Home equity lines of credit (HELOCs) were the favored tools of Ponzis during the housing bubble. These were used like a credit card with an ever-expanding credit balance that didn’t need to be paid back because the house was paying for it. Most borrowers viewed this as truly free money, and they behaved accordingly. This influx of spending drove the economy during the first half of the 00s, and the elimination of this stimulus and the subsequent need to repay this debt is what’s causing our economic doldrums today.
HELOCs are similar to other revolving lines of credit with a few key differences. HELOCs are secured by real estate whereas a credit card is not. If a borrower does not repay a HELOC, the lender can foreclose on the house to force repayment. A credit card is not similarly secured. HELOCs have a minimum payment like a credit card, but the payment is interest-only each month. No principal payment is required — at least at first. After an initial period, the HELOC can no longer be increased, and the balance must amortize to zero over a set period of time similar to a conventional mortgage. In this regard HELOCs are very similar to interest-only ARMs and Option ARMs which proliferated during the housing bubble and created the dreaded ARM recast problem.
Many housing market watchers concluded the wave of ARM resets and recasts would cause millions of defaults and foreclosures. They were half right. These loans did reset, but the interest rates were lower, so that caused little payment shock; however, these loans also recast from interest-only and negative amortization to fully amortizing causing a huge payment shock. The majority of the borrowers who used these loans did default, but these defaults did not lead to an expected wave of foreclosures because lenders chose to allow these borrowers to squat in shadow inventory without making any payments. In short, the payment shock from recasting loans was extreme, it did cause defaults, and these properties are yet to be recycled through the system.
The same issue is facing HELOCs.
By GRETCHEN MORGENSON
… During the initial years of home equity credit lines, borrowers must pay only interest. Borrowers can also pay down principal if they wish, but many homeowners, short on cash, haven’t done so. At Wells Fargo, for example, in the quarter ended March 31, some 44 percent of the bank’s home equity borrowers paid only the minimum amount due.
Being required to pay only the interest on these loans has made them easier for troubled borrowers to carry. But these easy terms are about to get tougher. What’s known as the initial draw period for home equity lines of credit is coming to an end for many borrowers. Soon, they will have to pay principal as well.
That is the definition of a recast. The problem with these loans isn’t resetting to a different interest rate. With today’s record low rates, that would not be a problem. The issue is recasting to fully amortizing payments, and that will increase the repayment burden on all borrowers. This will be devastating to the Ponzis because in our weak economy and conservative lending environment, they don’t have other sources of borrowing to cover the payments.
Ten days ago, the Office of the Comptroller of the Currency published some frightening figures about the looming payments. In its spring 2012 “Semiannual Risk Perspective,” it said that almost 60 percent of all home equity line balances would start requiring payments of both principal and interest between 2014 and 2017.
The amounts owed in these lines of credit climb significantly in coming years. While $11 billion in home equity lines are starting to require principal and interest payments this year, the amount jumps to $29 billion by 2014, the office said. That is followed by a surge to $53 billion in 2015 and $73 billion in 2017. For 2018 and beyond, it’s $111 billion.
This is no small problem. It’s very reminiscent of the ARM reset and recast problem.
“Home equity borrowers face three potential issues,” the report concluded. They include risk from rising interest rates — most of these loans have adjustable rates — and payment shock as borrowers realize they have to pay down principal. Refinancing difficulties are also a problem, it said, “because collateral values have declined significantly since these loans were originated.”
That’s for sure.
The properties backing many of these loans are no longer worth the amounts borrowed on them. And those amounts are enormous. In the first quarter of 2012, the top four banks held $295.1 billion in revolving residential lines of credit, according to Amherst Securities. Using data from the Federal Reserve, Amherst said Bank of America held $101.4 billion; Wells Fargo, $93.3 billion; JPMorgan Chase, $84.4 billion; and Citigroup, $15.9 billion. As a result, the risks to borrowers cited in the comptroller’s office report will also be faced by their lenders.
The top four banks are holding about $300 billion dollars in second mortgages on their books, and most of these are underwater and worthless. This is the biggest issue facing the banks today. It’s one of the reasons the government and federal reserve are so intent on forcing prices back up to the peak. If they don’t, the losses on these seconds and HELOCs could imperil the banking system.
How banks value these loans has become a hot topic among investors and regulators. This is to be expected, given that so many home equity lines are no longer collateralized by boom-era home values. Last January, for example, financial regulators issued supervisory guidance on how banks should adjust allowances for losses on these loans. And in the first quarter, Wells Fargo said it moved $1.7 billion in junior lien mortgages to nonaccrual status as a result of the guidance. That caused an increase in the bank’s nonperforming assets to $26.6 billion, a 33 percent rise.
But in the second quarter, Wells Fargo showed a 13 percent decline in nonperforming loan balances among junior lien mortgages.
These are among the riskiest loans in any bank’s portfolio. As borrowers are pressed to pay principal and interest, write-offs are almost certain to rise.
Banks have been ignoring this problem and kicking the can down the road hoping that rising home values would restore the equity backing these loans so they could foreclose and regain their capital. Rising prices is not likely to bail the banks out, but it’s the only viable plan they have, so they will likely continue to amend-extend-pretend their way through this problem. I expect to see all these loans modified to avoid the payment shock. Since these loans are underwater, they are a total loss in a foreclosure. No bank is going to be in a hurry to recognize these losses, particularly if they really believe a rising market will make them whole again.
It didn’t have to be this way, for borrowers at least. Had the loan modification programs created by the Treasury Department required banks to write down junior liens more aggressively, homeowners would not be facing a wave of increased payments. But Treasury did not, and its stance allowed the second-lien problem to balloon.
Gretchen Morgenson really has no idea what she is talking about. The second-lien problem did not balloon because the government did not require principal reduction. The problem was created when the banks underwrote these loans in the first place. These loans should never have been made. If the government had forced banks to write these loans down, it would have made them insolvent, and it would have created a huge moral hazard problem. Everyone would want these loans in the future because when house prices crash after the next bubble, borrowers know the debts will be forgiven. Who wouldn’t sign up for free money?
AS Laurie Goodman, an analyst at Amherst Securities, testified to Congress last year, neither of the Treasury’s loan modification programs dealt appropriately with second liens, which include home equity credit lines.
Ms. Goodman did not testify to the “appropriateness” of the government’s handling of the issue. Ms. Morgenson is obviously trying to push her misguided agenda of principal reductions by putting words in Ms. Goodman’s mouth.
In the Home Affordable Modification Program, for example, banks could modify a first mortgage — even reducing principal owed — while leaving the second or home equity line untouched.
And a subsequent program, the Second Lien Modification Program, known as 2MP, treats first mortgages and junior liens equally. Under that program, if there is a rate cut or a principal reduction on a first mortgage, the second lien gets the same treatment. This goes against centuries of practice regarding creditor repayment hierarchy.
Yes, the government trampled the rights of first mortgage holders. The inevitable lawsuits will probably be settled by another government bailout of those first lien holders who lost more than they should have.
“The negative equity position of many borrowers would be dramatically improved if the second lien was eliminated or reduced more in line with the seniority of the lien,” Ms. Goodman told Congress. “Indeed, loan modification programs would be markedly more successful if principal reductions were used on the first mortgage and the second liens were eliminated completely.”
But that didn’t happen. The Treasury didn’t force the banks to write down these loans, and billions in balances remain outstanding.
Thank goodness the government made the right decision.
Payment shock for borrowers is nigh. For those who are already struggling to pay their mortgages, this is an unwelcome burden. And it is one that might have been avoided.
Poor Gretchen. She is still whining about the fact that principal reductions are not forthcoming. I wonder if she is a loanowner who would have been helped?
So much has been written about underwater loanowners that it’s easy to forget it’s really the banks who are in danger. If loanowners start defaulting in large numbers or opt for strategic short sales, the banks will get clobbered. It isn’t just the first mortgages that are underwater. The second mortgages and HELOCs are also a big part of the problem.
A $96,000 HELOC was a total loss
In the commentary on today’s featured news article, I stated the problem with second mortgages and HELOCs was the origination of the loan, not the failure of banks to forgive the balance. Let’s take a look at a typical HELOC abuser, and you tell me if the greater good is served by forgiving this man’s $96,000 imprudent borrowing.
- This property was purchased on1/14/2002 for $135,000. The owner used a $121,500 first mortgage and a $13,500 down payment.
- On 3/5/2004 he refinanced with a $150,000 first mortgage.
- On 6/20/2005 he refinanced with a $160,000 first mortgage.
- On 8/10/2005 the obtained a $96,000 HELOC.
There is no way to be certain he used this HELOC, but if he did, do you think your tax dollars should go toward bailing out either him or the bank that loaned him money? Why? I think the bank should lose its money, and he should suffer damaged credit and potential collection efforts. Both should have consequences for making and accepting this loan.
San Clemente Overview
Median home price is $622,000. Based on a rental parity value of $575,000, this market is fairly valued.
Monthly payment affordability has been worsening over the last 4 month(s). Momentum suggests worsening affordability.
Resale prices on a $/SF basis increased from $280/SF to $289/SF.
Resale prices have been falling for 12 month(s). Price momentum suggests falling prices over the next three months.
Median rental rates increased $33 last month from $2,316 to $2,350.
Rents have been rising for 12 month(s). Price momentum suggests rising rents over the next three months.
Market rating = 3
$174,900 …….. Asking Price
$135,000 ………. Purchase Price
1/14/2002 ………. Purchase Date
$39,900 ………. Gross Gain (Loss)
($10,800) ………… Commissions and Costs at 8%
$29,100 ………. Net Gain (Loss)
29.6% ………. Gross Percent Change
21.6% ………. Net Percent Change
2.4% ………… Annual Appreciation
Cost of Home Ownership
$174,900 …….. Asking Price
$6,122 ………… 3.5% Down FHA Financing
3.62% …………. Mortgage Interest Rate
30 ……………… Number of Years
$168,779 …….. Mortgage
$60,014 ………. Income Requirement
$769 ………… Monthly Mortgage Payment
$152 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$44 ………… Homeowners Insurance at 0.3%
$176 ………… Private Mortgage Insurance
$410 ………… Homeowners Association Fees
$1,550 ………. Monthly Cash Outlays
($66) ………. Tax Savings
($260) ………. Equity Hidden in Payment
$7 ………….. Lost Income to Down Payment
$42 ………….. Maintenance and Replacement Reserves
$1,273 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$3,249 ………… Furnishing and Move In at 1% + $1,500
$3,249 ………… Closing Costs at 1% + $1,500
$1,688 ………… Interest Points
$6,122 ………… Down Payment
$14,307 ………. Total Cash Costs
$19,500 ………. Emergency Cash Reserves
$33,807 ………. Total Savings Needed
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