How Banks Can Win From Being Second By Peter Eavis The Wall Street Journal 02-04-2010

How Banks Can Win From Being Second
By Peter Eavis
The Wall Street Journal
February 4, 2010

If you thought all the bank bailouts were over, take a look at what is happening with lenders' large holdings of junior, or "second-lien," mortgages.

These loans stand behind the first mortgage and, in theory, should take a loss before first mortgages in any workout aimed at keeping a borrower in a house. However, government programs aimed at making first mortgages less burdensome have left the junior loans largely unmodified, meaning in some cases the junior lender is basically getting bailed out for free.

That appears to have created an uneven playing field. When modifying a first mortgage, the financial pain isn't just felt by banks. Other entities, such as bond investors who hold mortgage-backed securities and taxpayer-backed Fannie Mae and Freddie Mac, also hold first mortgages. By contrast, junior mortgages are held almost exclusively by banks.

If a borrower with a first mortgage and a home-equity line gets a modification on the senior loan, he or she has more money to pay the junior debt. The first-mortgage holders suffer, while the junior-mortgage holder, nearly always a bank, benefits.

And because junior-mortgage portfolios are huge, such a benefit could be material. At the end of last year, Bank of America, Wells Fargo and J.P. Morgan Chase had combined junior-mortgage loans of $381 billion, compared with $607 billion of first mortgages.

In response, banks say they often hold the first mortgage, too. And they say they have been modifying second mortgages of their own accord. However, banks typically haven't said how many junior mortgages have been modified. BofA is one that does, and says roughly 10% of the 700,000 modifications it has done since the start of 2008 were on second mortgages.

This creates a dilemma for the Obama administration. In theory, the results of its Making Home Affordable program could be improved if second mortgages took more of a hit. Borrowers in the program who receive a permanent modification end up with a median debt-payments-to-income ratio of 55.1%. That still is quite burdensome, and could lead to a high redefault rate. Extinguishing the junior debt could take that ratio a lot lower for many borrowers.

Granted, since early last year, the government has planned a program to modify junior mortgages. But banks aren't required to join, and, of the Big Three, only BofA has signed up so far. And since large banks have paid back aid from the Troubled Asset Relief Program, the government has lost leverage to get them to do more modifications.

Even so, the junior-mortgage issue may yet gain traction. Politicians could decide that modifying more junior mortgages is a way of reducing the fiscal burden of cleaning up the housing mess. As things stand, taxpayer-supported Fannie and Freddie bear the majority of government-sponsored modifications, adding to their losses. Mortgages held or guaranteed by these two are responsible for 57% of trial and permanent modifications under the Making Home Affordable program. In contrast, bank-owned mortgage loans account for only 9%. Throwing in banks' junior mortgages could increase the burden borne by the banks.

Meanwhile, bond investors holding securities backed by senior mortgages might start to kick up a fuss if these loans continue to take the most pain in modifications.

All this makes junior mortgages an important issue for those holding financial stocks. Banks benefiting from a shield around some of these loans may find it evaporates. If unemployment stays high and foreclosures remain a big economic problem, expect more focus on why not junior mortgages aren't always taking the brunt of losses, as they were designed to.