There’s been plenty of recent media attention to the prospect of investor lawsuits over fraudulent mortgages and mortgage securities. But investor lawsuits against mortgage servicers could be even more damaging than these other lines of legal inquiry. The four largest banks hold nearly half a trillion dollars worth of second-lien mortgages on their books—loans that could be decimated if investors successfully target improper mortgage servicing operations. The result would be major trouble for the financial system. The result would be major trouble for too-big-to-fail behemoths.
Mortgage servicers are the banking industry’s debt collectors. They accept payments and forward them along to investors who own mortgage securities-- servicers themselves don’t actually own the mortgages they handle. This is a recipe for trouble for a variety of reasons, but one of the biggest problems is the fact that the nation’s four largest banks also operate the four largest mortgage servicers. Bank of America, Wells Fargo, JPMorgan Chase and Citigroup service about half of all mortgages in the United States. They also have multi-trillion-dollar businesses whose interests often conflict with those of mortgage security investors.
The most glaring conflicts involve second-lien mortgages. Much of the foreclosuregate coverage has focused on first-liens—ordinary mortgages that people take out when they want to buy a home. But during the housing bubble, banks frequently sold second-lien mortgages in an effort to cash-in on inflated home prices. If you’ve had a mortgage for a few years, and paid down $30,000 of your home’s value, a bank might try to sell you a new $30,000 loan, backed by the equity you’ve accumulated in your house by paying your first mortgage.
In fact, banks were much more aggressive than this. Usually homeowners have to put up a certain amount of money up-front when they buy a house—this is the down-payment. But the profits available from mortgage securitization were tempting. Banks could issue a mortgage, sell it off to investors, and not have to worry about any potential losses. So banks got around down-payments by selling a second-lien mortgage at the same time they sold the ordinary first mortgage. The second-lien would be used to pay the down-payment on the first lien.
This is a neat trick, but if home values decline just a tiny bit, the second lien mortgage becomes almost immediately worthless. If a borrower can’t pay the first lien, the second lien is wiped out entirely. Similarly, if a bank modifies a first lien to lower a borrower’s overall debt burden, the second lien is also wiped out.
That’s a big deal, because even when home prices have declined dramatically, losses from foreclosure on first liens only eat up about 58 percent of the value of the loan, according to Valparaiso University Law Professor Alan White. The second lien, by contrast, is 100 percent gone.
The fact that four giant banks own almost half a trillion dollars of second-lien mortgages makes things very tricky. If a borrower gets into trouble on a first-lien mortgage, the mortgage servicer has three options. It can 1) foreclose, or 2) offer a loan modification that reduces the borrower’s overall debt burden (principal reduction), or 3) tweak the payment plan, charge some immediate late fees, and try to keep the borrower paying on the current debt level (extending the life of the loan, forgiving missed payments, lowering the interest rate).
If either of the first two are adopted, the second lien is wiped out. If the third option is pursued, the bank buys an extra few months of payments for the second lien. When the payment plan proves unsustainable, the bank can work out a new payment plan with the borrower, and hope for the best. This third tack often proves destructive for both borrowers and the first-lien owners. Tweaking payment plans can exhaust a borrowers’ savings and makes them unable to afford a meaningful loan modification. At the same time, it can generate fees for the servicer that investors ultimately pay for.
Many investors believe that banks are servicing first-lien mortgages for the benefit of second-liens. That’s because the megabank servicers own the second liens, while mortgage security investors own the first liens. This is a conflict-of-interest. A servicer is supposed to maximize the value of the first-lien for the investor. But it's conceivable that servicers--JPMorgan Chase, BofA, Citi, Wells Fargo-- are systematically screwing over both borrowers and investors in order to maximize profits on second-lien mortgages that are, by any reasonable economic analysis, already worthless.
It’s not clear how widespread this problem is. Academics and investors have been harping on it for literally years. But the market’s view about second-lien mortgages couldn’t be clearer. Second-liens trade at 25 cents on the dollar or less in the secondary markets. If a bank wants to sell a second-lien mortgage to another investor, it has to take a loss of at least 75 percent in order to do so. But regulators have allowed banks to account for their second liens at 90 percent or more of their original value.
Not every second-lien features this conflict-of-interest, and borrowers won’t abandon every second-lien. But <a href="http://rortybomb.wordpress.com/2010/03/09/principal-writedowns-and-the-fake-stress-test/">it’s easy to imagine hundreds of billions of dollars in losses on second-liens</a> hitting the four biggest banks (<a href="http://rortybomb.wordpress.com/2010/03/09/principal-writedowns-and-the-fake-stress-test/">see Mike Konczal's analysis from March here</a>). And the more investors learn about shoddy documentation in the foreclosure process, the more legal ammunition they have against servicers.
This, ultimately, is the most significant aspect of the letter investors wrote to Countrywide this week. Investors are pressuring Countrywide—a mortgage servicer owned by Bank of America—to push losses from about $16.5 billion worth of mortgages back onto the bank that securitized those mortgages. In this case, the bank that securitized the loans was another division of Countrywide, so the bank isn’t going to comply with the letter, since it means eating losses itself, and the situation is almost certainly headed for lawsuit territory (see Andrew Leonard’s explanation of the case here).
But that letter indicates that investors are organizing to go after improper mortgage servicing itself, not just fraudulent loan and security sales. That means investors are trying to sack banks with second-lien losses—and second-lien losses could easily dwarf the other losses that analysts have focused on so far.