Law Review: Agarwal, et al.- Second Liens and the Holdup Problem in First Mortgage Renegotiation

Abstract: Loss mitigation actions (e.g., liquidation, renegotiation) of delinquent mortgages might be hampered by conflicting goals of lenders at different seniority. In particular, a servicer has less incentive to take certain actions to reduce losses of investor-owned first lien mortgages if the servicer happens to own the second lien claim secured by the same property. Rather, the servicer has an incentive to hold up loss mitigation as it seeks to preserve the values of its own, junior, claim. The Study shows that a sizable fraction of delinquent mortgages with multiple liens are indeed characterized by the servicer holding a direct financial interest in the junior liens, but not the first-lien mortgage. The Study further shows that such cases are less likely to be liquidated or modified, and are instead more likely to not receive any loss mitigation actions from their servicers. Supporting the idea that second lien lenders pursue more profitable modifications, The Study finds that modification terms are less concessionary and redefault rate is lower. These results highlight a specific incentive-driven channel by which separation of mortgage ownership and servicing may present an impediment to loss mitigation of delinquent mortgages. Summary: This study from researchers at the Federal Reserve finds that several factors encourage 2nd mortgage lien holders to “hold up” loan modification unless they can recover some price about the true value of the 2nd lien. This factors include: (1) That foreclosures frequently generate no proceed above what is owed on the 1st mortgage, 2nd lienholders have little incentive to proceed themselves; (2) 2nd lienholders have no obligation to comply with short sales or other voluntary liquidations; (3) 1st lienholders fear that modification could alter lien priority; and (4) 2nd lienholder’s hope that non-performing mortgages may improve in the future. Based on this, the study finds that 2nd lien-holder often prevent loan modification and other voluntary resolutions of mortgage issues. This analysis was controlled for the already known difficulties that securitization presents for voluntary loan modification.

Party Status	2nd Lien Hold-Up	Securitization Hold-Up
Owns & Services 1st & 2nd Liens	No	No
Owns 2nd Lien Services 1st & 2nd Liens	Yes	Yes
Services 1st Lien Only No 2nd Lien	N/A	Yes

This study shows that when there is a 2nd mortgage, the likelihood of a mortgage modification is substantially lower. This is compounded when the servicer of the 1st mortgage does not own that mortgage, but also services and owns the second mortgage. This would seem to present a clear conflict of interest and potential breach of fiduciary duty to the actual holder of the 1st mortgage. Commentary: This study does not mention that 2nd mortgages can often be eliminated in a Chapter 13 bankruptcy through a “strip-off” of that mortgage. This elimination should increase the likelihood that 1st mortgages would subsequently agree to a mortgage modification, as the 2nd mortgage “hold up” has been removed. This is part of the basis for the Principal Paydown Plan supported by NACBA: http://www.americanbanker.com/issues/176_246/fhfa-fannie-freddie-bankruptcy-1045074-1.html For a copy of the study, please see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2022501