When is a $20 billion legal settlement not such a bad thing? When the fine print contains potentially tens of billions of dollars in future savings to make up for it.

 

A loophole in a foreclosure fraud settlement case could change the way banks and other creditors are treated during loan modifications.

 

Imagine a homeowner who has a mortgage and also a home equity line of credit or a second mortgage. The way it works now, if the homeowner can no longer pay and must give up the house, the proceeds from the sale of the house go first to the lender that holds the first mortgage. If there is money left over after the mortgage holder is paid off, then—and only then—does the holder of the second mortgage collect.

 

For generations, the holders of second mortgages have accepted more risk than the holders of first mortgages. But this just might change in certain cases.

 

Banks are currently negotiating with a coalition of state attorneys general to settle litigation brought over cases of foreclosure fraud. The goal is to force the mortgage holders to reduce the principal on loans that are worth more than the value of the house. Rumor has it that the deal may call for financial institutions to pay a combined $20 billion in fines or to create a fund of similar value to help the borrowers.

 

However, another provision of the settlement, which is still being negotiated, is more controversial. Normally, holders of first mortgages can write down—or reduce the stated value—of failed loans in order to reduce their taxable income. When this happens, the second mortgage may become a total loss. The proposed settlement would allow the holders of second mortgages to also write down their losses.

This change would be a boon to the biggest banks because they are the ones most likely to hold second mortgages or home equity lines of credit. The top four banks—Bank of America, JPMorgan Chase, Citigroup and Wells Fargo—currently hold about $408 billion worth of second mortgages. First mortgages, on the other hand, are often held by small banks, life insurance companies and even pension funds.

-David Wallechinsky

 

In Proposed Mortgage Fraud Settlement, a Gift to Big Banks (by Jesse Eisinger, ProPublica)

A Swift Deal May Not Be a Sound One (by Gretchen Morgenson, New York Times)

U.S. Pushes Mortgage Deal (by Nick Timiraos, Dan Fitzpatrick and Ruth Simon, Wall Street Journal)