The influential chair of the House Financial Services Committee is ratcheting up the pressure on lenders to write off nearly worthless second liens to clear the way for loan modifications to help homeowners avoid foreclosure.

In a letter to the heads of the four largest U.S. banks, Rep. Barney Frank (D-Mass.) noted that second liens are a major obstacle in the way of obtaining loan modifications for "underwater" homeowners. Despite the fact that many investors holding first liens are willing to modify those mortgages to help at-risk homeowners keep their homes, Frank said they are prevented from doing so by the refusal of second-lien holders to accept their own losses.

"Large numbers of these second liens have no real economic value," Frank wrote. "The first liens are well underwater, and the prospect for any real return on the seconds is negligible. Yet because accounting rules allow holders to these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans, which would allow willing first lien holders to reduce the principal and keep borrowers in their homes."

First lien holders are sometimes willing to reduce the principal on underwater mortgages, where the amount owed exceeds the value of the property because it allows them to minimize their losses compared to allowing the property to go into foreclosure. However, such loan modifications are often blocked by second lien holders, who can no longer claim any equity in the home but still hold out for a share of the compensation.

The problem of underwater mortgages, where homeowners owe more than their home is worth due to falling property values, represents a major challenge in dealing with the foreclosure crisis. Homeowners who are underwater on their mortgages are increasingly likely to default, in part because they feel they are losing money by continuing to make payments on a property that has fallen steeply in value.

Underwater ARMs a looming problem

A looming problem for the U.S. housing market is the large number of adjustable-rate mortgages that are underwater but have balloon payments due or are scheduled to reset to significantly higher payment obligations in the next few years. Many of these homeowners had counted on being able to refinance before this happened but now cannot do so due to a lack of equity in their property. For such homeowners, loan modifications offer the only realistic opportunity for keeping their homes and avoiding a major wave of foreclosures in the next few years.

"To save homes on a large scale, we must move past temporary modifications in interest rates or terms and focus on permanent principal reductions that result in truly sustainable mortgages," Frank wrote. "There is no more important priority for me in our efforts to restore stability to our mortgage market."

Frank called on the chief executives of Bank of America, Citibank, Wells Fargo, and JP Morgan Chase, all of which are active in the primary and secondary mortgage markets, to take immediate steps to allow such reductions to occur.

Bank of America has already agreed to allow automatic modifications of second liens for homeowners who obtain loan modifications under the administration's Home Affordable Refinance Program, with other lenders expected to join in as well. However, such modifications need not include forbearance or principal markdowns.

The administration is also launching a program in April that will provide financial incentives to second-lien holders who waive their claims in return for allowing short sales or deeds in lieu of foreclosures to proceed for homeowners who cannot qualify for loan modifications.