House Financial Services Chairman Barney Frank (D-MA) sent a letter to the four biggest banks asking them to write down second-lien mortgages to assist the modification effort and prevent foreclosures. These second liens have posed a big challenge to the modification push. Underwater borrowers probably can't pay their second mortgage if they can't pay their first. But for obvious reasons, banks aren't thrilled with admitting that these second liens are worthless: it will cost them billions of dollars. Should they listen?

The Financial Services Committee confirmed that the letter was sent. They're forawrding me a copy, but for now, you can find it in full on Zero Hedge. It's addressed to Bank of America, Citigroup, JP Morgan Chase and Wells Fargo. Here's the central point:

Large numbers of these second liens have no real economic value - the first liens are well underwater, and the prospect for any real return on the seconds is negligible. Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans, which would allow willing first lien holders to reduce principal and keep borrowers in their homes.


The four organizations you lead are major participants in the second-lien market. Failure to modify these debts has become a major and unnecessary obstacle to thousands of Americans being able to stay in their homes. I urge you in the strongest possible terms to take immediate steps to write down these second mortgages and allow principal reduction modifications of the underlying first liens to take place. If there are legal obstacles to your doing so, we will work with you to remove them.

First, Frank is actually partially right. In the case of underwater borrowers facing foreclosure, the second liens are probably worthless. Once foreclosure begins, those second liens are generally wiped out anyway, depending on state law.

So what kinds of losses are we talking about? Financial Times blogger Tracy Alloway says that they could be as much as $442 billion, since that's the total value of the second liens on the books of these four banks. That, I think, is a rather lofty estimate. I don't take this letter to mean that Frank wants banks to wipe out all of their second liens -- just those associated with mortgages that they could otherwise successfully modify. I haven't the foggiest clue what the value of all those liens would be, but I doubt they're anywhere near the full $442 billion. Just in thinking about some big numbers, if we are talking about preventing one million foreclosures for homes with second liens and the average second lien size is $50,000, then that would be $50 billion. I think that's a pretty liberal scenario.

Whatever the actual value of write-downs that these banks would have to incur in order to comply with Frank's request, there's definitely some pain involved for the banks. It's interesting that Frank isn't offering these banks any kind of carrot -- because let's face it: he hasn't got any kind of stick other than trying to shame them into it.

The reality, however, is that it may be in banks' best interest to write off these liens. If they do have essentially no economic value, and a bank thinks it will be better off modifying a mortgage than foreclosing, then it should want to eliminate the second lien. The problem, of course, is the associated loss. Right now, banks have an incentive to prevent these write-offs for as long as possible, so to spread them out and be able to better sustain them as the financial markets continue to stabilize. Banks don't want billions more in write-downs this year related to second mortgages. That's why something like I suggested in conjunction with principal reductions, where banks could be permitted to amortize these losses over the course of several years, could make Frank's request a little easier to stomach.

It's interesting that Frank is calling for this now, several months after the government had given up any control it had over these banks with their bailout repayments. During the days prior to repayment, Frank or others in Washington could have more easily strong-armed banks into fulfilling such requests. These days, however, their power is greatly diminished. So unless Frank brings any interesting solutions to the table to reassure the banks that these massive losses won't hurt them, I can't see them taking his request very seriously.

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