Banks grapple with second-mortgage troubles

Flickr photo by jonboy mitchell.

The pressure is all on second place.

Whether one calls it a second mortgage, second lien or home equity loan, the lenders who occupy the subordinate position in the debt stack on your home mortgage are finding out that being No. 2, quite frankly, sucks big time.

Back in the day, before 2007, when money was so cheap that even a grizzly bear wandering around the forest could get a mortgage for his cave, banks also were happy to extend home equity loans and lines of credit to single-family homeowners.

"Hey, Mr. Grizzly Bear, want to fix up that cave and make it a crib? Well, here's some Benjamins."

What's that old joke: You walk in one door of a bank empty-handed and out another with a toaster and home equity loan.

Since credit flowed like water, banks were equally happy to do an 80-20 loan, which was basically a first mortgage for 80 percent of the value of a home plus a home equity or second mortgage for the remaining 20 percent. Whoopee, no money down for the borrower.

Now it's time for banks to pay the piper. Here's the big problem: If the home value is underwater or the homeowners are having trouble paying bills, the holder of the second mortgage or home equity loan doesn't get paid back until after the holder of the first loan, which in those two scenarios almost never happens.

Those 80-20 loans by definition meant the loan-to-value was high, high, high, and now that home values have declined, collecting any money for the second-lien holder is slim at best.

If there is a HAMP (Home Affordable Modification Program) procedure or a short sale, the second-lien holder also gets wiped out. Needless to say, second-lien holders are in no rush to see loan modifications completed or jump into short sales, both of which would mean writing down the loans as full losses.

At most banks, home equity loans, no matter how precarious, for as long as possible are carried on the books at full value -- a bit of a fiction, but it does make the banks look better.

In March, Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, openly called for the major banks to start writing down second mortgages. His point being, reported the Wall Street Journal, was "the banks' reluctance to write down second mortgages is hurting efforts to reduce the first-lien mortgage balances of many borrowers who owe far more on their loans than the current value of their homes."

Indeed, one new change for the Obama administration's HAMP is that borrowers who get reduced payments on the first mortgage through HAMP would automatically get a break on the second lien as well.

Underneath all the politics, however, are some serious problems in regard to home equity loans: Delinquencies are rising very rapidly.

Shelley Leonard, a senior vice president of Consumer Lending Strategy at Lender Processing Services Inc. in Jacksonville, Fla., has been reading the home equity numbers as if they were tea leaves, and she doesn't like what she sees.

Historically, she said, delinquencies on home equity loans have been very low, but all that changed last year.

In 2005 and 2006, delinquency rates for home equity loans and home equity lines of credit remained under 1 percent. By the end of 2008, the delinquency rate for home equity loans crept above 2 percent. Then, over the course of 2009 those numbers vaulted to 5 percent, a major leap in percentage.

"Most of the gain was in a one-year period," Leonard reiterates. "That's a huge pick-up in delinquency."

The curve of home equity loan delinquencies mirrors that of the unemployment rate. Leonard suspects delinquencies will stay high as long as unemployment rates hover around 10 percent or climb higher.

As a result of home equity loan delinquencies, banks have taken some very large charge-offs. Net charge-off rates increased by 50 percent among the top five banks in 2009. Without naming names, Leonard said she knows one of the largest lenders of home equity loans took a $4 billion charge-off last year.

Behind the teller windows there's a lot of confusion. The home equity product more often than not is considered a consumer loan and not a mortgage, which means it falls into a different section of the bank.

"The challenge," Leonard said, "is that home equity is typically owned and managed in a different part of the bank from the mortgage loan silo. That means different systems, reporting, management, processes -- in short, different everything. It's become an ongoing challenge how the banks deal with home equity loans that are delinquent."

Even the consumer is confused.

It would be assumed that borrowers would come to the logical conclusion that if they could pay only one of two home loans, they should pay the first mortgage because that would maintain the home. However, the trend is exactly the opposite: Homeowners with cash-flow problems opt to not pay the first mortgage and continue to pay the second.

The only rationale for such behavior is that the payment on the second is lower because the balance is smaller and the homeowner can afford only to stay current with that loan. Unfortunately, it's the first mortgage that keeps you in the house. It doesn't matter if you remain current on the home equity loan; if you don't pay the first mortgage you will be staring into the heart of foreclosure.

The only good news in all of this, from the consumer standpoint anyway, is that origination volume has declined significantly, down 25 percent through the first three quarters of last year. That's mostly because rates are higher and criteria much more stringent.

Back in the day, banks would underwrite a home equity loan with no documentation, no appraisals, no nothing except an ability to sign on the dotted line. (Mr. Grizzly Bear had to leave a paw print.)

Today, the pendulum has swung fully to the other side. Now, the process and documentation to get a home equity loan is about as long and thorough as getting a mortgage. Perhaps, that's the way it should always have been.

Steve Bergsman is a freelance writer in Arizona and author of several books, including "After the Fall: Opportunities and Strategies for Real Estate Investing in the Coming Decade."

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