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Calling DeMarco's Bluff? Use the GSEs' Market Power to Force 2d Lien Write Downs

posted by Adam Levitin

There's been mounting pressure on the acting head of the FHFA, Ed DeMarco to order Fannie Mae and Freddie Mac to undertake principal reductions. DeMarco's pushed back, arguing that it's not fair for the GSEs to write-down principal when there are second liens on some of the loans that are on banks' books and the banks aren't doing write-downs (see here and here and Felix's critique here). DeMarco is arguing for strict observance of absolute priority. He notes that reducing the GSEs' first lien balances at taxpayer expense effects a bailout of the banks as it bouys the likelihood that their second liens will be repaid.  

DeMarco's correct about a write-down of the firsts alone being a bailout of the banks. But his argument for doing nothing doesn't hold up for two reasons. First, there are plenty of GSE loans without seconds. There's no reason not to do write-downs on those loans. And second, the GSEs have the market power to force the banks to write down seconds as a term of doing business with the GSEs. If DeMarco's serious about dealing with negative equity, he'll start running the GSEs' like the 800 lb. gorilla they are in the housing market.    

Not all GSE loans have second liens. It's not hard to determine if there's a second lien on a property--a title search and/or a credit report will show that. Those aren't free, but I hate to think that would be what's keeping DeMarco from ordering the GSEs to write-down principal on loans that don't have seconds. The possibility that some might have seconds shouldn't get in the way of writing down principal on those that don't have seconds.

More importantly, DeMarco's hardly a helpless babe in this situation. DeMarco has the leverage to force the banks' hand on second liens. The GSEs have no obligation to do business with anyone they don't want to deal with, and the GSEs get to set the terms on which they do business. There is nothing, absolutely nothing, that prevents DeMarco from instructing the GSEs to adopt a policy that they will not purchase mortgage loans from any financial institution that does not agree to abide by a second lien write-down policy. That could be a policy that says 2ds get written off completely if there is a principal reduction on the 1st, or one that makes for a pro rata reduction, etc. The precise terms aren't key.  

What is key is that the GSEs have the power to force these terms on the banks. The GSEs ARE the mortgage market today. They have monopsony power. (The GSEs' could also probably condition continuation of servicing rights on second lien treatment...)  If DeMarco wants to use the banks' seconds as an excuse not to do principal reductions, he needs to explain why he isn't willing to exercise the GSEs' market power. And it can't just be vague statements that it "isn't appropriate" or "legal restrictions."  He needs to be citing chapter and verse, but I don't think there's anything to cite and certainly not something that forecloses (no pun intended) the possibility--at most there's an issue to be litigated, which gives FHFA all the leverage it needs. And fwiw, FHA could do the same darn thing. (Ahem, Shaun Donovan.)  

Sadly, rather than thinking creatively about this issue, FHFA (and its GC in particular) seem to be spending an inordinate amount of time on devising ways to supp up the foreclosure process and get rid of those pesky laws protecting homeowners (such as through a uniform state law making to strip away consumer protections under the banner of uniformity--lowest common denominator prevails!) or requiring that servicers care for properties that have been abandoned. 

I'd love to see DeMarco order the GSEs not to do business with anyone who won't enter into a second-lien reduction agreement with them. It would focus a very sharp spotlight on the second liens on the banks' books. Clearly they can afford some principal reductions without going belly up, or else we wouldn't (or perhaps shouldn't) be seeing dividend payments. But this is the shibboleth: if DeMarco's serious about principal reductions, he's got the tool to do it. And if he isn't, it's time for him to go.  

Comments

1) What leverage does DeMarco have over banks that don't want to be in the mortgage business anymore anyway? Bank of America has already stopped doing business with Fannie and is doing a fraction of their past total business. Others are shutting down correspondent channels and aren't particularly thrilled with the current economics of origination/servicing.

2) The GSEs need new mortgages more so than the banks need to originate them. The new credit book subsidizes the legacy credit book.

3) For banks, holding onto seconds at par is a better deal than writing a 30y mortgage at 4% and delivering it to one of the GSEs.

Good try, but this won't work. Jaime et al will tell FHFA to go pound sound in the desert.

If DeMarco appears eager to do mods as opposed to foreclosures, than agreement from the holders of seconds is worth something, because they can effectively prevent this. In a foreclosure, most of those seconds are worthless. The hope here may be to placate the holders of seconds with some nominal "go away" money.
OTOH the administration is been very slow to realize just how common 2nds have become in the last 20 years. The foreclosure programs almost completely ignored 2nds, as if they were occasional HELOCs rather than a common source of purchase money, largely replacing mortgage insurance during the bubble.

--And while there are plenty of GSE loans without 2nds on the same property, on suspects that a far smaller percentage of them are in trouble.

Strip the seconds in Chapter 13, and then have the GSEs do the loan mod with a write down.

If there is no equity for the second mortgage to attach to, the second can be stripped in a Chapter 13 in most jurisdictions.

i don't understand the concept of de marco, he lacks of understanding in lending and underwriting procedures. for e.i. if the borrower has a total balance of 150 k, 1st lien is 100k, 2nd lien is 50k, if the market value of that property is down to 100K, then absolutely the second lien should be stripped down based on the market value of the property. second lien is automatically eliminated based on underwriting the loan through loan modification. another example, supposed that property were foreclosed and sold to third party, the second lien has no right over the first lien, they automatically lose their position unless they could prove that the property value is higher than the first lien. de marco should learn that this concept is very elementary arithmetic. i don't see any complex about how to carry the debt forgiveness, not all 1st lien can be forgiven, they have to start with the second lien to stripped then whatever the market value of such
property and the debt of the first lien should be consider if there is such underwater of the property then the first lien should also be consider. in the example above, the first lien will not suffer any debt forgiven because the debt on the 1st lien is what the market value of the property. is that complicated mr. de marco?

WHY haven't the Fed and OCC forced the banks to write down the 2nd liens based upon the dissipation of collateral?

ANSWER: Because the four largest banks would need massive capital injections if they did.

So WHY do you think DeMarco would do what Bernanke and Dugan wouldn't do?

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