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First and Second Lien Holders to Share Losses Through Settlement

Details of the $25 billion settlement involving state and federal officials and the five largest servicers will change how liens are prioritized, and in turn, opponents say, will benefit banks but hurt investors.

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Typically, in cases involving delinquent loans, the second liens are written off before a first lien takes any losses. Under the settlement, first and second liens will share in the losses equally, with both getting written down proportionally instead of wiping out the second lien, which tends to yield a higher return since it includes a higher risk.

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""Efforts to modify first liens only, or to modify firsts and seconds in proportion, are, in effect, transfer from the first lien holder to the second,"" said Mark Calabria, director of financial regulation studies at the Cato Institute in his written testimony during a hearing Thursday. ""We should reject such transfers, as they violate the basic principles of contract and property.""

Citing a CoreLogic report, Calabria said 11.1 million borrowers are underwater, and of those, 4.4 million have both first and second mortgages.

""The average LTV [loan-to-vale] of these borrowers is 138 percent, implying that in the event of a foreclosure, the second lien would likely have little, if any value,"" Calabria said in his testimony.

More often than not, Calabria said the first lien holders are the investors, whether its pension funds and such, and second lien holders tend to be banks.

Although a proponent of principal reduction, Laurie Goodman, senior managing director of Amherst Securities, said she agreed with what Calabria had to say about the issue during the hearing.

""The attorney general settlement scares me a great deal because essentially banks are getting credit for writing down investor loans,"" said Goodman.

About Author: Esther Cho

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