Mortgage Mess

Sadly, the mortgage mess is going to be with us for a long time.  The big thing that I think is likely to prevent a resolution any time soon is complicated, but worth thinking about.  It’s really much more complicated than I depict here, too, but for simplicity I’ve stripped it down to one issue and the essentials at that.

As you think about why more mortgages aren’t being renegotiated so that foreclosures can be avoided, consider this:

The holder of the first mortgage is quite often different from the holder of the second mortgage or HELOC.  If both mortgages were written at the same time, the chances are that the first was sold off and likely securitized, while the second was either held by the lender or sold in a separate securitization.  That second lien loan is, in many cases, worthless because of declines in market values of homes beyond the point where the homeowner has any equity (as discussed in this WSJ article).

For example, if the home was worth $250,000 and the owner got an 90% first mortgage and a 10% second at the outset ($225k and $25k, respectively), but that home is now worth only $190k (a drop of 24%–not unheard of these days to be sure), the second lien holder is S.O.L.

The reason that this is important and the reason that the crisis is going to be around for a long time is that those separate holders of the mortgages have different motivations and different exposures to be managed.  If the holder of the second lien is the originating bank and that bank acts as the servicer for both loans, there is a potential incentive for that servicer to not renegotiate the first mortgage to avoid having to realize the worthlessness of the second.  Setting aside the fact that the servicer can potentially make more money keeping a struggling homeowner barely alive than they can with a fully renegotiated loan, the holder of the second lien has no incentive to realize the true value of its position, so they don’t.

The government is pressing lenders to restructure mortgages to avoid foreclosures–but those are first liens that they’re thinking about.  If the first mortgage is restructured to the point that principal is forgiven and the balance reduced, the servicer/second lienholder must recognize that its loan is wiped out and write it down to zero if it’s still unsecuritized.  (If the second is securitized, the situation is potentially much more complicated.)  It’s not at all clear that this process of clearing bank balance sheets of “toxic waste” has occurred, despite the massive losses recognized during 2008.

To say nothing of the commercial real estate exposures that are lingering in a semi-dead state to be dealt with at some point in the future, hopefully after banks can earn enough money to replace the capital they’re about to deplete with big CRE write-downs.

More to come on this topic.

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