Zombie mortgage settlement erases millions in borrower debt

The Massachusetts attorney general's office announced it has reached a settlement with a mortgage servicer over its practice of resurrecting and collecting on sometimes long-forgotten defaulted second, or zombie, liens.

Per conditions of the settlement, Franklin Credit Management Corp. will cease debt collection on its entire portfolio of Massachusetts loans, which primarily consisted of second liens. The servicer also said it would not transfer or sell its loans to another company, thereby effectively erasing over $10 million worth of mortgage debt held by hundreds of Massachusetts homeowners.

Franklin Credit also agreed to pay a monetary penalty of $300,000 and change its policies if it seeks to conduct future business in Massachusetts. 

"Zombie second mortgages are ancient debts that servicers quietly sit on for years before attempting to collect on them. This unfair and harmful practice blindsides consumers, often putting them at new risk of losing their homes," said Attorney General Andrea Joy Campbell, in a press release.

More common prior to the Great Financial Crisis, second liens were sometimes taken out by borrowers to piggyback on top of a primary loan at the time of origination, using home equity as collateral. The separation of the two liens assisted many borrowers in making a down payment, achieving an 80% loan-to-value ratio on the primary mortgage or staying below conforming limits. 

In certain cases, though, homeowners were not fully aware they held two loans or thought the piggyback mortgage had been satisfied upon foreclosure or loan modification during the financial crisis, the attorney general's office said. 

Franklin Credit violated state regulations in resurrecting the liens to begin collection proceedings without adequate communication to borrowers or advice of loss-prevention measures, the AG said. Massachusetts law mandates servicers make good faith efforts to help homeowners avoid foreclosure.

The state claimed the servicer delayed sending notices to borrowers until their unpaid balances had risen to a level too high to implement a loan modification, in violation of foreclosure-prevention regulations, and sometimes charged fees to begin the process.

"This settlement should encourage other states to take action to protect homeowners who have been unfairly burdened by zombie second mortgages,"  said Andrea Bopp Stark, senior attorney at the National Consumer Law Center. 

Earlier this year, the Consumer Financial Protection Bureau released its own warning to servicers seeking to collect on zombie loans, noting that the practice violated federal laws. The bureau said that it had received an increasing number of complaints from consumers who had received notices about payments immediately due, even though no communication about the loans had been sent for over a decade in some cases.

The recent reappearance of zombie seconds occurs during a three-year-long stretch of surging home equity, with debt collectors potentially seeing opportunities in today's property values on many of the collateralized properties. 

While the volume of piggyback liens pulled back in the decade after the Great Recession, Corelogic recently reported a noticeably increasing share among newer government-backed originations. The share of Federal Housing Administration-guaranteed mortgages featuring piggybacked seconds grew to 18% this summer from 10.8% two years earlier, coinciding with higher prices and decreased affordability in the housing market.