Banks Using Leverage to Force Home Equity Repayments

The Wall Street Journal's (3/6/08) "Some Borrowers Hit New Snag In Refinancing" discusses efforts by Bank of America (BAC), IndyMac (IMB), National City (NCC) and Wells Fargo (WFC) to hold first mortgage refinancing hostage to their home equity loans and lines of credit. Their second lien position would move to first unless they subordinate to the new first mortgage. The banks are using their leverage to force borrowers to either repay their home equity loans and lines, or reduce the existing lines.

The WSJ gives examples of banks refusing to subordinate for borrowers with strong credit to refinance. The borrowers would get a new first mortgage with a lower interest rate and monthly payment, leaving more money available to pay the home equity loan. You would think that the banks would enthusiastically embrace this. But, it is more important for the banks to reduce their exposure to second liens. When home equity line of credit [HELOC] securitizations reach a certain delinquency level, banks are no longer reimbursed for HELOC advances to borrowers.

Previously, in "Power of 2nd Place", I spoke about banks using second liens to block short sales. (Short sales allow the property to be sold at less than the mortgage balance.) The first mortgage holder must negotiate compensation for the second lien holder in order to proceed and grant the new buyer a clean title. The same would be true in a "short" refinancing.

Home equity products differ from first mortgages in that they generally have recourse beyond the property. While it is often not practical to foreclosure on a home equity loan, the banks can pursue other assets. Just because banks have written second mortgages down to zero doesn't mean they cannot extract value from them.

Disclosure: Author is long BAC, IMB, NCC and WFC.

Comments

[erniem:]

I'd do the same thing. If they can't handle the mortgage.......

And the scenario is, of course, ARM first note, and then a HEL to squeeze "equity" out of the carcass before it rots. The mortgage crisis today owes equal parts of blame to owners and lenders, who colluded in an orgasm of greed and avarice.

2008 Mar 07 08:37 AM

[Kostya Tszy...:]

I have a bit of experience in this game...on both sides of the coin. Friends and enemies are made rather quickly.
It always reminded me of Nash's game theory.

2008 Mar 07 09:20 AM

[Malkiel:]

If "borrowers with strong credit" are the ones doing the refinancing then they are not "subprime" borrowers, are not the intended targets of bailout, and probably only took on an ARM in order to milk equity. They should be forced to clean up their second liens and outstanding balances in exchange for the consideration they're getting. At the end of it all they're getting to continue living in some of America's most exclusive or even luxurious housing in some of the most desirable locations. Privilege has its price...

2008 Mar 07 11:08 AM

[Anonymous i...:]

Its a bank's right to refuse to subordinate an existing HELOC to a new first mortgage. But, you can't automatically assume that someone is refinancing a first mortgage because they can't handle the current mortgage payment. People refinance for all kinds of reasons, including that one. Sometimes, they are just restructiring their personal debt, getting equity out (in the form of a long term, stable debt) to send their kids to college, or simply taking advantage of a better rate or term than what they've got on their current mortgage - and the banks dont have to have any reason or justification, whatsover, to refuse to subordinate an existing HELOC to a new mortgage. This is what the WSJ article eludes to - that its happening to people who would normally be considered "well qualified" to have them resubordinated. That, in an of itself, suggests that these are not people who are incapable of making their current mortgage payment.

Frankly, this WSJ article just illustrates a small example of what concerns me about the economimc stimulus package, the FNMA/FHLMC and FHA initiatives to help with this and that, ongoing rate cuts by the Fed that make it more attractive for banks to lend to consumers and so forth. None of these things force the banks - who are notoriously greedy - to go ahead and do, anything. They just make it more profitable to do so, when and if they decide to cooperate ... I mean, the fact that consumers who have HELOCS that are tied to Prime Rate have had their rates (and subsequently, their payments) go down over the last several months, is nothing more than the result of the terms of those HELOC(s) being tied to it. Its not a reflection or illustration of a the banks' generosity, concern and goodwill toward the consumer, in a time where we are facing a possible recession and in the midst of dealing with a consistently weakening dollar.

2008 Mar 07 11:53 AM

[I should know:]

This is just another example of “you’re damned if you do and you’re damned of you don’t”. The mortgage lending institutions are being chastised and demonized because they expanded their guidelines and approved borrowers for mortgages that would “normally” not be approved for a mortgage. Now the lenders are being demonized for more prudent underwriting and guidelines for borrowers who are refinancing their first mortgage with another lender and are asking that the current lender who is in second place to stay in second place without reviewing the current circumstances. Let’s say the second mortgage holder originally granted a $70,000 HELOC on a property appraised for $300,000 that had a first mortgage of $200,000. The first mortgage exposure is less than 67% of the appraised value and the second is 23%; a combined LTV of 90%, marginally risky for the HELOC lender, very little risk for the first mortgage lender. Now let’s say that the property owner wants to refinance the first mortgage and have the second subordinated. The home’s current market value is down a little, about 5% or $285,000. The first mortgage holder’s exposure is the first 70% of the value (very little risk) and the second mortgage holder’s exposure is the next 25% of the value; a combined LTV of almost 95%. Now you’re in to high risk territory. IF the house goes in to foreclosure and is sold after foreclosure expenses at 85% (more likely 65% to 75%) the first mortgage holder gets paid in-full and the second mortgage holder gets back about $32,000, about 46% what is due. Who’s carrying the risk? It sure isn’t the lender in first position; it sure is lender number two who gleefully subordinated the HELOC. Another bad decision for the mean old mortgage lender who won’t lend money to every “Tom, Dick, and Harry”. Frankly, I’m glad lenders are tightening credit and approval guidelines and standards. If YOU were the lender in second position holding the vast majority of the exposure and risk, what would you be doing?

2008 Mar 08 08:52 AM

[distinguish...:]

Your article isn't sufficiently clear as to whom it is that makes / pays the reimbursement (nor why it is called a reimbursement, which makes it sound like some government payment to banks) mentioned in:
"When HELOC securitizations reach a certain delinquency level, banks are no longer reimbursed for HELOC advances to borrowers."
Dr.LKR.

2008 Mar 08 11:06 AM

[notsosmart:]

who can define "well qualified". some pulled equity out of homes for vacations or high priced cars that should never have been drivn by them.ETC,ETC.my house is paid,i drive a 17 yr old car & so far my investment income averages about 8-9%.very little was learned from thesavings & loan scandal of a few years ago.i leared.

2008 Mar 08 11:25 AM

[Wall Street...:]

Dr.LKR. (thedoctor): Clarification on “When home equity line of credit [HELOC] securitizations reach a certain delinquency level, banks are no longer reimbursed for HELOC advances to borrowers.”

Before the predetermined delinquency limit for the trust is hit; every time the bank or mortgage servicer provides an advance to their HELOC customer, the bank or mortgage servicer is reimbursed an equal amount from the securitization trust.

2008 Mar 08 08:56 PM

[David Podgu...:]

this practice shows which lenders will come out on top at the end of this "crisis" and which will be investigated for making it worse.

holding people that are hurting hostage rather than trying to work with them is a practice that will definitely end up being looked into by the Fed.

I believe that state Banking regulators should work now to stem this practice. getting a HELOC these days is tough enough as it is, but when the lenders will not subordinate or freeze the account entirely, they are just hurting the consumer.

alas ... banks really aren't interested in the consumer since they really are only accountable to their shareholders

2008 Mar 09 05:55 PM

[Rod Everson:]

The post by "I should know" frames the issue well. While it seems to make sense to prefer that the homeowner should be allowed to get into a more secure financial situation, it's also true that circumstances have changed and the holder of the second mortgage (the HELOC) is in a more precarious position than when the original loan was made.

By denying the subordination request, the holder of the second gains negotiating power and might be able to improve his position somewhat (via a higher rate, shifting some of the second to the first, outright reduction of the balance on the second, etc.) and he is acting within his rights in attempting to do so.

In any case, the borrower signed documents enabling this situation in the first place. Contracts do matter, so far anyway.

2008 Mar 11 12:49 PM

[Frank V:]

I have an interest only first and an interest only second. I asked to refi to one loan that was fully amortizing and and would gladly pay PMI. I have a credit score above 680 and the loan would be full doc. They said no unless I lower the LTV ( the property value has dropped a bit ). Thanks a lot, I can see where banks want to help!

2008 Mar 11 05:38 PM

[Really Frus...:]

I'm in similar same situation as Frank. We don't live a lavish life, it's very basic, go to work, and are happy just spending time in our yard and maintaining our gardens-we don't travel.

We entered into a first and second interest only loan as that is all we could get with a lower credit score due to my husbands back child support (which is on a repayment plan). As our economy deteriorates and it is more difficult keeping up with payments we need assistance so we don't lose everything we have worked so hard for. We have weighed the option of selling but the value of our home has dropped $20,000 in one year. We have found a lender that will give us a 30 year fixed FHA loan with a lower interest rate. Our current mortgage lender has denied the Subordination therefore leaving us no other option but to bail out and allow a foreclosure. Will our current mortage lender benefit from this? NO! The value of the home is not worth the amount we owe.

2008 Jun 10 08:03 PM

[Mike J:]

With all of the "superior logic" that went into creating the fundamentals of the mortgage industry and associated secondary market, it boggles me that people rely upon similar worldly means by which to come through the crisis. After nearly ten years at the same company, I was laid off, and eventually stopped paying my mortgage. My family's home was scheduled to be sold at auction on a Tuesday; the day before, on Monday, a modification was approved, and the sale was stopped. By the grace and covenant of God, who does not desire for you to be homeless (people will attempt to blow this statement out of the water, but read up on the covenant of God first--Galatians 3&4; Genesis 17:7; Hebrews 6:13-20; Deteronomy 28), my family still has our home. Worldly thinking--greed, envy, mismanagement, lies--got many people into this situation. God wants to get them out; it is not His will for people to stuggle like this. People need to allow Him to make miracles happen, per His promises to Abraham and us.

2008 Jul 13 10:06 PM