Gretchen Morgenson’s story, confirmed as an issue by FHFA Acting Director Ed DeMarco, about banks being enriched by Fannie and Freddie principal reductions if their second liens aren’t wiped out is simply an expression of reality. If the seconds are allowed to stand, the banks make money on the increased ability to pay on the seconds as a result of reducing principal on the firsts. That’s just basic logic. The rebuttal was that nobody seriously thinks that the seconds shouldn’t be wiped out if the firsts get written down. That’s not true, as Felix Salmon had to grudgingly admit.
Now we get confirmation that it is, in fact, government policy to maintain seconds while writing down firsts, from no less than the US Treasury Department. Treasury official Michael Stegman wrote a blog post that depressingly refers to “various sources” rather than citing Gretchen Morgenson herself (I guess I should be comforted that I’m not the only person to whom this happens). Anyway, Stegman then goes through the motions of defending Treasury’s policies on second liens.
In fact, the principal reduction program that we have asked the FHFA to allow the GSEs to participate in, the principal reduction alternative of the Home Affordable Modification Program (HAMP), is designed to protect against exactly this result.
Of course, not all under water GSE loans have second liens. But if they do, under HAMP, where a first lien mortgage is modified, then the holder of an eligible second lien must modify that lien proportionately if they are a participant in the Second Lien Modification Program (2MP). Most major servicers are participants in 2MP, so most will be obligated. Thus, any HAMP modification that includes principal reduction would trigger an obligation on the part of a participating second lien holder to write an eligible second down to the same degree. It is also worth noting that Treasury-paid incentives to first lien holders apply to matched second liens, though those incentives are less than the ones for first lien modifications, in light of their subordinated status.
So here’s his defense against a windfall for the banks: he says that, in fact, second liens will not have to be wiped out in the event of a principal reduction on the first lien, but only written down pari passu. This is the same standard in the foreclosure fraud settlement with respect to second liens. You cannot with a straight face say to anyone even marginally sophisticated about housing policy that this represents anything but a violation of accepted lien hierarchy. The seconds are supposed to take the full hit before the firsts get touched. That’s why they are considered junior liens in the first place.
Then, as an added bonus, Stegman casually mentions that the banks holding the second liens get a financial incentive for having to write down their loan in a mandatory fashion. I couldn’t tell you why they’re getting such an incentive, but just rest assured that those banks, who get money for doing nothing and a boost to the ability to pay on their written-down second liens rather than a total wipe-out, aren’t getting a financial windfall.
It’s true that not every GSE loan falls into this category; lots of them have no second liens at all (that we don’t know how many, just like the fact that we don’t know how many mortgages there are in the United States, is a stunning regulatory failure). And principal reduction should absolutely be used as a tool for rescuing borrowers. To those who say that taxpayers would pay (through HAMP incentive payments) for these write-downs, that’s the purpose of those incentive payments, and I’d like to see them actually used rather than sitting in a Treasury account. I could even live with the scenario described here, regardless of the impact on the banks, if it actually succeeded in averting foreclosures and keeping borrowers in their homes. (There are other issues with it, of course, including the fact that private securitization markets will never reconstitute if investors keep getting ripped off in favor of banks, and that the current oligarchic state of our political system will only change, to the benefit of the mass of citizens, by taking away some of the financial and political power from the banks, which this only perpetuates.)
But don’t try to play this game that a clear benefit to the banks isn’t a benefit to the banks. I don’t even know who this Treasury blog post is written for. Anyone with the most rudimentary knowledge of the mortgage and/or securities business would recognize the argument as bogus within two minutes.