Bank of America Corp., Wells Fargo & Co. and three other banks that settled a nationwide probe of foreclosure practices this month will get a bonus from the deal: protection for $308 billion of home-equity loans they hold.
The banks that service about half the nation’s mortgages on behalf of investors will be able to share losses on their junior loans with bondholders and get credit toward the cash they pledged to spend in the settlement, said an Obama administration official involved in drafting the $25 billion agreement. Second liens would typically be wiped out before senior-mortgage investors take a loss, said Laurie Goodman, managing director at Amherst Securities Group LP in New York.
It’s “a gift to the banks, at investors’ expense,” said Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame. “A proportionate write-down of the first and second represents a reversal of normal lien priority.”
Loss-sharing will break the logjam that occurs when banks drag their feet processing modifications on mortgages that outrank their junior liens, said the Obama official, who declined to be identified because this arrangement hasn’t been made public. Government foreclosure-prevention programs have resulted in less than 1 million modifications, a quarter of the goal the administration set three years ago. Home-equity mortgages have been a reason for that, said Arthur Wilmarth, a professor at George Washington University Law School in Washington.
Roadblock to Modifications
“The roadblock to getting comprehensive modifications has been the efforts of these banks, the biggest servicers, to protect their second liens,” Wilmarth said. “To only suffer losses on an equal basis as first-lien investors is a good outcome for them.”
The servicer agreement resolved state and federal probes into foreclosure abuses including robo-signing, the fraudulent endorsement of court documents. The banks have pledged $20 billion in various forms of mortgage relief, including principal reductions, plus payments of $5 billion to state and federal governments.
The settlement has been criticized by money managers including Scott Simon at Pacific Investment Management Co., who said investors who bought mortgage-backed securities will suffer losses as banks earn credits for easing loan terms.
“This was a relatively cheap resolution for the banks,” Simon, the mortgage head at Pimco, which runs the world’s largest bond fund, said after the settlement’s Feb. 9 announcement. “A lot of the principal reductions would have happened on their loans anyway, and they’re using other people’s money to pay for a ton of this. Pension funds, 401(k)s and mutual funds are going to pick up a lot of the load.”
While a summary of the settlement has been released, the details haven’t been made public. The document may be issued as soon as this week, according to the Obama official. The credits banks will get for writing down home equity loans won’t be as much as they will get for reducing the balance on primary mortgages, the official said.
The servicers involved in the agreement are Bank of America, Wells Fargo, JPMorgan Chase & Co., Citigroup Inc. and Ally Financial Inc.
Bank of America had $102.9 billion of home equity mortgages in the third quarter, surpassing its $86.3 billion market capitalization, according to the Federal Deposit Insurance Corp. Wells Fargo had $95 billion, JPMorgan had $79.7 billion, Citigroup was $27.8 billion, and Ally, the bank that sparked the state and federal investigation into foreclosure practices, had $2.2 billion.
Tom Kelly, a spokesman for New York-based JPMorgan, Rick Simon of Bank of America, Tom Goyda of Wells Fargo, Gina Proia of Ally, and Sean Kevelighan for Citigroup declined to comment.
Since Feb. 9, Charlotte, North Carolina-based Bank of America has declined 1.7 percent, Citigroup in New York fell 2.2 percent, San Francisco-based Wells Fargo gained 1.5 percent,and JPMorgan advanced 3.2 percent. Ally was bailed out by the government in 2008 and is pursuing an initial public offering to repay taxpayers who own the Detroit-based lender.
About 92 percent of home equity loans are held on the balance sheets of U.S. banks, according to data compiled by Amherst. The five banks in the mortgage settlement own 42 percent of the second liens. That makes it “very likely” a servicer of a primary mortgage will hold a property’s junior loan, Goodman said in a report this month.
“A conflict arises because the servicer has a financial incentive to service the first lien to the benefit of the second-lien holder, which may oppose the financial interest of the investor,” she wrote.
Nearly 11 million home loans in the U.S. were underwater in the third quarter, according to CoreLogic Inc. in Santa Ana, California. About 4.4 million of them had home equity mortgages, with an aggregated value of $180 billion. That represents 20 percent of the $888 billion of outstanding second-lien loans, according to Federal Reserve data.
Home equity lines of credit, or Helocs, were used during the 2001 to 2006 housing boom as a way for owners to cash in on rising real estate values for money to spend on cars, vacations and property renovations. In addition, some homeowners refinanced their primary mortgages into bigger loans to extract equity from their properties.
“Homeowners everywhere felt richer and rushed to ‘monetize’ the increased value of their homes,” Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., said in his Feb. 25 annual letter to investors. “These massive cash infusions fueled a consumption binge throughout our economy. It all seemed great fun while it lasted.”
Homeowners who took out Helocs were given checks and a debit card to make the loans easy to tap. Primary-mortgage holders couldn’t stop, and rarely knew about, homeowners who took out home equity loans on their collateral.
“People turned their homes into cash registers,” said Keith Gumbinger, vice president of HSH Associates, a mortgage data firm in Pompton Plains, New Jersey. “They used their Helocs like pre-paid credit cards.”
Home-equity loans were also used as so-called piggyback mortgages that took the place of down payments. By 2006, when U.S. home prices peaked, most banks were willing to give “no-equity equity loans,” lending up to 100 percent of a property’s value, said Peter Ticktin, a Florida foreclosure attorney. Some banks advertised loans that exceeded home values by 25 percent.
“Now those home equity loans are so far underwater, they can’t see the surface,” said Ticktin, who negotiates with banks on mortgages in default. “The banks have been adamant about protecting their second-lien interests, no matter how underwater they are.”
Treating a senior and junior lien on an equal basis will result in higher rates for primary mortgages as investors add a risk premium to compensate for the danger of higher losses, said Amherst Securities’ Goodman.
“It will ultimately result in more expensive first lien mortgages, as investor realize they will be less well protected than their lien priority would indicate,” said Goodman.