After the Housing Crisis - Second Liens and Contractual Inefficiencies

8/13/2019 After the Housing Crisis - Second Liens and Contractual Inefficiencies

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The research and conclusions expressed in this paper are those of the author(s) and do not necessarily

reflect the views of Pew, its management or its Board.

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After the Housing Crisis: Second Liens and Contractual Inefficiencies

Chris Mayer, Ed Morrison, and Tomek PiskorskiColumbia UniversityMay 2012

1. IntroductionSecond liens are thought to be an important problem for banks, consumers,

and mortgage modification policies targeting the housing crisis. For banks, the

problem is that they appear to be overexposed to the risks attendant to second liens.

These liens account for about $870 billion of U.S. household debt (Equifax Credit

Trends, August 2011) and ninety percent of this second lien debt is carried on the

balance sheets of commercial banks (FDIC 2012). As property values decline and

foreclosure rates increase, second liens are particularly vulnerable due to their

junior priority relative to first mortgages. This vulnerability appears to put

commercial banks at substantial risk because second liens account for over half of

bank capital (Lee, et al. 2012).

For consumers and policymakers, the problem is that second liens may

undermine mortgage modification efforts (Mayer, et al. 2009).1In particular, it is not

uncommon for the first and second liens to be serviced by different parties. When

different parties service the different liens, there is the potential that the second lien

servicer may hold up efforts to modify the mortgages. Effective modification could

require a substantial write-down or even elimination of the second lien. Instead of

agreeing to that kind of modification, servicers of second liens may prefer to play a

wait-and-see strategy, hoping the homeowner continues paying and housing values

recover. So a policy of providing a modest payment for the second lien to get out of

the way when writing down the first lien might be efficient (Mayer, et al. 2009).

Most analysts agree that the existence of second liens gets in the way of efficient

1We note that there are compelling arguments that in times of significant adverse macroshocks, debt forgiveness and loan renegotiation can create value for both borrowers andlenders (see for example Bolton and Rosenthal, 2002; and Piskorski and Tchistyi, 2008).


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mortgage modification and thus may be contributing to the foreclosure crisis in the

country (Amherst Mortgage Securities, 2010).

To illustrate the hold-up problem, suppose that a home is encumbered by

two liens, a first lien equal to $110 and a second equal to $30, each serviced by two

different servicers. Suppose as well that the homes current market value is $100,

but that lenders would receive $90 in a foreclosure due to the administrative costs

and other frictions generated by the foreclosure process. In some circumstances

when the homeowner refuses or is unable to pay, modificationreducing the

homeowners current cumulative loan-to-value (CCLTV) to $100is economically

efficient. Lenders will receive a greater overall recovery from a modification of the

mortgage debt than from a foreclosure.2

But the fragmented ownership of themortgage debt could prevent this efficient outcome. Modification requires that the

homeowners CCLTV be reduced by $40. The first lien lender is highly unlikely to

reduce its lien by this amount (from $110 to $70) because its recovery would fall

below what it could expect from foreclosure. The second lien lender is also unlikely

to write down its lien, absent some compensation. Because its lien is worthless in

foreclosure, the second lien lender has nothing to lose from holding up any

modification effort. Indeed, it can credibly refuse to modify its lien unless the first

lien lender shares some or all of its gains from modification (relative to foreclosure).

Efficient modification, therefore, requires first lien investors either to (i) write down

their lien to $70 or (ii) pay the second lien lender a bribe that could be as large as

the first lien lenders gains from modification. The bribe effectively taxes the

modification and thereby reduces its likelihood of happening.

But hold-up is not the only challenge posed by second liens. Even when both

liens are serviced by the same entity, problems arise when the first is securitized

2To keep this example simple we abstract from possible incentive issues and asymmetricinformation between borrower and lender (or servicer), such as the likelihood that aprogram modifying mortgages may encourage some borrowers to default who would nototherwise do so. See Mayer et al. (2011) for discussion of these issues.


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and the second is a portfolio loan on the servicers balance sheet. This is a frequent

occurrence. More than half of second liens are held on the balance sheets of the

largest banks, and these same banks service more than two-thirds of securitized

first liens. When a bank services both liens, but only owns one of them, a potential

conflict of interest arises. The servicer may delay or prevent modification of the first

lien in order to delay recognition of losses on the second, and to prolong payments

on the second. Conflicted servicers may also service the two liens in a way that

prioritize payments to second liens, held on their own balance sheet, over first liens,

held by outside investors. This reversal in the contractual priority of the liens is

sometimes called lien shifting (Frey, 2011).Additionally, accounting and other

regulatory rules may require a write-down of the second lien when the first is

modified. If second liens represent an important part of a banks capital

requirements, it may be reluctant to take actions (with respect to first mortgages)

that tend to reduce its capital base.

Government policies have attempted to address problems with outstanding

second liens, without success. HAMP (Home Affordable Mortgage Program) offers to

pay second lien holders a nominal amount to cover costs of modifying or writing-off

second liens, but has resulted in only 76,218 such modifications as of April, 2012,

with fewer than 17,000 of them involving write-offs.3

In this essay, we assess the gravity of problems posed by second liens and

propose legal and contractual responses. We begin our analysis in Section 2 by

quantifying the importance of second liens and discussing evidence that second

liens adversely impact mortgage modification efforts. We note that it is important

not to overstate the problems posed by second liens. Although homeowners owe

$717.2 billion in second lien debt, about $570 billion of that arises from home equity

lines of credit (HELOCs). Most of the remaining debt ($148 billion) arises from

3Treasury Department, March 2012 Making Home Affordable Report.


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closed-end second liens (CES).4As Lee, et al. (2012) show, most HELOCs were given

to borrowers with a conforming/prime first mortgage and relatively strong credit

scores, while CES were often given to borrowers with nonprime mortgages and

much weaker credit.5 In fact, CES balances are down more than 40 percent from

their peak, often due to defaults and subsequent write-offs by lenders. Thus only a

relatively small fraction of all second liensworth about $150 billionare in the

riskiest category of mortgages. As Lee, et al. note that HELOC performance might

deteriorate in the future if defaults grow again for underwater borrowers with

HELOCs, although that has not yet occurred.6Nonetheless, CES might still be worthy

of policy concern because of risks the pose for more than $600 billion of outstanding

first mortgages with which they are associated.

We then turn, in Sections 3 and 4, to potential legal and contractual

responses. While temporary policies have been proposed to alleviate problems

posed by second liens during economic crises, as noted above, such policies have

had only a limited impact on modification efforts. With most underwater borrowers

today still making payments on both first and second liens, we think it is important,

therefore, that policymakers and market participants design a durable framework

today for resolving the problems posed by second liens in the future. We therefore

propose (i) federal legislation and (ii) call for contract standardization that would

mitigate, if not eliminate, coordination and conflict of interest problems going

4Based on Equifax Credit Trends (March, 2012).5Additionally, to the extent that second liens are being carried at inflated values on bankbalance sheets, recent FDIC guidance is now forcing more realistic valuations(http://www.federalreserve.gov/newsevents/press/bcreg/20120131a.htm).In April 2012,Wells Fargo and JPMorgan reclassified $3.3 billion in second liens as nonperforming assets(http://www.bloomberg.com/news/2012-04-13/wells-fargo-jpmorgan-label-more-junior-home-loans-as-bad-assets.html). Further write-downs by other banks, such as Bank of

America, are expected soon.6One striking fact: According to a recent Zillow report, While a third of homeowners withmortgages is underwater, 90 percent of underwater homeowners are current on theirmortgage and continue to make payments.(http://www.zillow.com/blog/research/2012/05/24/despite-home-value-gains-underwater-homeowners-owe-1-2-trillion-more-than-homes-worth/)


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forward. In particular we propose, that federal law require all second mortgages to

include a provision that automatically eliminates the second lien (but not the

personal debt of the borrower) when associated first mortgage is underwater and

the first mortgage lender has committed to reduce the principal balance. This

proposal mitigates coordination problems because it permits unilateral

modification of the first mortgage, without consent or resistance from the second

lien lender. We discuss legal protections that would prevent first mortgage lenders

from using this power to disadvantage second lien lenders. We also propose that

banks and investors adopt standardized pooling and servicing agreements (PSAs)

that prohibit servicers of securitized first mortgages from owning associated second

liens. Such standardized PSAs would mitigate conflict of interest problems.

2. Evidence2.1 Quantifying the Extent of Exposure

According to data from Equifax Credit Trends (March, 2012), consumers owe

about $10.93 trillion to various lenders. Of that total, first mortgages represent

about $7.93 trillion and second liens are another $717.2 billion. Among the

outstanding second liens, the bulk ($569.1 billion) are home equity lines of credit

(HELOCs), which are revolving credit lines backed by the collateral in a home as well

as consumers personal credit. In total, HELOCs are about the same size as all other

types of revolving credit: Credit lines such as bankcards and retail credit cards

represent $583.7 billion. Closed end second liens (CES) are much smaller,

representing about $148.1 billion, less than 10% of all other non-revolving debt

such as auto, student and various loans ($1.69 trillion).

The distinction between HELOCs and CES is important. Banks argue that

HELOCs were given to borrowers with relatively high credit worthiness and were

underwritten to a great extent based on the credit quality of the borrower, not just

home value. Lee, et. al. (2012) provide evidence consistent with this claim, showing

that origination FICO scores and subsequent default rates for HELOCs are similar to


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those for prime first mortgages. Moreover, because HELOCS were often used to

finance home improvements, homeowners who took on HELOCS likely occupy

homes that have improved in value, reducing the probability that these borrowers

will default. By contrast, the origination characteristics and subsequent

performance of CES are much closer to those of subprime first mortgages. In terms

of payments, default rates on CES remain more than twice as high as for HELOCs.

When the first mortgage defaults, 20 percent of CES borrowers and 30 percent of

HELOC borrowers continue to pay their second lien for more than a year while

remaining seriously delinquent on their first mortgage.7These observations suggest

that HELOCS are less likely than CES to have an adverse impact on mortgage

modification efforts.

In light of these differences between CES and HELOCs, it is instructive to

examine second lien holdings by commercial banks. Table 1 shows these holdings

for the four largest banks in the U.S. For three of the four banks (Bank of America,

Wells Fargo, and JPMorgan Chase), the total value of second liensCES and

HELOCsexceeds the value of tangible common equity, and by a substantial

amount for Wells Fargo. But the second liens at highest risk of defaultCES

represent a relatively small fraction (no more than 18 percent) of overall second

lien holdings by these banks. The bank with largest exposure to CES is Walls Fargo,

for whom holdings of these liens represents about 24 percent of tangible common

equity.

These observations suggest that the risks posed by second liens may be

primarily associated with CES, which represent a relatively small proportion of all

second liens. This is not to say, however, that CES are not worthy of policy concern.

To the contrary, they may create obstacles to modification for hundreds of billions

of dollars of first mortgages. Recent data suggest that outstanding CES balances total

7By comparison, about 40 percent of credit card borrowers and 70 percent of auto loanborrowers will continue making payments a year after defaulting on their first mortgage.


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held in the servicers portfolio or is securitized.In addition these data have

comprehensive information on loan renegotiation actions performed by the

servicers.

The authors compare two cases: those in which the first and second

mortgages are portfolio loans held by a single bank, and those in which the first is

securitized and the second is a portfolio loan held by the same bank that services

the first mortgage. They find that securitized first liens with seconds are less likely

to be liquidated or modified than portfolio first liens with seconds. Put differently,

when ownership of the first and second liens is fragmented, the first lien tends to sit

in limbo: it is neither modified nor foreclosed upon- a situation that persists even

when the liens are serviced by the same bank.

Overall, the evidence provided by Agarwal, et al. (2011a) is consistent with

presence of both coordination problems and conflicts of interests between the

owners of first and second liens. It is also in line with prior research providing

evidence that securitization affects servicing and renegotiation of first lien

mortgages (see Piskorski et al (2010), Agarwal et al (2011b), and Zhang (2011)).

3. A Policy ProposalThe hold-up power of second liens is no surprise, and was likely anticipated

by first mortgage investors when they invested in the first mortgages. But the

primary concern of first mortgage investors appears to have been the possibility

that first mortgage servicersusually the originating bankswould modify the first

mortgages in ways that benefit second liens on the same properties (Frey, 2011).

First mortgage servicers might do that because they often carry the second liens on

their balance sheets and therefore face a conflict of interest in servicing the first

mortgage. But this response to potential conflicts of interest has two key defects,

which have loomed large in the financial crisis: when modifications are in the best

interests of first lien lenders, the PSAs (i) create severe roadblocks to modification


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(see Mayer, et al. 2009) and (ii) do nothing to remedy the hold-up power of second

lien lenders.

To be sure, its unclear how PSAs and first mortgages could have been

drafted to remedy the hold-up power of second lien lenders. First mortgages could

have included provision prohibiting homeowners from taking on second liens

without the consent of the first lien investors or the servicing agent (so-called

negative pledge clauses) and imposing penalties when homeowners violate the

prohibition (such as fees or higher interest rates). First mortgages might also have

included provisions stating that, in the event that a homeowner receives consent to

take on a second mortgage, the second mortgage lender must enter an inter-creditor

agreement that minimizes the risk of hold-up in the event that the homeownersuffers distress. These kinds of inter-creditor agreements are commonly observed in

corporate lending. Indeed, the term silent second lien has a radically different

meaning in the corporate lending sector: instead of describing a lurking lien that

first lien lenders are unaware of (as it does in residential lending), it describes a lien

subject to an inter-creditor agreement that requires second lien lenders to give their

automatic consent (and remain silent) to negotiations between the borrower and

first lien lenders.

But these contractual solutions to the hold-up problem are costly to deploy,

particularly because they require close monitoring of the debtors balance sheet. If

first mortgage lenders do not monitor homeowners, lenders might only discover the

existence of second mortgages after the homeowner is distressed (or in

bankruptcy). At that point, there is little gain to imposing fees or other penalties,

which will only deepen the homeowners distress and make mortgage modification

even more difficult. But the cost of monitoring likely outweighs the benefit in most

cases: The value of a first mortgage is typically too small to justify the careful

monitoring that is necessary.


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We are describing a complex contracting problem. It could be hard for

homeowners to credibly commit themselves not to take on second mortgages, and

first mortgage lenders may be unable to monitor homeowners in a cost-effective

way. Put differently, it appears that private contractual solutions may not prevent

ex-post hold-up by second lien lenders in a cost-effective way.

We believe this justifies a regulatory response to the hold-up problem, at

least during housing crises. When housing prices suddenly experience large

declines, the hold-up problem creates an important externality: because it prevents

efficient modifications, it contributes to widespread foreclosures, damages

communities, and prolongs the crisis.

We propose the following solution to the hold-up problem: Federal (or state)

law should require that every second mortgage include a provision that

automatically eliminates the second lien, thereby converting the second mortgage

into unsecured debt, upon the occurrence of two conditions: (i) the first mortgage

lender (or servicer acting on behalf of investors) agrees to reduce the principal

balance of the first lien and (ii) the appraised value of the home indicates that it is

worth less than the first lien (i.e., LTV>100). This solution would permit automatic

stripdown of second liens when those liens are worthless in foreclosure

(requirement ii) and threaten to hold-up efficient modifications that have been

proposed by the first lien lender (requirement i). Because second liens can be

stripped down only when the first lien lenders agree to modify their own liens, our

proposal deters first lien lenders from using our policy strategically to divert value

from second lien lenders. If second lien lenders nonetheless believe that their liens

were stripped down unnecessarily, they would have the right to bring suit against

first lien lenders. The suit, however, could only ask a court either to (i) assess

whether the first lien exceeded the appraised value of the home at the time the

second lien was stripped down or (ii) verify that first lien lenders modified their

own liens.


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The primary virtue of this solution is that it facilitates principal reductions

without requiring a bankruptcy filing. Under current law, summarized by Levitin

(2009), a homeowner can generally strip down a second lien in bankruptcy,

provided the home value is less than the first lien (LTV>100). But a bankruptcy

filing is very costly to the homeowner and creditors: it damages the homeowners

credit score, forces the homeowner to submit to a multi-year plan of repayment that

is sufficiently onerous that nearly two-thirds of homeowners are unable to complete

the plan, and discharges unsecured claims, including stripped down second liens.

Moreover, bankruptcy is an overly aggressive solution to the hold-up problem.

Many homeowners default on their mortgages simply because their homes are

worth far less than the combined mortgage balance. The homeowners have

sufficient liquidity to pay the mortgage balances, but conclude that it makes no

sense to continue paying a debt that far exceeds the value of the home it secures.

These homeowners dont need bankruptcy, which potentially readjusts all of their

debts. They need a simpler solution that adjusts only their mortgage debts.

Although our solution strips down second mortgages, it does not delete the

underlying debts. Homeowners will remain liable for the entire remaining balance

of the second mortgage. That balance, however, will become an unsecured debt,

much like a credit card balance. If that balance is too large for a homeowner to pay,

she will still have the option to file for bankruptcy to discharge the debt. If she does

that, the outcome will be the same as if our proposed solution did not exist: the

second mortgage debt will be discharged. What our proposed solution permits,

however, is the possibility that the homeowner can modify her first mortgage, pay

her unsecured debts (including the second lien) in full, and keep her homeall

without incurring the costs of a bankruptcy filing.

This solution shares much in common with the bail-in proposal for

systemically important institutions (Duffie 2009) and Adlers longstanding

chameleon equity proposal for corporations(Adler 1997). Under each of these


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proposals, senior claims convert to junior claims when the institution suffers

distress, thereby achieving a restructuring without a costly bankruptcy or other

resolution process.

We do not believe our proposal presents meaningful constitutional

questions. Assuming it was implemented via federal legislation, our proposal would

invoke Congresss power to regulate commerce (here, mortgage markets) and

would not violate the Takings Clause because it would apply prospectively to

mortgages originated in the future. If a state were to implement our policy, we do

not believe it run afoul of the Constitution. There is precedent for states taking

aggressive steps to limit the kinds of mortgages supplied to their residents. Until

1997, for example, Texas prohibited homeowners from taking on home equity loansunless the loans were to finance home improvements or tax payments. Since then,

certain kinds of home equity loans have been permitted, but only if they do not

increase CCLTV above 80 (see Forrester 2002).

One potential weakness of our proposal is that it depends heavily on the

discretion of the first mortgage servicer, which must decide whether to invoke the

procedure for writing-down second liens. If the first mortgages are securitized and

the servicer owns second liens associated with those first mortgages, the servicer

will labor under precisely the same conflict of interest that has long concerned first

mortgage investors. A solution to this problempreviously proposed by Frey

(2011)is to prohibit servicers from owning second liens while servicing

associated first liens for others. That solution, however, can be implemented by

contract. We therefore do not propose regulation to implement it.

Our proposal would undoubtedly affect the price of credit. Second lien debt

will almost surely become more expensive because our proposal limits recoveries in

the event that home values decline substantially. The price of first mortgage debt

could decline because our proposal eliminates ex post holdup problems.


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4. Alternative ProposalsAn alternative policy, favored by scholars such as Levitin (1999), is to revise

consumer bankruptcy law (especially Chapter 13) to permit homeowners to

reduce (cramdown) the principal balance of their residential mortgages to equalthe current values of their homes. Current bankruptcy law forbids cramdown with

respect to first mortgages and above-water second liens: if a homeowner wants to

retain a primary residence, the homeowner must pay the existing principal balance,

or any lower balance to which the lender agrees during a consensual modification.

Proposed reforms would change this: An underwater homeowner could enter

bankruptcy and, by invoking cramdown, exit with a mortgage balance that is no

greater than the homes value.

This proposalto permit cramdown in bankruptcycould alleviate the

hold-up problem created by second liens. Current law does permit cramdown with

respect to underwater second liens: If the value of the home is less than the first

mortgage, an underwater second mortgage can be converted into unsecured debt,

which can then be discharged by the bankruptcy process. Thus, current bankruptcy

law gives homeowners and first mortgage lenders power to overcome second lien

hold-up. But this power can be invoked only if the homeowner files for bankruptcy.Not only is bankruptcy itself a costly process, but the benefit from filing is limited

because homeowners cannot restructure first mortgage debt in bankruptcy. If the

bankruptcy code were revised to permit cramdown of first mortgages, homeowners

would have leverage to restructure all mortgage debts and would likely be more

willing to use the bankruptcy process to address hold-up problems created by

second liens.

In our view, proposals to revise the bankruptcy code are unwise because

cramdown is an overly aggressive remedy for a problem that is amenable to tailored

solutions, such as the one we propose.


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It is said that homeowners need to be given leverage or a stick in

negotiations with mortgage servicers and that cramdown is the appropriate stick.

We agree that a stick may be necessary when mortgage modification requires

negotiation with multiple lenders, some of whom may hold-up modification efforts.

Our proposal creates such a stick by automatically writing down underwater second

liens when the associated first lien is being modified. Unlike bankruptcy cramdown,

our proposal does not require a borrower to bear the monetary and reputational

costs of filing for bankruptcy, does not lead to a potentially unnecessary

restructuring of other debts (such as credit cards and auto loans), and does not

expose first lien lenders to the possibility that a bankruptcy judge will mandate

overly aggressive modification. We say that a modification is overly aggressive if it

extends greater concessions to the borrower than a modification that the borrower

and lender would have privately negotiated on their own, in the absence of frictions

such as hold-up problems and conflicts of interest. Our proposal fosters private

negotiation by reducing these frictions. Bankruptcy cramdown gives homeowners

the option to bypass private negotiation and seek more aggressive modification in

bankruptcy court.

There are several reasons why judicially-administered cramdowns could be

overly aggressive. Perhaps the most important is judicial error. Judges may

undervalue homes: The lower the assessed home value, the greater the cramdown

of the first lien. Judges might also select an inappropriately low interest rate for

future payments by the debtor: If the debtors risk of default is high, but the interest

rate fails to account for this, the expected value of future payments to the lender will

be less than the judicially determined (and potentially erroneous) value of the

home.9The risk of judicial error is non-trivial because bankruptcy judges have

9A number of courts have selected an interest rate equal to the prime rate plus a riskpremium equal to one to three percent, as noted by the Supreme Court in Till v. SCS CreditCorp., 541 U.S. 465, 480 (2004). This formula likely produces an interest rate that isinappropriately low when the risk of default is high. Currently, for example, the prime rate


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extremely large caseloads during non-crisis periods and would have even larger

caseloads during a crisis period if cramdown were permitted.10Likewise, it is not

clear that bankruptcy judges are generally sufficiently knowledgeable to choose the

right course of action, particularly during a crisis. Lack expertise could result in less

effective modifications, potentially increasing the risk of re-default and subsequent

foreclosure. Moreover, while the number of bankruptcy judges could be increased

during crises, it is unlikely that Congress can act sufficiently quickly to do this. This

delay could prolong a housing crisis and exacerbate associated losses.

We are assuming that judicial error is harmful to lenders. It might be thought

that, if judges are unbiased, their errors are equally likely to benefit and harm

lenders. That is likely untrue. First, when faced with uncertainty, judges may preferto err in favor of households, resulting in overly aggressive modifications. Second, it

is unclear whether judicial error would ever benefit lenders. If judicial error yields

insufficientlyaggressive modification, the lender has incentive to make it more

aggressive in order to avoid re-default or foreclosure. If the error results in overly

aggressive modification, the lender is harmed. An overly aggressive modification

could reduce lender liens by too much, but it could also offer benefits to

homeowners who not be offered them in private negotiation. Either way, lenders

are harmed by cramdown relative to the privately negotiated outcomes. Finally,

even assuming errors could benefit lenders, these errors tend to increase the overall

risk of mortgage financing by increasing uncertainty regarding future cash flows.

Because bankruptcy cramdown likely reduces lender recoveriesand

increases uncertainty regarding future cash flowsrelative to privately negotiated

is 3.25%. Yields on high-yield corporate bonds are about 7.68%, more than four percentagepoints higher than the prime rate. Data are taken from Bloomberg.com.10During the 12-month period ending June 30, 2008, for example, there were 368bankruptcy judges and 967,831 bankruptcy filings, implying a caseload of 2,630 bankruptcyfilings per judge (Mayer 2009). That caseload will rise substantially if cramdown ispermitted, and will rise dramatically during a crisis if homeowners view cramdown as aprincipal avenue for achieving mortgage modification.


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modifications, it will likely affect the price of credit. The magnitude of this effect is

unclear, but studies such as Pence (2006) show that the supply of credit is adversely

affected by laws that reduce creditor recoveries. A cramdown-induced increase in

the price of credit will likely harm borrowers and reduce overall welfare.

For these reasons, we believe that bankruptcy cramdown is an overly blunt

tool for dealing with problems arising from second liens. Our proposal is more

tailored and avoids imposing unnecessary costs of first mortgage lenders. Indeed,

our proposal can be seen as simply taking rules that currently apply in bankruptcy

(permitting cramdown of wholly underwater second liens) and applying them to

second liens generally, facilitating private negotiation between borrowers and their

first mortgage lenders.

5. ConclusionThe results in this paper suggest that the second lien problem, while quite large,

may not serve as a major impediment for a recovering housing market. Most

outstanding second liens are HELOCs, which were given to higher credit quality

borrowers who are current on their first and second liens. Of the lower quality

closed end second liens, more than 40 percent are already burned off. Theremaining CES balances are large, but would likely not threaten the capital position

of a major bank without large increases in HELOC losses as well. Furthermore, the

potential problems with conflicts of interest for second lien holders being more

willing to modify securitized first liens to preserve second lien recoveries that are

on their own balance sheet have been mitigated by new FDIC rules that require the

second lien holder to write off their second lien balance when the first lien becomes

delinquent.

However, existing evidence suggests that problems with second liens

nonetheless have contributed to the slow housing recovery and excessive

foreclosures. Coordination problems may have led to some additional foreclosures


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as lenders were unable to pursue principal modifications on the first lien, even if

such modifications were relatively rare in the crisis. As well, the ability to hold up

the process and collect additional payments might have encouraged second lien

holders to provide cheaper credit to borrowers, exacerbating excessive homeowner

leverage in the period leading up to the crisis.

Our proposal provides a road map to a new solution to help prevent second lien

hold-up problems from interfering with modifications in the future. We believe that

this proposal would provide a simple contractual solution to the second lien

problem, reducing the current situation that encourages lenders to provide second

liens over unsecured credit or larger first liens. Of course, homeowners might also

be worse off taking out second liens relative to a larger first lien or unsecured creditin a downturn, but consumers may not be as well as equipped as lenders to choose

credit fully anticipating future potential problems. Thus our contractual solution

allows first lien holders to more easily convert second liens to unsecured credit

when they want to undertake a principal modification without the need to enter

bankruptcy.

Finally, we believe that future contractual solutions would be justified to try to

prevent other frictions that have exacerbated the impact of the crisis on

homeowners, servicers, and investors. For example, mortgages might contain

provisions that allow for automatic modification if home prices fall below some level

or household incomes fall (Piskorski and Tchistyi, 2010). Borrowers might be

allowed to use an underwater mortgage finance the purchase of a new home in a

different market (where unemployment might be lower) if that homeowner

purchased a new home for at least as much money as their current home was

wortha so called portable mortgage. Automatic refinancing when interest rates

fall would also help homeowners by encouraging refinancing without large

origination costs. The crisis has exposed many appreciable frictions in the mortgage

market that made it more difficult for the economy to recover and surely harmed


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homeowners and investors. We have an opportunity to develop new structures in

the future to address these issues.


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Mayer, Christopher, Edward Morrison, Tomasz Piskorski, and Arpit Gupta, 2011,Mortgage Modification and Strategic Behavior: Evidence from a Legal Settlementwith Countrywide, Working paper.

Pence, Karen, 2006, Foreclosing on Opportunity: State Laws and Mortgage Credit,

Review of Economics and Statistics88, 177-82.

Piskorski, Tomasz, and Alexei Tchistyi, 2010,"Optimal Mortgage Design." Review ofFinancial Studies23, 3098-3140.

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1

Table 1:

CES and Revolving Second Liens by 4 Largest American Banks

(in billions of dollars)

Originator Closed End2ndLiens

Residential RevolvingLines of Credit

Share of TotalRevolving

Total Revolvingand 2ndLiens

Tangible CommonEquity Capital

Bank of America $25.9 $116.9 17.7% $142.8 $120.4

Wells Fargo $18.3 $105.5 16.0% $123.8 $75.6

JPMorgan Chase $11.3 $100.7 15.3% $112.0 $110.7

Citigroup $24.2 $30.8 4.7% $55.0 $121.0

Total Top 4 $79.7 $353.9 53.7% $433.7 $427.8

Notes:Individual bank data from Q2 2010 Federal Reserve data. Total 1-4-family servicing from InsideMortgage Finance. Total Residential Revolving Lines of Credit refers to revolving lines of credit heldat FDIC-insured institutions. It is not the total universe. Total Revolving Second and Second Liens

Total/by Investor is from Federal Reserve Flow of Funds data (Z1).

Documents

After the Housing Crisis - Second Liens and Contractual Inefficiencies