For three years, I have been writing about the looming home equity line of credit (HELOC) disaster. The media pundits paid little attention. Then a Reuter’s article about HELOCs resetting to fully amortizing loans appeared last month. Finally some commentators took notice of the problem. Unfortunately, most pundits have tried to reassure their readers that it will not be much of a problem. One influential writer actually said that many of these HELOCs were already paid off, refinanced or extinguished because of foreclosures and short sales. Really? What nonsense.
HELOC Madness Revisited
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! Here is a real example of the insanity that gripped the nation – especially in California – during the bubble years. It comes from a 2010 post on the IrvineHousingBlog in California:
“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.”
Much of the impetus for shoveling out HELOCs came from the banks. The FDIC reported in 2004 that banks were charging nonuse fees on HELOCs that were open but inactive. They actually penalized homeowners for not borrowing still more.
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
To see the danger of a HELOC reset to the borrower, you need to understand what a HELOC is. 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.
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: 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. 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.
Will HELOC Defaults Soar After The Resets?
What concerns me is the coming delinquency rate of bubble era HELOCs which will be resetting. Those HELOCs originated after 2009 don’t bother me at all. Keep in mind that there were very few standards for bubble era HELOCs. The interest rate was almost always tied to the prime rate. The percentage over the prime rate was known as the margin. The crazy thing is that some lenders were so anxious to dole out HELOCs that they would sometimes offer a negative margin. This meant that the HELOC interest rate was actually below the prime rate. That is completely insane, right? Some unscrupulous lenders would offer a teaser rate for up to six months. Then the HELOC rate would reset much higher without even notifying the borrower. So their rate could jump from the 3% teaser to 9% or higher. Some of these lenders did not even explain that the loan became fully amortizing at the end of the ten year draw period. I have no doubt that there are HELOC borrowers from the bubble years who do not yet know that their loan will soon reset to full amortization. An important paper written by researchers at the NY Federal Reserve Bank in 2012 provides some extremely crucial data on HELOC delinquencies. The following graph from that study shows us some very essential information.
This graph shows us the delinquency rate of HELOCs based on the year of their origination. Clearly, the delinquency rates are highest for the two years 2006 and 2007. The graph is important because it tells us that the delinquency rate for HELOCs originated during the bubble era is much higher than the overall 5% rate reported by some of the “too-big-to-fail” banks for their entire HELOC portfolio. Actually, the graph reveals even more than that. The different colored lines give us the delinquency rate based upon how long after the first lien the HELOC was originated. You can see that the highest delinquency rate was for piggy back HELOCs taken out at the same time as the first mortgage. The delinquency rate declines as the time between the first mortgage and the HELOC increases. The important point to keep in mind is this: Delinquency rates for those 2006 and 2007 HELOCs where the first mortgage had been originated no early than 2006 were extremely high – greater than 15%. When the 2004 HELOCs begin to reset in January, the payment shock for the borrowers will be huge. I am confident that many of them will see their monthly payment double and even triple. This is most likely for the California HELOCs. Remember, almost 40% of all bubble era HELOCs were written in California. How you would react if you were that borrower and your home was considerably underwater. Would you continue making your monthly HELOC payment or would you stop paying? The temptation to keep your first mortgage current but default on the HELOC will be very great. Clearly, we do not know for sure what the delinquency rate will be for HELOC borrowers whose loans reset. Yet we are beginning to get some preliminary evidence. The Reuter’s article I referred to at the beginning of this article cited Bank of America which declared that 9% of their HELOCs which had already reset were delinquent. What are we certain of? First, HELOC originations soared throughout 2004. The total for all of 2004 was much higher than the previous record number in 2003. So I am confident that the number of HELOCs resetting in 2014 will be much higher than this year. We also know that the peak year for HELOC originations was 2005 – 4.5 million. Although quite a large number of them were actually refinanced into still larger HELOCs – especially in California – I am sure that the number of HELOCs resetting in 2015 will far surpass next year’s total. We also know that in 2006, HELOC originations declined only slightly from the record of 2005. Data from the NY Federal Reserve Bank shows that the delinquency rate for 2006 HELOCs has been much higher than for those from 2005. Part of that is due to the fact that home prices were generally higher that year and therefore the 2006 HELOC properties are more underwater. 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.