Second-Mortgage Misery

by Robbie Whelan
Wednesday, June 8, 2011

Nearly 40% Who Borrowed Against Homes Are Underwater

Almost 40% of homeowners who took out second mortgages—extracting cash from their residences to cover everything from vacations to medical bills—are underwater on their loans, more than twice the rate of owners who didn’t take out such loans.

The finding, in a report released Tuesday by real-estate data firm CoreLogic Inc. (NYSE: CLGX – News), illustrates the consequences of easy borrowing amid the housing boom’s inflated prices. The report says 38% of borrowers who took cash out of their residences using home-equity loans are underwater, or owe more than their home is worth. By contrast, 18% of borrowers who don’t have these loans were underwater.

It’s not clear how much cash withdrawn from homes during the boom was used to acquire luxuries such as expensive automobiles, and how much went to basic necessities, including tuition expenses, or renovations intended to raise a property’s value.

What is clear is that home-equity loans, which account for about 10% of the U.S. mortgage market, have been a headache for homeowners and lenders alike. Second mortgages refer to any loan taken out on a property that is subordinate to the first mortgage, and include home-equity loans or lines of credit.

Second mortgages are weighing on a fitful recovery, in which housing has figured as particularly weak spot. The S&P/Case-Shiller National Index last week showed that home prices tumbled 4.2% nationwide in the first quarter, its third straight quarter of price declines after a modest recovery in early 2010. Nationwide, prices have fallen 34% since their peak in 2006. The inventory of unsold homes will take 9.2 months to sell, the National Association of Realtors said recently, about 50% higher than what is considered a healthy level.

“When a homeowner’s house is underwater, “it’s harder to get a credit card or a car loan, you can’t put your home up for a small business loan,” said Mark Zandi, chief economist at Moody’s Analytics. “There are all sorts of little, pernicious effects that you don’t necessarily think about.”

CoreLogic found that borrowers with second mortgages had deeper levels of negative equity—an average of $83,000 compared with $52,000—than borrowers without second mortgages. In many cases, borrowers withdrew cash from their properties using home-equity loans or lines of credit, a type of second mortgage. The CoreLogic report doesn’t include cash-out refinancing, a common practice during the boom, where borrowers opted to extract cash while refinancing their first mortgage.

According to Federal Reserve Board data, homeowners took out a total of $2.69 trillion from their homes at the height of the housing boom between 2004 and 2006. That tally includes cash-out refinancings.

“Easy access to home equity loans during the housing boom put borrowers who extracted home equity at more risk,” said Mark Fleming, CoreLogic’s chief economist. “The price declines were felt more severely by people who took out home-equity loans.”

Overall, the CoreLogic report found that the percentage of underwater homeowners declined slightly in the first quarter. About 10.9 million Americans who borrowed to buy their homes, or 22.7% of all homeowners with a mortgage nationwide, were underwater in the first quarter, down from 11.1 million, or 23.1%, in the fourth quarter of 2010.

The modest decline wasn’t a sign of an improving market. Rather, the change reflected completed foreclosures, which reduced the total number of homeowners in the market, CoreLogic said.

“The implication is that there are still a lot of people who are at risk of default, so delinquency and default rates are going to reflect that large amount of negative equity for some time to come,” said Jan Hatzius, chief U.S. economist for Goldman Sachs Group.

The risks extend beyond the borrowers to banks. While the majority of first mortgages were bundled into pools and resold to investors as securities, second-lien mortgages are heavily concentrated on bank balance sheets.

Nearly three-quarters of roughly $950 billion in home-equity loans outstanding were held by commercial banks at the end of last year, according to Federal Reserve data. More than 40% of that debt is on the books of the nation’s four largest banks: Wells Fargo & Co. (NYSE: WFC – News), Bank of America Corp. (NYSE: BAC – News), J.P. Morgan Chase & Co. (NYSE: JPM – News), and Citigroup Inc. (NYSE: C – News) Requiring big writedowns on those loans could burn through banks’ capital.

Second mortgages have made it more difficult for troubled borrowers to negotiate loan modifications with lenders. Economists say borrowers with second mortgages on homes that are underwater are far more likely to walk away from their homes.

Homeowners seeking a “short sale,” in which they sell their property for less than the value of the outstanding mortgage, have a much harder time doing so when they have a second loan, because all the lenders involved must agree to take losses on the sale, and second-lien holders take the first losses in such a situation.

 In 2005, Matt Facchini, took out a $200,000 home-equity loan on his home in Toms River, N.J., and used it to pay his divorce settlement, pay down some credit card debt and make home renovations, including installing new fences and restoring the swimming pool.

Two years ago, after price declines put him approximately $190,000 underwater, he walked away from the home, and is currently trying to negotiate a short sale. But Mr. Facchini, who works installing insulation for pipes, worries that the lender on his second mortgage will demand that he pay the approximately $70,000 deficiency on the second loan.

“I’m sweating. I have a broken car sitting in my driveway that I can’t afford to fix. I can’t get a loan to buy a new car because my credit is ruined,” Mr. Facchini said. “I’m hoping they don’t come after me for the money I owe them. That would be, for me, the end of it all.”

Nevada, which has seen homes lose half their value on average in some markets, had the highest rate of negative equity, with 63% of its mortgaged properties underwater, followed by Arizona (50%), Florida (46%) and Michigan (36%). Two-thirds of homeowners with a mortgage in Las Vegas are underwater, while 56% of homeowners in Stockton, Calif., and 55% of Phoenix mortgage-borrowers have negative equity

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