While many efforts to encourage mortgage modifications have been tried during the past three years, the state of Oregon has come up with something original and unique: It’s moving forward with an idea that costs taxpayers nothing and will, er, motivate many lenders to write down loans.
Passed in the Oregon house by a vote of 58 to 0, and in the state senate by unanimous consent, HB 3656 doesn’t fool around with cash payments to lenders or other niceties. Instead, the deal is very simple: In a foreclosure action the right of a piggyback second lender to sue for a deficiency judgment is eliminated.
In practical terms here’s what Oregon is getting at.
In 2006 the Todds bought a home for $500,000. On the advice of their lender, and with approval of the lender’s underwriters, they financed the property with a piggyback loan that included a $400,000 first lien and a $100,000 simultaneous second loan.
The result of the Todds’ piggyback loan was this:
- It allowed the Todds to buy property with no money down, a property which they otherwise could not afford.
- It allowed the lender to originate a conventional first loan equal to 80 percent of the purchase price. Because it’s 80 percent financing, this mortgage was instantly sold to Wall Street banks and brokers, packaged with other loans, and used to create a mortgage-backed security. Having sold the loan, the lender could use the cash it received to fund additional mortgages and generate new fees.
- While the first loan was a conventional mortgage and easy to sell, the second loan was more risky and not-so-easy to market. It may have been sold separately from the first loan to produce cash, or in some cases it may have been retained by the originating lender to generate interest income.
- Because the piggyback financing had an 80 percent first loan there was no need for the Todds to buy private mortgage insurance (PMI). This reduced their monthly cost of ownership.
The lender got to originate two loans instead of one and thereby pocketed more fees and charges.
Higher Prices For All
One result of the creative financing offered to the Todds and many other buyers was that they could bid more for real estate. This forced other purchasers to also raise their bids even if they were buying for cash. Artificially increasing the pool of potential buyers with “nontraditional” financing was one reason home prices rose so quickly for several years — and then collapsed so quickly when such mortgages were no longer available.
Let’s now move ahead to 2010. Mr. Todd has lost his job and the first lender agrees to modified mortgage terms under the federal government’s Making Home Affordable program. However, the second lender doesn’t agree to a modification, and that forces the property into foreclosure — even though the second lender will get nothing from a foreclosure.
Here’s why the second lender will get nothing.
In a foreclosure sale lenders are paid in order: The first lender receives all the money from a foreclosure sale until its claim is entirely satisfied. Any money left over is paid to the second lien holder. In the case of the Todd property, it might sell for $375,000 at foreclosure so the first lender would get back most of its money while the second lender will get nothing.
In this situation, the second lender opposes the loan modification because it thinks it can get money by suing the Todds for a deficiency judgment after the foreclosure. If it wins, the second lender can then bankrupt the Todds and take their few remaining assets.
The Oregon Approach
Oregon bill HB 3656 says this is nonsense. Specifically, a House summary of the bill explains that “in cases where a second loan was created as part of the same purchase or repurchase transaction as the one on which the foreclosure action was taken, and when it was owed to or originated by the beneficiary of the foreclosure or its affiliate, the holder of the second loan cannot sue for restitution.” Translation: Holders of simultaneous second loans cannot get a deficiency judgment after a foreclosure, so they may as well try to get what they can through the modification process.
“The targeted legislation seen in Oregon is simply a state-sponsored mortgage modification program,” says Jim Saccacio, chief executive officer of RealtyTrac.com, the leading online marketplace for foreclosure properties and data. “It effectively changes the terms of many second loans in a way which gives more leverage to troubled borrowers and first mortgage investors. At the same time, it doesn’t impact all second mortgages, only those which were part of the piggyback lending process.”
You can see where this is going. One can easily imagine lawmakers in other states introducing similar bills. Or, they can start taking a targeted approach to other aspects of the lending process.
For instance, there could be legislation which prohibits deficiency claims for any mortgage which allows negative interest. Or legislation which extends the foreclosure process by six months for any mortgage with a pre-payment penalty. The angry mood of the country is beginning to make such rules at the state level more feasible if not probable — just look at the votes in the Oregon legislature.
Second loans represent a lot of risk which is why lenders get higher interest rates for making them. The Oregon proposal makes that financial exposure real, a reckoning many would argue is only fair and appropriate.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.