The Economics of Second Liens

Ruth Simon has a huge piece in yesterday's WSJ on second liens: home equity loans and lines of credit which are junior to primary mortgages. These things can cause a lot of trouble for homeowners:

"The people in the first position will say, 'Until you get a deal with the second, why should I make a deal with you?'" says Iowa's Mr. Thompson. Second-mortgage holders are often reluctant to approve a short sale or deed in lieu of foreclosure that could wipe out their claims, he adds.

At the same time, the second-mortgage holders often reject offers of as much as $2,000 for loans they've already written off, just because the costs involved in evaluating the offer and releasing the borrower from the lien. So while a second lien might be worthless to the person who owns it, it can make life very difficult indeed for everybody else.

One thing that's interesting to me is that default rates on these second liens, which one might expect to be astronomical at this point, are in fact not all that high. Home equity loan default rates are at 4.65%, while default rates on home-equity lines of credit are only 2.01%. Economy.com estimates that total losses on $1.1 trillion of these loans might total $58 billion; reading the story, recovery values on these loans are negligible, which means that the economy.com estimate implies that eventually about 5.3% of the loans will have to be written off. Which is lower than I might have guessed.

In the mean time, it turns out that I was only half right when I said this week that "people have to max out their home equity lines before they default on them". Washington Mutual (WM) and Citigroup (C) are already unilaterally reducing the credit lines of borrowers whose credit scores have fallen or whose houses have dropped in value. What's more, Simon reports that "in some cases, servicers are telling borrowers they will take 10 cents on the dollar to settle their claim".

In other words, if you're going to need that money available in your home equity line of credit, you might think about tapping it now, before it disappears. In the worst-case scenario, you'll only need to pay 10% of it back.

Comments

[Rocktex:]

Great post!
A guy who really knows the tricks of ABS mechanism!
Thanks for updating my understanding on the current discount rate on junior liens.

2008 Jan 17 11:55 AM

[daver:]

Where are you getting your default rate data from? I would love to get a look at it.

2008 Jan 17 04:16 PM

[valuemanager03:]

OK recounting of the facts... until your last paragraph - which advocates people maxing out their line of credit in hopes of paying 10% back on it. That's not the 'worst-case' scenario. The worst-case is you lose the house (which is the only reason the 2nd lien holder would accept 10% or nothing) - and your credit is wrecked so you go back to renting for 7 years. The other scenario is that they stay in their home, and have to pay off 100% of the loan plus interest over time.

Losing the home may be the only option for stretched borrowers - but unfathomable to recommend anyone to do that and guarantee that they drown in debt. It's thinking like that which is reducing the countries financial smarts and wrecking families.

2008 Jan 18 10:22 AM

[Richard Shi...:]

Felix,

It may very well be prudent to draw against your HELOC if you anticipate needing the money and are worried, but implying that people should do it because they will only have to pay back 10% is a little mis-leading don't you think? In fact, if you do it with the intent to only pay back 10% it may be fraud. Rethink that statement.

2008 Jan 20 12:57 PM

[Rocktex:]

Rich,

Felix is just pointing out a very real real real reality which is getting popular in our society or economy. To me, he has done nothing to imply his position.

15 months ago, I loaned one of my credit cards to my sister-in-law. By using mine, her balance of $17,000 was fully transferred into mine at 3.99% interest. She would pay about $450, instead of almost $1,800 a month to her own. She continued to directly pay my credit card banker and she had appreciated my help until 3 months ago.

Now she is kind of regret to ask help from me when I read her words in between. She wished she could know the "smart" broker ( or the right approach) earlier who negotiated with her credit card creditors for her. She got a good deal to pay 10 cents on a dollar, paid off all the balance remaining on her credit cards and she paid mine off.

I have no idea what's going on for her to easily wipe out all credit debt and have a fresh new start. All I know is, since then, my wife has told me 3 times:
"What kind of world is this? I kept coaching my young sister to save. She should stop over-spending. She and her 3 daughters went to have a professional hair-stylist every week and has all kinds of impulsive purchases. I save my money to have mine and my daughters washing our hairs at home by ourselves. I don’t buy such those fancy, junky computer stuffs for my daughter. See, I didn’t buy my daughter a ipod when their 3 daughters have updated to the newest many times. Now my sister is joking at me and says: I am owing nothing now and you still owe a banker a mortgage. Why you have to save? Why don’t you go out to my hair-stylist as we did. When you have problem, you go to see my programmer. I can‘t stand her bragging her wisdom!"

Great systems we have created nowadays! I have to admit that time is changing and I don’t know most of things or see the logics behind them.

2008 Jan 23 12:29 PM