Delinquent on a first mortgage but still making monthly payments on a home equity credit line or second mortgage?
If so, a finance and real estate professor from DePaul University has some controversial advice: Stop paying on the second immediately.
Rebel Cole believes that is simply throwing good money after bad. Those seriously delinquent on the first mortgage are likely headed for foreclosure unless both lenders agree on a modification or principal reduction plan. But if someone continues to make payments on the second, the bank that holds that revenue-producing note may have minimal motivation to participate in a workout, he believes. Cole estimates that between 1 million and 3 million homeowners are in this position nationwide — so it’s a big problem.
By abruptly stopping payments, according to Cole, the bank that owns the second mortgage will be forced to set aside significant additional capital for loss reserves. Contrast that with that bank’s current situation: It gets to report the home equity loan as “performing” for accounting purposes, requiring no extra capital allocations, he claims. This is despite the fact that the delinquent first mortgage — which takes payoff priority over the second and may well be underwater — probably renders the true market value of the home equity loan around zero in any foreclosure.
Once the bank is forced to set aside additional capital — as high as 100 percent of the face amount of the equity line — “it starts to really feel pain,” Cole said in an interview. Now it should be more willing to negotiate with the borrower and the first mortgage holder to work out a loan modification, principal reduction or short sale. And if not, the borrower can simply bank the money that would otherwise be paid on the second mortgage.
It may take a year until a foreclosure filing, and 350 days or more, depending upon the location, before someone actually has to vacate the house. Meanwhile, that person will be saving money every month.
Sound like a smart financial strategy? Cole has been pushing the idea in analysis and opinion articles, but what are the real pros and cons for consumers?
Start with the core idea that banks will be vulnerable to big hits to capital for loss reserves if someone stops paying on a second mortgage — thereby softening them up for principal reductions later. That’s not likely to happen, according to banking executives and financial regulators, because current federal loss-reserve rules already require institutions to proactively set aside additional reserves on seconds once there is any hint that the associated first mortgage is in distress — whether through delinquency, a loan modification or other indications.
Also, Cole’s estimate of as many as 3 million homeowners with paid-up seconds but delinquent firsts appears to be far overstated, according to new data from the Office of the Comptroller of the Currency. Recent bank examinations found that about 235,000 second liens may be in that position — a substantial number, officials concede, but nowhere near Cole’s estimate of the size of the problem.
Even more important, the personal impact when someone stops paying a second lien could be severe. Credit scores will definitely take a hit. If someone is behind on the first loan, the scores are probably depressed already. But stiffing the lender on the second mortgage will push them down even more, further limiting access to new credit in the future.
Worse yet, in some states, even if someone goes through foreclosure, the bank could legally pursue that borrower for full payment on the face amount on the unpaid second. The bigger the outstanding home equity loan, the more likely the pursuit.
Asked for comment, federal financial regulators bristled at Cole’s proposals. Timothy Long, senior deputy comptroller of the currency, called the professor’s recommendations misguided.
“That kind of advice to borrowers is dangerous,” Long said in an interview.
Top officials of major banks generally were reluctant to talk on the record about Cole’s ideas, but Dan Frahm, a Bank of America spokesperson, said his company’s “approach has been not to let second lien issues prevent us from modifying” mortgages, including “making principal reductions, even when the second lien is owned by a third-party investor and has not been modified.” The bank also said stopping payment on a second would not enhance a borrower’s chances of a modification or principal reduction.
Bottom line here: Follow professor Cole’s advice at your own peril. There is little evidence it will be effective in convincing a lender to do anything.
Kenneth Harney is a syndicated real estate columnist.