Will HELOCs Trigger a Banking Crisis?
After disregarding the looming home equity line of credit (HELOC) disaster for several years, Wall Street and media pundits have finally taken notice. Homeowners with HELOCs will soon see them convert to fully amortizing loans and will face a huge increase in their monthly payment. Banks have not set aside adequate reserves to cover a HELOC-driven crisis, which would impact even those investors in broadly diversified index funds.
Here is the problem in a nutshell: Over the next three years, roughly three million homeowners who either could not pay off their bubble-era HELOCs or were unable to refinance into a more affordable one will face soaring payments on these second liens.
Let's see how this problem could impact your clients.
How the HELOC bubble developed
In 2004, housing markets in major metros were on fire, fueled largely by swarms of speculators out to make their fortune. As underwriting standards collapsed, homeowners saw the value of their homes soar. Refinancing to cash-out the growing equity in their homes became irresistible. Banks were eager to accommodate.
This was done in one of three ways: refinance the first mortgage with a larger one; take out a HELOC; or refinance an existing HELOC with a bigger one. In each case, the borrower had money from the bank usable for any purpose.
Take a good look at this chart from Equifax that shows the number of HELOCs that were originated each quarter during the bubble years.
From the beginning of 2005 to the end of 2007, roughly 10.8 million HELOCs were originated. In the fourth quarter of 2005 alone, nearly $130 billion of HELOCs were issued. The average amount of a HELOC loan in those three months was more than $130,000.
When the sub-prime market collapsed in the spring of 2007, originations of HELOCs continued unabated for more than a year through the middle of 2008. According to Equifax, the total of outstanding HELOCs did not peak until late 2009 at $672 billion of cumulative issuance.
Some of these bubble-era HELOCs were taken out by homebuyers as so-called “piggy-back” second mortgages at the time of purchase. This enabled them to purchase a home with little or no down payment. However, the vast majority were originated after the home purchase – usually within two years.
Millions of homeowners were not content with taking out a single HELOC. Many refinanced their HELOCs – some more than once – to take advantage of rising home values and pry still more cash out of the house. California was the center of this HELOC madness. Between 2004 and 2006, roughly six million HELOCs were refinanced around the country.
HELOCs were encouraged and spurred on by lenders. In 2004, the FDIC reported that banks were charging non-use fees on HELOCs that were open but inactive. Some actually penalized homeowners for not borrowing more.
How a HELOC recast works
In the midst of this housing bubble, no one saw the potential danger posed by interest-only HELOCs, which would convert to a fully amortizing loan ten years later. After all, nearly everyone was convinced that home prices would continue rising.
To understand the danger of millions of bubble-era HELOCs recasting to a fully amortizing loan, I need to briefly explain HELOCs.
A HELOC is similar to a business line of credit. Using the residence as security, a homeowner was usually given a line of credit with a prescribed limit upon which the borrower could draw at any time. During the bubble years, some banks offered HELOCs where the available credit increased automatically as the equity in the house rose along with the home’s value.
For HELOCs originated during the bubble years, the homeowner had a period of anywhere from five to 10 years when funds could be drawn. During this time, the borrower was usually required to make only interest payments. The rate was adjusted monthly and was pegged to the prime rate.
At the end of the 10-year draw period, the loan converted to a fully amortizing one. The repayment period was typically between 10 and 20 years – usually 15 – at the end of which the HELOC had to be fully repaid.
HELOCs lured millions of homeowners between 2004 and 2007 because the interest-only monthly payment was not very much – often only a few hundred dollars. Why worry about the fact that in 10 years the loan would become fully amortizing when home values were soaring by double digits?