After the Housing Crisis: Second Liens and Contractual Inefficiencies Chris Mayer, Ed Morrison, and Tomek Piskorski

Columbia University May 2012 1. Introduction Second 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).1 In 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

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

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 the mortgage 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
To keep this example simple we abstract from possible incentive issues and asymmetric information between borrower and lender (or servicer), such as the likelihood that a program modifying mortgages may encourage some borrowers to default who would not otherwise do so. See Mayer et al. (2011) for discussion of these issues.
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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.

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

Treasury Department, March 2012 Making Home Affordable Report.

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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.

closed-end second liens (CES).4 As 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.6 Nonetheless, 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
Based on Equifax Credit Trends (March, 2012). Additionally, to the extent that second liens are being carried at inflated values on bank balance 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-juniorhome-loans-as-bad-assets.html). Further write-downs by other banks, such as Bank of America, are expected soon. 6 One striking fact: According to a recent Zillow report, While a third of homeowners with mortgages is underwater, 90 percent of underwater homeowners are current on their mortgage and continue to make payments. (http://www.zillow.com/blog/research/2012/05/24/despite-home-value-gainsunderwater-homeowners-owe-1-2-trillion-more-than-homes-worth/)
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4 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.

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. Evidence 2.1 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
5 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.

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.7 These 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

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

$148 billion. When we look at non-agency securitized first mortgages that have an associated CES,8 we observe that the average LTV of the first mortgage is close to 80 percent and that the CES increases CCLTV by about 18 percentage points. This suggests that the ratio of first mortgage debt to second mortgage debt is about 4:1 (80/18 is approximately equal to 4). Assuming this ratio describes the ratio of first to second lien debt among all homeowners with CES debt, we estimate that the $148 billion of outstanding CES debt is associated with over $600 billon of first lien mortgages. This is a sizeable amount of first lien debt subject to the potential holdup and conflicts of interest problems arising from second liens. We should also note that problems arising from second liens will continue to evolve. Some recent evidence suggests that some HELOCs may be deteriorating in quality (Lee, et al. 2012). If so, the problems posed by second liens will increase. On the other hand, the FDIC is now inducing commercial banks to apply more realistic valuations to second liens held on-balance sheet (about 90 percent of all second liens). If the first mortgage is delinquent, banks are expected to write-down the value of the associated second. This change in accounting might reduce the threat of hold-up going forward. Banks may be less opposed to modifications that write down the face value of second liens held on-balance sheet because FDIC policy is already forcing those write-downs. 2.2 Evidence of coordination and conflicts of interest related to second liens Emerging evidence suggests that second liens do generate coordination and conflicts of interest that inhibit modification efforts. In a recent work, Agarwal, et al. (2011a) examine properties subject to first and second liens. They use unique dataset from the OCC/OTS that matches the first and second liens on exact property address. This data allow them to separately identify whether the same or different servicer is servicing the first and second liens, and whether the first lien is being

Based on Black Box-Equifax data.

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.

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 Proposal The 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
8 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.

(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 homeowner suffers 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.

9 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.

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 strip down 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.
0are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board. 1

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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
1are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board. 1

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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 loans unless 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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2are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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4. Alternative Proposals An 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 equal the 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.

3are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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

A number of courts have selected an interest rate equal to the prime rate plus a risk premium equal to one to three percent, as noted by the Supreme Court in Till v. SCS Credit Corp., 541 U.S. 465, 480 (2004). This formula likely produces an interest rate that is inappropriately low when the risk of default is high. Currently, for example, the prime rate
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4are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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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.10 Likewise, 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 prefer to 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 insufficiently aggressive 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 percentage points higher than the prime rate. Data are taken from Bloomberg.com. 10 During the 12-month period ending June 30, 2008, for example, there were 368 bankruptcy judges and 967,831 bankruptcy filings, implying a caseload of 2,630 bankruptcy filings per judge (Mayer 2009). That caseload will rise substantially if cramdown is permitted, and will rise dramatically during a crisis if homeowners view cramdown as a principal avenue for achieving mortgage modification.
5are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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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. Conclusion The 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. The remaining 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
6are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board. 1

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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 credit in 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
7are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board. 1

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homeowners and investors. We have an opportunity to develop new structures in the future to address these issues.

8are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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References: Adler, Barry, 1997, A Theory of Corporate Insolvency, New York University Law Review 72, 343-. Agarwal, Sumit, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, Yan Zhang, 2011a, Second Liens and the Holdup Problem in First Mortgage Renegotiation, working paper Agarwal, Sumit, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, Douglas Evanoff, 2011b, The Role of Securitization in Mortgage Renegotiation, Journal of Financial Economics, forthcoming. Bolton Patrick, and Howard Rosenthal, 2002, Political Intervention in Debt Contracts, Journal of Political Economy, 110, 1103-1134. Donghoon Lee, Donghoon, Christopher Mayer, Joseph Tracy, 2012, A New Look at Second Liens, forthcoming in the Housing and the Financial Crisis, Edward Glaeser and Todd Sinai, editors, NBER and University of Chicago Press. Duffie, Darrell, 2009, A Contractual Approach to Restructuring Financial Institutions, in Ending Government Bailouts As We Know Them, Kenneth E. Scott, George P. Shultz, and John B. Taylor, editors, Hoover Institution Press. Forrester, Julia Patterson, 2002, Home Equity Loans in Texas: Maintaining the Texas Tradition of Homestead Protection, Southern Methodist Law Review 55, 157-178. Frey, William, 2011, Way Too Big to Fail, Isaac M. Gradman (Editor). Amherst Mortgage Insight, 2010, Second Liens: How Important? Research Report, Amherst Securities Group LP, January 29. Levitin, Adam, 2009, Resolving the Foreclosure Crisis: Modification of Mortgages in Bankruptcy, Wisconsin Law Review 2009, 565-655. Mayer, Christopher, 2009, Testimony Before the House Committee on the Judiciary regarding H.R. 200, The Helping Families Save Their Homes In Bankruptcy Act Of 2009, And H.R. 225, The Emergency Homeownership And Equity Protection Act. Mayer, Christopher, Edward Morrison, and Tomasz Piskorski, 2009, A New Proposal for Loan Modifications, Yale Journal on Regulation 26, 417-429.

9are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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Mayer, Christopher, Edward Morrison, Tomasz Piskorski, and Arpit Gupta, 2011, Mortgage Modification and Strategic Behavior: Evidence from a Legal Settlement with Countrywide, Working paper. Pence, Karen, 2006, Foreclosing on Opportunity: State Laws and Mortgage Credit, Review of Economics and Statistics 88, 177-82. Piskorski, Tomasz, and Alexei Tchistyi, 2010,"Optimal Mortgage Design." Review of Financial Studies 23, 3098-3140. Piskorski, Tomasz, Amit Seru, and Vikrant Vig, 2010, Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis, Journal of Financial Economics 97(3), 369-397. Piskorski, Tomasz, and Alexei Tchistyi, 2011, Stochastic House Appreciation and Optimal Mortgage Lending, Review of Financial Studies 24, 1407-1446. Zhang, Yan, 2011, Does Loan Renegotiation Differ by Loan Status? An Empirical Study, OCC Working Paper.

0are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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Table 1: CES and Revolving Second Liens by 4 Largest American Banks (in billions of dollars)
Originator Bank of America Wells Fargo JPMorgan Chase Citigroup Total Top 4 Closed End 2nd Liens $25.9 $18.3 $11.3 $24.2 $79.7 Residential Revolving Lines of Credit $116.9 $105.5 $100.7 $30.8 $353.9 Share of Total Revolving 17.7% 16.0% 15.3% 4.7% 53.7% Total Revolving and 2nd Liens $142.8 $123.8 $112.0 $55.0 $433.7 Tangible Common Equity Capital $120.4 $75.6 $110.7 $121.0 $427.8

Notes:

Individual bank data from Q2 2010 Federal Reserve data. Total 1-4-family servicing from Inside Mortgage Finance. Total Residential Revolving Lines of Credit refers to revolving lines of credit held at 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).

1are those of the author(s) and do not necessarily The research and conclusions expressed in this paper reflect the views of Pew, its management or its Board.

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