Mortgage Mayhem: Second Liens Become Sticking Point

NEW YORK (TheStreet) -- As banks are getting down in the trenches to help borrowers take mortgage debt down a notch, second liens are increasingly becoming a first priority.

Banks have begun to make long-awaited progress in resolving distressed primary mortgages -- even if it requires a principal cut, a short sale or an outright foreclosure. But non-primary loans have hindered progress as the industry continues to work through hundreds of billions of dollars' worth of first-mortgages that have fallen behind.

A healthy portion of the $10.7 trillion in outstanding U.S. mortgage debt is made up of non-primary loans. There are no federal data to indicate the breakdown of primary vs. junior mortgages. But using the four largest mortgage servicers as a proxy, 61% of their outstanding residential debt is tied up in non-primary loans.

There are home-equity lines of credit that were extended when home values soared past the initial purchase price. There are also so-called "piggyback" mortgages - secondary, tertiary and even quaternary loans - that lenders extended to those who wanted to buy during the boom but lacked cash for down payments.

Banks had been kicking the can down the road for second liens, trying to make headway on first liens first. But the issue is now front and center for a simple reason: If a borrower can't afford to pay the first mortgage, there's no reason to think he will be able to pay other types of home-loan debt any better.

"The second-lien holders are going to be taking massive losses," says Greg Hebner, who provides loss-mitigation services for large mortgage companies as president of MOS Group.

(To hear more from Hebner on why it's taken so long to address the second-lien issue, click the audio button below.)

Hebner explains that second-lien holders have little recourse for handling troubled borrowers other than taking "big haircuts" on principal. Even though some second-lien holders can pursue foreclosure, they won't get any money until the first mortgage is made whole. Home-equity lenders have even less recourse, since the debt is comparable to a credit-card line: Secured only by notional home values that have wasted away.

"All you can kinda do is look at those people and say, 'Boy, it sucks to be you right now,'" says Hebner, referring to holders of second-lien debt. "These folks are really in a bad way because very few of them have any equity."

The economics of a foreclosure -- or last-ditch tactics like short sales and deed-in-lieu transactions -- make less sense for a lender or investor, the further one moves down the pecking order of subordination.

For instance, a borrower may have a $200,000 first mortgage and a $20,000 second mortgage on a home now valued at $250,000. After legal fees and the cost of processing a foreclosure or "foreclosure alternative," there's little chance that even the first lender will be made whole.

As a result, lenders and investors have been holding onto non-primary debt, hoping an eventual pickup in the economy will boost home values enough to bring some of that equity back. The loans have remained in relatively good shape for the time being, due to the extended low interest-rate environment.

"I know it's a shocking number ... but something like half of all ... the cases where the first is in default, the home equity's still paying," JPMorgan Chase (JPM) CEO Jamie Dimon told investors in mid-July.

But Hebner points out a Catch 22: When the economy finally starts to pick up, sending home values higher, interest rates will follow.

"What's the borrower going to do when their Libor index sets in, or some second that they have tied to a T-bill or a federal yield goes from 2 or 3% to 5 or 6%?" he says, concluding that, "As a second-lien holder, I may be lucky to get any money back at all."

(To hear Hebner discuss the economics of foreclosure for second-lien holders, click the audio button below.)