The Housing Chronicles Blog: Now home equity loans increasingly souring

Wednesday, March 12, 2008

Now home equity loans increasingly souring

A few years ago, when homeowners were using their home equity lines of credit and loans as "ATMs," it was great news for lenders who aggressively pushed them with lines as small as $10,000. For those lenders which largely avoided sub-prime loans -- such as Wells Fargo -- it also initially appeared much safer. Unfortunately, the potential loss models used by these lenders were wrong, and greatly underestimated default rates, and now home equity loans are going bad at a rate they just didn't anticipate. From a story in the Wall Street Journal:

When times were good, banks raked in billions of dollars in profit from home-equity loans, which allow borrowers to tap the accumulated value in their property with either a loan for a specific amount or a line of credit. As long as home prices were rising, lenders had little to worry about.

But falling home values are leaving banks with little or nothing to collect on many home-equity loans in case of default. Some stretched borrowers are keeping up with their mortgage and credit cards -- but not their home-equity loan.

The problems are already causing trouble for J.P. Morgan Chase & Co. and Wells Fargo & Co., and are expected to hit other large banks when first-quarter earnings results are released next month. The pain is likely to deepen through the rest of 2008, sapping capital levels and resulting in tighter lending standards as banks try to reduce their risk...

Projected losses from home-equity loans aren't anywhere close in size to the carnage caused by the declining value of mortgage-related securities. (Those losses now total more than $150 billion.) But the cascading delinquencies and charge-offs represent one more piece of the U.S. banking industry that is in big trouble after years of bumper-crop profits.

Originally used to finance home-improvement projects, borrowers increasingly turned to home-equity loans to pay off other debts, such as credit cards. Home-equity loans also became a popular way to fund vacations and expensive electronics -- or to buy a house with little or no money down without paying for private mortgage insurance.

Now, the steep decline in housing prices and weak economy are turning the home-equity business upside down. About 4.65% of fixed-rate home-equity loans were delinquent in the fourth quarter of 2007, up from 3.11% a year earlier, according to Equifax Inc. and Moody's

While banks can foreclose on a first-lien mortgage, lenders often have little recourse when trying to collect a delinquent home-equity loan, especially if another bank holds the primary mortgage. Banks holding home-equity loans generally can only seize the collateral -- a house -- after the mortgage is paid off.

When another bank holds the mortgage and the mortgage payments are current, the home-equity lender is effectively powerless to collect the debt.

Unfortunately for home-equity lenders, many borrowers understand that pecking order, concluding there are few repercussions if they stop making payments on their home-equity loan...

J.P. Morgan, Wells Fargo and other banks are now backing away from brokers to focus on home-equity loans offered through their own retail branches, where customers already have a relationship with the bank. Citigroup Inc. has slashed the number of home-equity loans originated through brokers by 90%.

Meanwhile, financial institutions are refusing to provide home-equity loans to homeowners whose residences are already weighed down by big mortgages in states like California and Florida where home values are falling fast.

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