Home equity lines of credit are in resurgence, originations outpacing recent years without showing signs of slowing. Through June 2015 alone, new HELOCs rose almost 15% over comparable periods and exceeded the 2014’s dollar limit by 24%. Despite this growth, underwriting standards seem to remain high, with only 1.5% of all HELOCs during the period originated for subprime borrowers.[i]
However, it should surprise few that many pre-recession second-lien products were not written to today’s standards. Like today’s HELOCs, many from that era included a 10-year draw period during which borrowers pay only interest; thereafter, the borrowers begin making higher payments of principal and interest. Alternatively, some bubble-era loans used 10-year balloon provisions. Written between 2003 and 2007, many of these loans are either due or coming due for principal repayment leaving borrowers with expanded monthly payments or loan maturity.
These loans represent a significant rate of default on instruments that may have less security than realized. In a recent paper, the Federal Reserve Board noted that HELOCs that reach the end of their draw periods are significantly more likely to default, and HELOCs with balloon provisions are more likely to default.[ii] The paper found that borrowers with FICO scores below 725 and combined loan-to-value ratio above .8 were almost 9 percent more likely to default at end-of-draw, and 16 percent more likely to default at balloon payment.[iii] Banks, especially banks with a large portfolio of second lien products, should be preparing for this uptick in defaults as their bubble-era HELOCs balloon or end their draw periods
If the situation seems pressing, it is riskier for smaller community and regional banks. Moody’s reports that while larger banks carry significant exposure to bubble-era HELOCs in terms of sheer volume, smaller regional banks carry more of these second-position loans in proportion to other assets.[iv] Because the vast majority of these loans are second liens, banks carry them in portfolio rather than assign them to investment pools or GSEs, making the prospect of loss even greater.
Some consumers may be able to shoulder these payments while others with substantial equity may be able to refinance their loans into existing first mortgages, but many borrowers’ home values will be too low to refinance or sell the property; although home equity has rebounded, many areas across the Carolinas remain below bubble-era values that fueled these loans.
To address potential crush of defaults, in 2014 the OCC, NCUA, FDIC, and the Board of Governors of the Federal Reserve System issued a report aptly titled “Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods.”[v] In the guidance, the bureaus suggested that institutions work to reduce borrower “repayment shock” by providing ample notice of loan terms and using prudent loss mitigation and other workouts. Because of the diminished security afforded by their second lien position, this may be the only alternative for many banks.
When second position HELOCs default due to maturing or missed payments, the lack of equity in the collateral present lenders with limited options. In some regions—especially areas that saw significant speculation—LTV ratios on first liens may leave second liens “underwater,” limiting available workouts. The high number of modifications made since the financial crisis will exacerbate this problem because first liens will not leave as much equity as predicted over the second lien’s draw period, further diminishing equity held by second lien holders.
First lien defaults offer a great deal of options to resolve issues; borrowers may convey an interest in the property voluntarily (by a deed-in-lieu or short sale) or involuntarily (by foreclosure), or retain possession of the property and bring the loan current through modification, reinstatement, and payoff. Further, while federal and state programs created after 2008 allow some borrowers to cure default, most are limited to first liens.
While these options are theoretically available, their efficacy is limited in second lien defaults. Voluntary conveyances require that sufficient equity exist in the property to satisfy the first lien, second lien, and closing costs. Foreclosing in second position presents similar issues. Even first position creditors often fail to recover the total debt owed during foreclosure between declining property values, high costs, and long waits. In second position, a junior lien-holder forecloses “subject to” the first position mortgage that must be paid off to acquire clear title. While a second lien holder may use the threat of eviction after foreclosure to pressure borrowers to cure default, it is questionable that this will effectively force reinstatements.
The class of options in which the borrower retains possession of the property is not likely to be effective if the borrower faces a balloon payment. If the loan has matured and the borrower must pay the entire balance, traditional reinstatement will be unavailable. Moreover, alternative financial institutions are not likely to be available for refinancing if the loan is already in default.
Because second lien holders’ options are so restricted, loan modifications are likely to be the most attractive option. Loan modifications may include interest rate reductions, principal write-downs, or payment term extensions. Lenders dealing with a matured account may agree to freeze the equity line and extend the term of the loan so that the borrower can make more manageable payments and the bank can quickly deal with matured loans so that they do not accumulate on its balance sheet. Alternatively, if the borrower is unable to make the increased payment of principal and interest after the end of the draw period, a lender may decide to extend the term of the repayment schedule so that the borrower can remain current.
No matter the track that a bank decides to take, it will need to move quickly and efficiently if a large enough population of HELOCs begin to default or reach maturity. Lenders should identify loans particularly susceptible to default at maturity or reset, and attempt available loss-mitigation efforts. However, understanding the limitations of foreclosure and other remedies will help lenders move effectively to prevent impending losses.
[i] Kenneth R. Harney, Boom in Equity Allows Homeowners to Cash in and Even Cash out, The Washington Post, available at http://www.washingtonpost.com/realestate/boom-in-equity-allows-homeowners-to-cash-in-and-even-cash-out/2015/09/28/7cfb940c-660d-11e5-9223-70cb36460919_story.html.
[ii] Kathleen W. Johnson and Robert F. Sarama, End of the Line: Behavior of HELOC Borrowers Facing Payment Changes, 1, Federal Reserve Board, Washington D.C. (July 10, 2015) (available at http://www.federalreserve.gov/econresdata/feds/2015/files/2015073pap.pdf).
[iii] Id. at 17.
[iv]Kate Berry, ‘Payment Shock’ on HELOCs is a Looming Concern for Regional Banks, National Mortgage News (Jan. 22, 2014) (available at http://www.nationalmortgagenews.com/dailybriefing/payment-shock-on-helocs-a-looming-concern-for-regional-banks-1040806-1.html).
[v] Available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140701a1.pdf.