Will lenders kick the can when billions in HELOCs recast and payments skyrocket?
Lenders mastered kicking the can. When millions of borrowers stopped paying their debts, rather than foreclose on delinquent borrowers, lenders collectively decided it was in their best interest to cut deals, entice borrowers to make payments, and pray house prices would recover when they could foreclose without losing billions. Can-kicking became the policy of necessity; Politicians encouraged it, some legislatures mandated it, most borrowers asked for it, but lenders required it, which is really why it happened. If lenders had foreclosed on all the delinquent mortgage squatters and liquidated the inventory, house prices would have retreated to Great Depression levels, and our entire banking industry would have gone bankrupt. My fantasy was averted.
For the next several years, the housing market is a waiting game as lenders wait for higher prices to finally resolve their legacy loan problems. MLS inventory is low because lenders are denying short sales, approving loan modifications, and allowing delinquent mortgage squatters to live payment free. The lack of MLS inventory is forcing the depleted buyer pool to compete for available properties and bid up prices. As prices rise, collateral value returns, and lenders could foreclose and recover their original capital, which is why lenders are so motivated to see house prices go up.
Borrowers who only have one mortgage will emerge from beneath their debts first. This will help the FHA and GSEs remain solvent. However, borrowers with more than one mortgage will need scuba gear for many years after their first mortgage clears. Lenders retain second mortgages, which includes HELOCs, on their balance sheets, and since these mortgages get nothing in a foreclosure until the first mortgage is paid in full, many of these second mortgages are 100% exposed. In a foreclosure, the lender losses everything. Therefore, a lender may have $200B in first mortgages on their balance sheets but no significant loss exposure, but the same lender may have $50B in HELOCs on their balance sheet with $40B in potential loss exposure. The HELOC exposure of most banks could bankrupt them. It’s a big deal.
Banks would die if they foreclosed on all the properties with second mortgages and HELOCs. Therefore, in my opinion, banks will do whatever it takes to avoid foreclosing on these loans. When the story broke last month about looming recasts of HELOCs which would raise payments and likely cause rising delinquencies, I dismissed it as another issue lenders would paper over with more can-kicking. Mike wrote the post Home Equity Lines another problem just to be HARP’ed. Keith Jurow, the author of today’s featured article has a different opinion. He notes that the TBTF banks that own these HELOCs don’t necessarily control the first mortgage, and the first lien holder may decide to foreclose anyway. Also, banking regulators are forcing banks to write off delinquent second mortgages if the first mortgage is underwater, and that process should continue.
By Keith Jurow
December 16, 2013
… We seem to have forgotten the insanity of the bubble years. Nothing was more mind-boggling than the home equity line of credit (HELOC) borrowing from 2004 – 2007.
By 2004, major housing markets were soaring because of speculators out to make a killing. As rampant speculation fueled the housing bubble, homeowners watched the value of their homes soar. The temptation to pull some of the growing equity out of their house was very tempting.
This was done with HELOCs in one of two ways. The first was to take out a new HELOC. The second was to refinance a HELOC with a larger one. This chart shows the incredible number of HELOCs that were originated each quarter during the crazy bubble years.
Between the first quarter of 2005 and the end of 2007, roughly 10.8 million HELOCs were originated. In the first quarter of 2003, there was only $242 billion in HELOCs outstanding according to the NY Federal Reserve Bank. By early 2005, it had skyrocketed to $502 billion. That number did not finally peak until late 2009 at $672 billion according to Equifax.
Some of these bubble-era HELOCs were taken out by home buyers as so-called “piggy-back” second mortgages at the time of purchase. However, the vast majority were originated after the home purchase – usually within two years.
Many homeowners refinanced their HELOCs – some more than once – to pry still more cash out of the house. Between 2004 and 2006, roughly six million HELOCs were refinanced. Amazing! …
Regular readers of this blog know how common this behavior was. I profiled thousands of such cases over the years.
California – Epicenter of the HELOC Mania
Nowhere was the madness of HELOC borrowing more incredible than in California. During 2004 and 2005, a total of 1.43 million HELOCs were originated in California just for the purchase of homes according to figures I received from CoreLogic.
These California HELOC numbers may be hard to believe. However, they make sense when you consider the speculative frenzy that occurred during the bubble years. In 2004-2005, borrowers would take out a purchase HELOC to buy investment properties in other hot markets such as Las Vegas and Phoenix.
While the loans were recorded as California HELOCs because the borrower’s property was in California, the purchased home was actually in another state. CoreLogic provided the following HELOC origination numbers to me for California.
According to CoreLogic, an additional 868,000 HELOCs were originated in California during 2004-2005 as “cash-out” refinancings of previous HELOCs. These homeowners tapped their piggy bank house by refinancing their HELOC with a larger available credit line.
How a HELOC Reset Works
A HELOC is similar to a business line of credit and has some similarities to a consumer credit card as well. Using the residence as security, a homeowner is usually given a line of credit with a prescribed limit upon which the borrower can draw at any time. During the zaniest bubble years, some banks actually offered HELOCs where the available credit increased automatically as the equity in the house rose along with the home’s value.
For bubble-era HELOCs, the homeowner received a draw period of anywhere from five to ten years when funds could be drawn. During this draw period, the borrower was usually required to make interest payments only. The rate was adjusted monthly and was pegged to the prime rate.
Here is the problem. At the end of the 10-year draw period, the loan becomes fully amortizing. The repayment period was typically between ten and twenty years at the end of which the HELOC had to be fully repaid.
HELOCs were irresistible because the interest-only monthly payment was not very much – often only a few hundred dollars. Why worry about the fact that in ten years it would become fully amortizing? Borrowers focused on the soaring value of their home.
This is actually a loan recast. The problem isn’t just a loan resetting to a different interest rate. In our current interest rate environment, loan resets won’t cause problems. However, a recast changes the loan terms from interest-only to fully-amortized payments. Even if the interest rate remains the same, the payment will increase dramatically.
In my opinion, the solution is simple; lenders will extend the interest-only period until the loan is above water. If this takes 3, 5 or 10 years, it doesn’t matter. As long as the loan is underwater, I don’t see the lender doing anything that may cause a delinquency because regulators will force them to recognize the loss.
HELOC Resets Have Begun
The earliest bubble era HELOCs are beginning to face the end of the 10-year draw period. Take a good look at this chart showing originations of both HELOCs and closed-end second mortgages from the New York Federal Reserve Bank.
HELOC originations are in red. You can see that they began to soar in 2003. Those HELOCs have started to reset this year. An increasing number of resets will occur next year with the 10-year anniversary of the 2004 vintage HELOCs. Still more will reset in 2015 and nearly as many in 2016.
Now take another look at the earlier chart showing quarterly HELOC originations. The annual origination figures look like this:
2005 – 4.5 million
2006 – 3.4 million
2007 – 2.9 million
That is a total of 10.8 million HELOC originations during the peak bubble years. This does not even include those originated during 2004. Nearly 40% of these bubble era HELOCs were opened in California where the average amount was roughly $130,000. For those HELOCs originated between 2004 – 2007 which are still in existence and have an accompanying first mortgage, it is no exaggeration to say that 98% or more of those properties are now underwater.
If those properties are in Coastal California, they might not be underwater, but anywhere else, and these HELOCs have no collateral backing.
Now here is the truly frightening part. When the 10-year draw period ends, the HELOC converts to a fully amortizing loan. The payoff period varied from a minimum of ten years to a maximum of twenty. Most had fifteen year payoff periods. How much might the monthly payment increase?
Let’s take a typical California HELOC from 2004 with a balance of $150,000. Using today’s average HELOC rate of 5.5%, the interest-only payment would be about $687 per month. When the loan becomes fully amortizing with a payoff period of fifteen years beginning some time in 2014, the monthly payment would soar to roughly $1,225 per month. Quite a jump!
If the loan balance was higher, the leap in monthly payment would be even greater. How many HELOC borrowers will be willing and able to pay this amortizing amount? That is the big question. …
In my opinion the bigger question is how many lenders will go ahead with the recast rather than simply kick the can with an extended interest-only period. If these loans are allowed to recast, the delinquency rates will skyrocket.
It is very likely, therefore, that HELOC delinquencies will soar for those resetting in 2016. By that year, California should be a complete disaster.You had better prepare for what is coming in the next four years with the HELOC resets. Almost all of these HELOCs are second liens. When the borrower defaults on an underwater property with a HELOC, the loan is not simply written down. It is written off as worthless. Some of the largest banks will regret that they handed out millions of HELOCs during the bubble years.
The scenario will play out just as Keith has outlined if the recasts are allowed to happen. It will be a banking disaster, which is why I believe lenders will can-kick this problem.
What do you think? Is there any chance lenders don’t can-kick this problem until better days?
Real estate news coverage suspended for holidays
Real estate news coverage is suspended from December 21 through December 31. Regular real estate related news posts will resume on January 1, 2014. I apologize for the inconvenience. Since the end of the year is a time of family and reflection, and since it’s not a time many people focus on real estate, I decided to offer something different.
Tony Bliss was a close friend of mine who lost his heroic battle with cancer in late 2012. He wrote about his experience in a series of gripping posts that reveal a beautiful and courageous man. I was deeply moved by these posts — some of which are admittedly difficult to digest. This writing is raw. Real. Be forewarned that if you read his posts, you will never be the same. You will laugh, cry, fear, hope, and stare into the abyss of your own mortality. I am honored to share this great work with you here starting December 21st and concluding December 31st.
One of the HELOC abusers Keith wrote about
The former owner of today’s featured REO bought at the bottom of the last real estate recession with a low down-payment loan, and as house prices rose, she went to the home ATM machine at every opportunity.
- This property was purchased for $125,000 on 11/21/1997. The owner used a $121,358 first mortgage and a $3,642 down payment.
- On 11/30/2000 she refinanced with a $144,000 first mortgage.
- On 2/7/2002 she opened a $25,000 HELOC.
- On 6/11/2003 she refinanced with a $175,000 first mortgage.
- On 1/24/2005 she refinanced with a $200,000 first mortgage.
- On 9/22/2005 she opened a $20,000 HELOC.
- On 8/17/2006 she refinanced with a $235,000 first mortgage.
- On 12/9/2009 she refinanced with a $245,000 first mortgage.
- She defaulted on that 2009 refinance in early 2011, and she was allowed to squat for well over two years. The bank finally booted her out on 8/26/2013.
4802 TIARA Dr #221 Huntington Beach, CA 92649
$279,900 …….. Asking Price
$125,000 ………. Purchase Price
11/21/1997 ………. Purchase Date
$154,900 ………. Gross Gain (Loss)
($22,392) ………… Commissions and Costs at 8%
$132,508 ………. Net Gain (Loss)
123.9% ………. Gross Percent Change
106.0% ………. Net Percent Change
4.9% ………… Annual Appreciation
Cost of Home Ownership
$279,900 …….. Asking Price
$9,797 ………… 3.5% Down FHA Financing
4.48% …………. Mortgage Interest Rate
30 ……………… Number of Years
$270,104 …….. Mortgage
$92,095 ………. Income Requirement
$1,365 ………… Monthly Mortgage Payment
$243 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$58 ………… Homeowners Insurance at 0.25%
$304 ………… Private Mortgage Insurance
$409 ………… Homeowners Association Fees
$2,379 ………. Monthly Cash Outlays
($208) ………. Tax Savings
($357) ………. Principal Amortization
$16 ………….. Opportunity Cost of Down Payment
$55 ………….. Maintenance and Replacement Reserves
$1,886 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$4,299 ………… Furnishing and Move-In Costs at 1% + $1,500
$4,299 ………… Closing Costs at 1% + $1,500
$2,701 ………… Interest Points at 1%
$9,797 ………… Down Payment
$21,096 ………. Total Cash Costs
$28,900 ………. Emergency Cash Reserves
$49,996 ………. Total Savings Needed