Trouble for Second Mortgage Holders

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The subprime mess has hit lenders and homeowners hard. To stop the bleeding, lenders are reconsidering their instinctive reaction to foreclose on borrowers, particularly second mortgage holders.

In the financial marketplace, when the going gets tough, the tough get resourceful. The lending industry, for example, is pursuing new options for dealing with the subprime mortgage problem. That's because foreclosure is increasingly proving itself to be an undesirable method for resolving delinquent payments. As a result, lenders are now pursuing other options, no matter how ugly they may be.

Fear of foreclosure

Foreclosures are being abandoned because of sinking home values. If a lender decides to foreclose on a homeowner, it must buy out the first mortgage and hope to recoup its losses-including past-due interest, foreclosure fees, etc.-through the resale of the property.

Unfortunately for lenders, slumping home prices are making that financial maneuver next to impossible. By initiating foreclosure proceedings, a lender can wind up digging a deeper financial hole for both itself and the borrower. As a result, many are considering a different course of action.

Recovery via write-off

In lieu of foreclosure, lenders are beginning to write off their loans. This doesn't mean that the customer no longer owes money for the loan-it simply takes the asset off the lender's books.

This short-term solution can lead to long-term complications. It's the equivalent of sweeping dirt under the rug: The dirt is hidden, but it never actually goes away. When homeowners decide to sell their homes, they'll still have to contend with that home equity loan. At that point, the borrowers and the lender will need to work out a resolution.

Tightening the lines of credit

Another lender tactic is to tighten the credit available to higher-risk borrowers. In a stark contrast to the freewheeling, exceedingly generous lending that ran rampant a few years ago, lenders are now evaluating their loan portfolios on a case-by-case basis. Borrowers with poor credit scores are being labeled as potential risks for defaulting on a loan. Lenders will shrink their lines of credit, especially in areas that have experienced share decline in home values.

In addition to assessing lines of credit on a case-by-case basis, lenders are also working with individual borrowers to resolve their credit problems. Lenders may sell the second mortgages off at substantial discounts to third party investors, or simply work with the borrowers to set up a program to lower monthly payments. Either way, the industry is taking a piecemeal approach to a widespread problem.

The decline in home values has battered the lending market, and given rise to some creative problem solving. Where in the past, a foreclosure would have been a knee-jerk reaction in times of rising home values, today, lenders are pursuing different options, such as writing off loans and shrinking the credit that they made available. In the midst of market conditions that have turned conventional wisdom on its ear, a new way of problem solving appears to have only just begun.

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