Lien On Me

January 19, 2010

Second liens are a big obstacle to any attempt to reduce outstanding principal on first mortgages as part of a modification.  When the second lien holder will not agree to take a haircut on their loan, there’s scant incentive for the first lien holder to do so.  After all, the second lien holder’s payoff in a loan failure comes behind the first one.  Why would a first lien holder agree to take less and have the second, whose risks of loss is supposed to be higher and who is charging a premium rate of interest to cover that higher risk, walk away whole?  

A recent article on Bloomberg sums up the problem very well.  It also contains this provocative passage:

The government is considering changes to permanently cut balances on which borrowers owe more than the property is worth, said Michael Barr, the assistant Treasury secretary for financial institutions.

“We are in the process of reviewing that now as we have been continually,” Barr said on a conference call last week.“You have to be very careful not to design a program that would change people’s behavior across the country.” (I noted some of these “moral hazards” in earlier posts.)

Treasury crafted a modification program for second lien holders, but according to the Bloomberg article, none of the lenders holding $1.05 TRILLION of this debt has actually signed up to participate in it. 

A program through which the government acquired these mortgages and restructured them, including through the use of “friendly” foreclosures, could break the logjam described in this article.  

So could bankruptcy.  But bankruptcy judges do not have the right to modify first mortgages through bankruptcy—authority the Obama Administration sought but failed to get Congress to grant—and forcing a bankruptcy just to clear the seconds seems a poor policy choice.