Iffy strat­egy for delin­quent loans

If the first mort­gage is in ar­rears, stop pay­ing on the sec­ond, a pro­fes­sor ad­vises.

Los Angeles Times - - Business - Ken­neth R. Har­ney re­port­ing from washington ken­har­ney@earth­link.net Dis­trib­uted by Washington Post Writ­ers Group.

Are you delin­quent on your first mort­gage but still mak­ing monthly pay­ments on your home eq­uity credit line or sec­ond mort­gage?

If so, a fi­nance and real es­tate pro­fes­sor from DePaul Uni­ver­sity has some con­tro­ver­sial ad­vice for you: Stop pay­ing on your sec­ond mort­gage im­me­di­ately.

Rebel Cole be­lieves you are sim­ply throw­ing good money af­ter bad. If you are se­ri­ously delin­quent on the first mort­gage, you’re prob­a­bly headed for fore­clo­sure un­less both of your len­ders agree on a mod­i­fi­ca­tion or prin­ci­pal re­duc­tion plan. But since you con­tinue to make pay­ments on the sec­ond loan, the bank that holds that rev­enue-pro­duc­ing note may have min­i­mal mo­ti­va­tion to par­tic­i­pate in a work­out, he be­lieves. Cole es­ti­mates that 1 mil­lion to 3 mil­lion home­own­ers are in this po­si­tion na­tion­wide.

By abruptly stop­ping pay­ments, Cole says, you will force the bank that owns your sec­ond mort­gage to set aside sig­nif­i­cant ad­di­tional cap­i­tal for loss re­serves. Con­trast that with that bank’s cur­rent sit­u­a­tion: It gets to re­port your home eq­uity loan as “per­form­ing” for ac­count­ing pur­poses, re­quir­ing no ex­tra cap­i­tal al­lo­ca­tions, he says.

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 your home eq­uity loan around zero in any fore­clo­sure.

Once the bank is forced to set aside ad­di­tional cap­i­tal — as much as 100% of the face amount of your eq­uity line — “it starts to re­ally feel pain,” Cole said.

Now you should find it more will­ing to ne­go­ti­ate with you and your first mort­gage holder to work out a loan mod­i­fi­ca­tion, prin­ci­pal re­duc­tion or short sale, he says. And if not, sim­ply bank the money you’d oth­er­wise be pay­ing on the sec­ond mort­gage.

It may take a year un­til a fore­clo­sure fil­ing, and per­haps an­other year, depend­ing upon your lo­ca­tion, be­fore you ac­tu­ally have to va­cate the house. Mean­while, you’ll be sav­ing money ev­ery month.

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 you stop pay­ing on your sec­ond mort­gage — thereby soft­en­ing them up for prin­ci­pal re­duc­tions later.

That’s not likely to hap­pen, ac­cord­ing to bank­ing ex­ec­u­tives and fi­nan­cial reg­u­la­tors, be­cause fed­eral loss-re­serve rules al­ready re­quire in­sti­tu­tions to proac­tively set aside ad­di­tional re­serves on sec­ond loans 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 ef­fect on you when you stop pay­ing a sec­ond lien could be se­vere. Your credit scores will def­i­nitely take a hit. Since you’re be­hind on the first loan, your scores are prob­a­bly de­pressed al­ready. But stiff­ing the lender on your sec­ond mort­gage will push them down even more, fur­ther lim­it­ing your ac­cess to new credit in the fu­ture.

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.

Top of­fi­cials of ma­jor banks gen­er­ally were re­luc­tant to talk on the record about Cole’s ideas, but Dan Frahm, a Bank of Amer­ica spokesman, 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 mort­gage 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 that it will be ef­fec­tive in per­suad­ing your lender to do any­thing.

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