In a previous REAL ESTATE CHANNEL article, I discussed the madness of borrowing through home equity lines of credit (HELOC) during the bubble years. Now is a good time to take an in-depth look at these second liens and the dangers they pose for the housing market and the large banks.
A Brief Explanation of HELOCs
A HELOC is quite 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 given a line of credit with a prescribed limit upon which the borrower can draw at any time.
The homeowner receives a draw period of anywhere from five to ten years when funds can be drawn. During this draw period, the borrower is usually required to pay interest only. The rate is adjusted monthly and is pegged to the prime rate. The repayment period is typically ten to twenty years. The monthly principal payment is usually the outstanding balance at the end of the draw period divided by the number of months in the repayment period.
Because qualifying standards were based primarily on the equity in the home, HELOCs became nearly irresistible in those states where prices were rising rapidly in 2004-2005. Homeowners discovered that their home had actually become a money tree which they could shake almost at will.
Madness of HELOC Lending During the Bubble Years
Aided by the seemingly limitless desire of banks to lend money, homeowners opened an incredible number of HELOCs during the bubble years of 2004-2006.
Nowhere was the madness of HELOC borrowing more astounding than in California. During the two key years of 2004 and 2005, a total of 1.43 million HELOCs were originated in California just for the purchase of homes according to figures received from CoreLogic.
Wait a minute, you say. That's more than the total number of homes sold in California during these years. Correct. A total of 1.25 million existing single family homes were purchased in California in 2004-2005 according to the California Association of Realtors.
At first, these California HELOC numbers may be a little puzzling. However, they make sense when you consider the speculative mania that occurred during the bubble years. In my earlier REAL ESTATE CHANNEL article about investor speculation, there was an example of caravans filled with out-of-state speculators looking to buy investment properties in Austin. One was a young Californian who had sold a few of his Phoenix investment properties so he could roll his profits into Austin homes.
This is what thousands of HELOCs were used for in California. 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 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.
When the housing market finally collapsed in 2007, banks were slow to curtail their HELOC lending. Equifax reported that 4.6 million new HELOCs were originated in 2007-2008.
California was different. From a peak of nearly 92,000 in June 2005, purchase HELOCs had plunged to a mere 563 by December 2008. In March of this year, only 22 were closed throughout all of California. That's right - twenty-two. Unfortunately, the damage had already been done.
Massive Problem of Underwater Homeowners with HELOCs
Another earlier REAL ESTATE CHANNEL article cited an Equifax report that 13.6 million HELOCs were outstanding in September 2009. A phone update with Equifax on August 31, 2010 clarified that since September 2008, banks have reduced available lines of credit for HELOC users by $122 billion. Notwithstanding this tightening, there was still a total of $649 billion outstanding HELOC debt nationwide in July 2010 and 13.2 million HELOCs.
Although the average outstanding HELOC balance is roughly $49,000 now, this figure hides the real problem. The average HELOC written in California for residential purchase in 2004 was $150,000 and in 2005 was $139,000. Hundreds of thousands of Californians took out a HELOC and then refinanced it several times to pull cash out from their growing equity. Here is an example of how it worked from a recent post on IrvineHousingBlog:
"The original sales price is not clear from my records, but it looks as if the buyers paid about $1,200,000 in 1997. There was a $900,000 loan which I assume was 80% of the total purchase price. The original owners were a couple, and after the point where only the wife is on title in 2004 -- presumably after a divorce -- the HELOC abuse became truly remarkable.
On 3/11/2004 the wife appears alone on title, and the first mortgage is $999,800.
On 8/30/2004 she refinanced with a $1,000,000 first mortgage.
On 12/28/2005 she refinanced with a $2,170,000 first mortgage.
On 2/1/2006 she got a HELOC for $250,000.
On 8/22/2006 she refinanced with an Option ARM for $2,500,000.
On 11/15/2006 she opened a HELOC for $490,000.
On 8/1/2007 she refinanced with another Option ARM for $3,225,000.
On 10/22/2007 she opened a HELOC for $500,000.
Total property debt is $3,725,000.
Total mortgage equity withdrawal is $2,725,200 during a four-year stretch."
Of the 13.2 million outstanding HELOCs, it is not far-fetched to estimate that at least 95% of these borrowers are in "negative equity" when you add the first and second liens together. For California, the figure could be 98%.
The following situation, described on the advice blog, bills.com in November 2009, is quite common in California:
"I purchased my home in CA for $300K. I then refinanced in 2001 and pulled money out for upgrading the home - new home loan $480K. I refinanced again for a better interest rate (non-adjustable). In 2006, I opened a home equity line of credit to upgrade again (build a pool, etc.). My home equity line of credit is now at $248K. Total loans on home are today about $718K. I am in good standing with loan modification with the first but cannot afford to pay home equity line of credit."
You're probably wondering why the HELOC lender let the homeowner run up a loan balance of $248,000, especially since it was not even taken out until 2006 when home prices were already leveling off. Unlike first mortgages the vast majority of which were sold by lenders and securitized during the bubble years, second liens were kept on the balance sheet of the banks. But this was California where prices went in only one direction - up.
A sadder situation described on the same blog is that of a 62 year old California homeowner who purchased his house in 1975 for $38,000. He refinanced "3-4 times over the years" mainly for "personal use - cars, etc." The first lien is now $365,000. He opened the HELOC seven years ago and continually tapped into it. The outstanding balance on it had climbed to $265,000. Because the condo had plunged in value to only $350,000, this homeowner stopped making payments on the first mortgage four months earlier.
Nationwide, a growing number of "underwater" homeowners have already stopped paying on their first mortgage and many have halted payments on both the first and the HELOC. Some lenders are going after defaulting HELOC borrowers by asking a court to garnish the borrower's wages. Borrowers in this situation often pursue the option of filing for a Chapter 13 bankruptcy in which the judge has the option to reclassify the HELOC as an unsecured loan.
We need to keep in mind that HELOC loans are overwhelmingly second liens which stand in line behind the first mortgage in case of foreclosure. If a bank forecloses on the first mortgage of an underwater homeowner, the HELOC second lien holder is essentially wiped out. The HELOC becomes an unsecured loan and it is up to the lender to decide whether or not to try to work out some kind of deal with the borrower for a portion of the remaining balance.
In short sale situations where there is a first mortgage and a HELOC, the realtor often tries to negotiate with the HELOC holder to work out a discounted payoff on the HELOC that is acceptable. The HELOC lender has no leverage because if a foreclosure is pursued by the first mortgage holder, the HELOC is basically worthless.
One Texas realtor's website, shortsalestexas.net, actually provides advice on how to pursue these negotiations. He suggests offering 3% of the HELOC balance to the lender. If the lender balks, he counsels realtors not to offer any more than 5% of the balance. He claims that in his experience most lenders have accepted his initial offer.
Sea of Troubles Facing "Too Big to Fail" Banks
In mid-April of this year, the website housingwatch.com as well as others posted a summary of the sobering report issued by the research firm, CreditSights. The report warned that HELOCs were the next big problem for the large "too big to fail" banks.
Let's see why they might issue such a warning. Remember, there are currently $649 billion in HELOC loans outstanding. Three of the "too big to fail' banks reported a total of $321 billion in outstanding HELOC loans on their balance sheet in the second quarter 2010 Call Reports which came out a few weeks ago.
Does this mean that these banks have $321 billion in potentially worthless loans? You judge. On August 12, I spoke at length with the owner of a Utah-based firm whose business is buying HELOC and home equity loans from the large banks. His business is divided between secured second liens where the first mortgagee had not yet foreclosed and unsecured second liens in which the lender had already foreclosed.
It is a risky business because the borrowers have already defaulted and the bank has written off the debt. Unlike many other second lien debt collectors who have gone out of business, he has survived by buying only 1% of all the defaulted loans that are offered to him by the banks. In effect, he becomes the banker and his job is to work out new terms on a loan which is a small fraction of the original debt. The key to his success is coming up with terms that the borrower is willing to accept and make regular payments on.
Because the loan amount which these borrowers are willing to agree to is relatively low, this business owner made it clear that he will not pay much for a second lien regardless of the size of the outstanding loan balance. For unsecured second liens where the property has already been foreclosed, he will not pay more than $500 no matter what the size of the outstanding debt.
What this tells me is that most of the $321 billion in HELOCs loans owned by the "too big to fail" banks are probably worth no more than a few thousand dollars each if the borrower defaults. A growing number of HELOCs where the property has already been foreclosed and repossessed by the banks are worth perhaps $500 each.
It sounds incredible, doesn't it? Clearly, banks are recognizing the seriousness of the HELOC problem. According to an August 11 article published in the New York Times, banks charged off $19.9 billion of HELOCs in 2009 and another $7.88 billion in this year's first quarter. Those three "too big to fail banks" together charged off a total of $6.62 billion in HELOCs in the first half of 2010 as reported in their second quarter Call Reports.
The enormity of the HELOC disaster is well-illustrated by the example of a Phoenix attorney cited in that August New York Times article. He had been retained by nearly 300 new clients in the past year who were planning to walk away from their properties even though they could afford to pay the first mortgage - so-called "strategic defaulters." They all had home equity loans which ranged from $50,000 to $150,000.
Only 5% of these clients said they would continue paying their home equity loans no matter what. The other 85% of them said they would default on the second lien and worry about it "only if and when they were forced to."
It is truly worrisome to contemplate what could happen if this attitude continues to spread among the millions of underwater HELOC borrowers.