HELOCs and the Latest Pressure on U.S. Consumers

Charles Scharf, head of J.P. Morgan’s retail business:

Leaning on outside mortgage brokers for home-equity business was one of the biggest mistakes we’ve made. Those loans have performed worse than home-equity loans generated by J.P. Morgan.

The Prince, like many financial bloggers, has followed the plight of the increasingly burdened U.S. consumer for some time. (See this post, this post, this post, and this post for examples). Last week we got more important news that signifies that the U.S. consumer is overextended, with little access to more credit and will be forced to cut spending. The press (WSJ, HousingWire) and financial bloggers (Barry Ritholtz at The Big Picture, Calculated Risk) have commented on the default rates for Home Equity Line of Credit [HELOC] loans. From a lender's perspective, these loans are toxic because they are subordinate to the claims of the lender on the house. So if a homeowner can only afford to make their regular mortgage payment, and he does not make his HELOC payments, then this will negatively impact the homeowner's credit score, but none of their assets - especially the home - can be taken by the HELOC lender. HELOCs used to be taken out to finance home improvements or pay for high health bills. In recent years, with housing prices rising across the country, they were taken out to subsidize discretionary spending. Buy the hummer, take the vacation, get the plastic surgery, etc. and don’t worry because housing prices will keep rising and you’ll get to refinance your Option ARM once it is about to reset. We no longer live in that fantasy world and many consumers are overleveraged and barely making their payments. Or they are trying to decide which loans to default on, since they are unable to make payments on all the loans.

This is just the latest sign that the consumer in the U.S. is under serious pressure. The tightening of credit and the credit crisis have certainly contributed to the recession which the WSJ poll of economists confirmed. Yet, what will really decide the length and severity of this economic downturn will be the actions of U.S. consumers. Consumer confidence has been down. Consumer lending and mortgage lending are also way down which is making it increasingly difficult for the overlevered U.S. consumer to continue to consume beyond his or her income. HELOCs were just one of many instruments that consumers tapped into, driving the U.S. personal savings rate even lower. Investing in a home used to be a form of forced savings. With HELOCs that has ceased to be the case. Give the American consumer a dollar and he or she is going to spend two.

Now with incomes not rising and home values falling, it is becoming more and more difficult to keep consuming with little new consumer credit available. Plus, to all those homeowners under pressure to make their post-reset ARM mortgage payments and their home equity loan payments, don’t even think about selling your home and paying off your home equity loan, as recent reports show demand for homes is at a 5 month low.

But now The Prince is going to take the bait. He is going to bet against the U.S. consumer. Many may think this is folly but The Prince believes the consumer will not be able to spend the U.S. out of recession this time. Dropping consumer spending in the U.S. is going to take a toll on international markets obviously. Countries like China that are export economies and have not developed a large enough consumption base will be hit hardest by the American consumer with empty pockets and no access to new debt. Given the pressure the U.S. consumer is under, the technocrats in Beijing must be a bit apprehensive right now.

More excerpts from the WSJ article:

Other types of consumer loans also are souring, including credit cards and auto loans. But delinquent home-equity loans are rising faster, representing 12.5% of all delinquent loans in the fourth quarter at Bank of America Corp., the largest U.S. bank in stock-market value. That was up from 9.4% in last year’s first quarter, according to research firm SNL Financial...

Meanwhile, financial institutions are refusing to provide home-equity loans to homeowners whose residences are already weighed down by big mortgages in states like California and Florida where home values are falling fast.

"This product was meant to help people do construction on their house, [and] do debt consolidation — not to take out every last dollar of equity in their home to finance a different kind of lifestyle," Mr. Scharf said. J.P. Morgan is "rolling our changes back to represent that kind of product."

Here is an interesting article from HousingWire about Fitch downgrades related to HELOCs.

Want to know who lent the money for all these HELOCs? Take a look at these charts from Mortgage News Online.