"Optimal Mortgage Design." Review ofFinancial Studies23, 3098-3140.
Piskorski, Tomasz, Amit Seru, and Vikrant Vig, 2010, Securitization and DistressedLoan Renegotiation: Evidence from the Subprime Mortgage Crisis,Journal ofFinancial Economics97(3), 369-397.
Piskorski, Tomasz, and Alexei Tchistyi, 2011, Stochastic House Appreciation andOptimal Mortgage Lending, Review of Financial Studies24, 1407-1446.
Zhang, Yan, 2011, Does Loan Renegotiation Differ by Loan Status? An Empirical
Study, OCC Working Paper.
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The research and conclusions expressed in this paper are those of the author(s) and do not necessarily
reflect the views of Pew, its management or its Board.
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Table 1:
CES and Revolving Second Liens by 4 Largest American Banks
(in billions of dollars)
Originator Closed End2ndLiens
Residential RevolvingLines of Credit
Share of TotalRevolving
Total Revolvingand 2ndLiens
Tangible CommonEquity Capital
Bank of America $25.9 $116.9 17.7% $142.8 $120.4
Wells Fargo $18.3 $105.5 16.0% $123.8 $75.6
JPMorgan Chase $11.3 $100.7 15.3% $112.0 $110.7
Citigroup $24.2 $30.8 4.7% $55.0 $121.0
Total Top 4 $79.7 $353.9 53.7% $433.7 $427.8
Notes:Individual bank data from Q2 2010 Federal Reserve data. Total 1-4-family servicing from InsideMortgage Finance. Total Residential Revolving Lines of Credit refers to revolving lines of credit heldat FDIC-insured institutions. It is not the total universe. Total Revolving Second and Second Liens
Total/by Investor is from Federal Reserve Flow of Funds data (Z1).