Government to Banks: We Recommend Throwing Good Money After Bad

This post first appeared on Minyanville and Cirios Real Estate.


Every month, it seems, Washington dreams up new and fantastic ways to funnel taxpayer money towards a growing list of undeserving recipients.

Now, in the latest attempt to coerce banks into modifying delinquent mortgages en masse, the Treasury Department plans to offer cash incentives to lenders who lower interest rates or forgive principal on second liens (so-called "piggyback" loans). According to Bloomberg, the new program aims to simplify the modification process and help struggling borrowers avoid foreclosure.

The subprime second lien was a highly profitable, nearly usurious loan product that proliferated during the housing boom. Once reserved for high-quality borrowers and those with sufficient equity in their homes, seconds became an easy way to jam borrowers into homes they couldn't otherwise afford.

If a homeowner wants to take out a first mortgage for more than 80% of the home's value, he or she is typically required to take out mortgage insurance, issued by firms like Radian (RDN), MGIC Investment Corp (MTG) and the PMI Group (PMI). For years, the cost of insurance -- plus the required down payment -- limited home ownership to those who, by and large, could afford to buy responsibly.

But as housing demand ballooned from 2002 to 2005, banks discovered they could just loan borrowers the down-payment money - and charge a hefty fee to do so. Without those pesky requirements -- and by bypassing the sometimes strict credit guidelines of mortgage insurers -- banks were able to open up their loan products to a whole new group of unqualified borrowers.

Second liens, by virtue of being subordinate to first liens, carry additional risk, and thus a higher interest rate. In other words, if a borrower defaults, the holder of the second lien has to wait until the first mortgage holder is made whole before getting paid.

And since seconds carried super-high interest rates, securities backed by this type of loan offered juicy returns for investors. It should come as no surprise that the second-lien market was dominated by Bear Stearns (now JPMorgan (JPM)), Countrywide (now Bank of America (BAC)), and Citigroup (C) (now in hock to Uncle Sam for a cool $300 million).

Now, the Obama Administration wants to give billions to not only the banks who wrote these loans, but the borrowers who accepted them. The program is destined for failure.

In fact, it's already failed.

A little over a year ago, Fannie Mae (FNM) and Freddie Mac (FRE) introduced an initiative called the "HomeSaver Advance." Under the program, borrowers behind on their mortgage payments could take out an unsecured line of credit to get current. Under this program, Fannie and Freddie lent out $462 million over the course of the next 12 months.

Now, based on current market prices, the loans are worth a whopping $8 million, or $0.017 cents on the dollar. Talk about throwing good money after bad.

The President's initiative to modify seconds is no different: It takes a situation destined for foreclosure and simply prolongs the agony. This prevents the borrower from getting out from under his mountain of debt and starting anew. Meanwhile, homes become ever more dilapidated, and banks further delay their own days of reckoning.

The rationale for this program is obscure - though it does provide yet another way to hand taxpayer money over to the very banks who got us into this mess in the first place.