For the past four years, I have written extensively about the housing bubble and its collapse. I tried to describe the total madness of bubble-era home equity lines of credit (HELOC) and to warn about the disaster that is almost certain to come.

Recently, the media has begun to look at the potential problems with these outstanding HELOCs. Their focus has been on the thorny issue of HELOCs originated during the bubble years from 2004 to 2007 that have begun to convert into fully amortizing loans.

On July 1, the major regulatory agencies issued guidance for financial institutions servicing HELOCs. They said that, to avoid defaults, it’s better for borrowers and institutions to work together when the borrowers are suffering financial difficulties.

The Bubble-Era Madness
Let me describe the enormity of the problem that these servicers face. In the bubble era, the payments for HELOCs were normally interest-only during the draw period of 10 years. The interest rate was tied to the prime rate and adjusted up or down. At the end of draw periods, the loan resets into a fully amortizing loan with a pay-down period of 15 to 20 years.

When the loan converts, monthly payments often double or triple. Figure 1 from the credit reporting firm Equifax shows us what is coming for these borrowers.

Bubble-era HELOCs were loans originated during the speculative madness from 2004 to 2007. Most of the first mortgages taken out by these borrowers required little or no down payment. Hence, millions of these properties are still underwater.


 

Because many of these borrowers may be experiencing financial difficulties, the guidance from agencies such as the Federal Reserve System Board of Governors, the FDIC and other bodies recommends establishing modification programs which are “consistent with the nature of the borrower’s hardship, have sustainable payment requirements, and promote orderly, systematic repayments of amount owed,” says a joint statement from the agencies.

Fearful of massive delinquencies, the regulators insisted that the servicers “provide payment terms that are sustainable and avoid unnecessary payment shock.” However, they also wanted to avoid a repeat of the mess caused by interest-only HELOCs and first mortgages. So they strongly urged servicers to “avoid modifications that do not amortize principal in an orderly and timely fashion.”

That sounds sensible. Unfortunately, the goal of avoiding unnecessary defaults conflicts with the insistence that the terms amortize the loan over a reasonable period. The Equifax chart makes it clear how much additional burden a reset to a fully amortizing loan will place on these homeowners. Between now and 2017, the average payment increase will grow each year, even if rates do not rise.

It is useful to put yourself in the shoes of a typical borrower whose HELOC is about to reset. Assume you purchased a home in California for $500,000 in early 2005—not at all unusual. Millions of bubble-era HELOCs were taken out in that state alone. Because home prices were soaring, the banks encouraged you to take out a HELOC for $100,000. You would only have to pay interest on it for 10 years. You figured that by then the house would be worth much more than you paid. It was too good a deal to pass up.

You put very little down when you bought the home, which was customary during these years. Your HELOC interest rate was set at 2% over the prime rate. Although rates were rising in 2005 and 2006, you were saved by the Fed’s efforts to push rates down after the credit collapse. Because the prime rate has been declining, your monthly HELOC payments actually went down. With today’s prime rate of 3.5%, you are paying only 5.5%—or roughly $458 each month. Fortunately, you’ve been able to handle that without too much difficulty.

But now, your HELOC servicer notifies you that the reset is coming in six months. Uh-oh! You had totally forgotten about that. With a reset to a 5.5% loan that fully amortizes over 15 years, your payment will soar to $817. That hurts!

You respond to the servicer’s help line and explain that this $359 per month increase would be very burdensome to you. Politely, you are informed that the best they can do is lower your rate to 3% for the next five years, which would reduce the payment jump to only $232.

Now you have some hard thinking to do. Because you bought very close to the peak of the housing market, you believe your home is still underwater. Do you take a chance that your local housing market will strengthen and allow you to eventually rebuild some equity? You hadn’t given that any thought when you bought the house.

However, you have noticed that there are now lots of homes on the market in California and sales have slowed. Prices seem to be weakening also. What if that continues? You have read about how the market has been supported by all those cash buyers, but they have pulled back recently. What if that continues? Who will buy your house? You have noticed that couples in their 20s complain that they cannot afford to purchase a home.

Suddenly it hits you. You realize that your lofty price expectations in 2005 were a mere fantasy. Unfortunately, you are stuck with the awful burden of decisions you made that year.

You’ve read that Wall Street believes the worst is over and the housing market is “recovering.” Your gut tells you otherwise, so you ask yourself this question: Again, if this optimism is misplaced, what will happen to my financial situation? Do I really want to continue paying off these two burdensome mortgages for the next 15 years?

May I suggest that millions of homeowners will be asking these questions over the next couple of years? Do you think that mortgage servicers or Wall Street analysts have any idea what percentage of HELOC borrowers from the bubble years will decide to default? I doubt it.

However, we do have a good sense of what might be coming. A HELOC that converts into a fully amortizing loan becomes very similar to a home equity installment loan (HEIL). These are fully amortizing second liens collateralized by the property and have a fixed monthly payment. HEILs were very popular until the HELOC madness began in 2004.

How have they fared during the post-collapse period? Not well at all. According to Equifax, there was roughly $275 billion in outstanding HEILs in March 2008. That figure plunged by half to $134 billion as of April 2014.

Why? Have 50% of all the outstanding HEILs in 2008 been written off by the lenders? No. Some were consolidated and rolled into first mortgages when the homeowners refinanced. Based on Freddie Mac figures, this amounts to roughly $60 billion. This leaves about $80 billion on which borrowers defaulted and which has been written off by lenders.

Why have these loans done so poorly? Because interest rates on bubble-era HEILs were much higher than the HELOC rates—typically 7% to 9%. Also, as amortizing loans, HEILs had much higher monthly payments than the interest-only HELOCs did. So borrowers defaulted by the millions. And because these were second liens, the lenders could do little else except write them off.

Does that mean the worst is over for outstanding HEILs? No. The Federal Reserve Bank of New York reported that as late as mid-2012 more than 9% of all outstanding HEILs were seriously delinquent. That is much higher than the delinquency rate for HELOCs.

I suggest that because a HEIL is so similar to a HELOC, which converts into a fully amortizing loan, it is very likely that default rates for resetting HELOCs could be as bad as the track record for bubble-era HEILs or even worse.

Keep in mind that the outstanding amount in HELOCs is much larger than that of HEILs. As of July 2014, roughly $480 billion of HELOCs is still on the books of lenders. That is a truly sobering thought.

My Advice to You
I seriously doubt that the servicers can come up with a HELOC modification program that meets the requirements of the regulators’ guidelines. Perhaps servicers could prevent “unnecessary defaults” if they decided to continue interest-only payments indefinitely. However, the guidelines explicitly rule that out.

There are still roughly 10.2 million HELOCs outstanding, according to Equifax. You must keep in mind that the vast majority were originated during the bubble years. When none of the regulatory agencies anticipated the bubble’s collapse, why should we expect them to find a way out of this mess? I don’t.
How does this affect your clients? First, many probably own an expensive home and one or more investment properties. I gave a presentation three years ago after which an attendee came up to me and asked what she should do about her five underwater investment properties. You will probably have many of your clients ask similar questions over the next year.

You probably also have clients who own shares in mortgage REITs or hedge funds heavily invested in mortgage-backed securities. They are betting on a continued recovery in housing markets. It is a much bigger gamble than they realize. I have written extensively about the total collapse in mortgage REIT share prices in 2008 and 2009, and if you are advising your clients to assume that this will not happen again, it may not be prudent advice.

In January, I gave the closing presentation at Institutional Investor’s Risk & Liquidity forum in Manhattan. My topic was “The Wisdom of Knowing When to Sell.” Wall Street does not teach that to investors. Yet it is indispensable for every investor, regardless of the assets in their portfolio.

You will probably agree with me that the old buy-and-hold strategy of years past is very dangerous in this QE world. What should prudent investment advisors recommend that their clients do? Didn’t prudence require them to advise selling real estate-related assets in 2005 and 2006 before the collapse began? I suspect that relatively few gave such wise advice.

As I see it, we are again at the precipice looking over a cliff. If you think I am exaggerating, go to my article archives at Realclearmarkets.com or at dshort.com and read several of them. Can you or your clients afford to disregard the warnings?

Having followed real estate markets closely for many years, I was astounded at how long real estate prices were able to rise before the collapse finally began in late 2006. I have also been amazed at how the “kick-the-can-down-the-road” strategy has lulled us into a dangerous complacency and a belief that the coast is clear.

My advice for you and your clients is to assume the worst and plan accordingly. The conventional wisdom now is that going into cash is a loser’s game. May I ask why? Institutional investors would love to have moved heavily into cash before the 2008-2009 crash.

There is a time to buy, a time to hold and a time to sell. My analysis tells me that this is the time to sell real estate assets of all kinds. 

Keith Jurow  is a real estate analyst who has been writing in-depth articles about housing and mortgage markets for more than four years. His new subscription report—Capital Preservation Real Estate Report—launched a little over a year ago.