The housing market bubble isn't over, after all.
Thousands of home equity loans made in the peak years of the housing bubble are just starting to reach their 10th birthday, which for many borrowers will bring very bad news.
You see, most home equity loans are interest-only for the first 10 years. But after that, the borrower must start paying down the principal, which can cause their monthly payments to triple or more.
For example, the monthly payment for a typical borrower with a $30,000 home equity loan and an interest rate of 3.25% would rise from $81.85 to $293.16.
Other homeowners could see their monthly payments jump by $500 or $600, depending on the amount and terms of the original loan.
This is worrisome news for everyone - the borrowers, the banks that hold these home equity loans, and the overall housing market, which hasn't fully recovered from the housing market bubble and doesn't need any fresh headwinds.
"The day of reckoning has arrived for those who took out those home equity loans, and for the banks that pushed home equity lines of credit like they were cheap credit cards," wrote Bob Stokes of Elliot Wave International.
Another Housing Market Bubble
The problem has only just started to bloom...
The home equity loans turning over now were made in 2003, just as the housing market bubble was heating up. It didn't peak until 2007.
According to the Federal Deposit Insurance Corporation (FDIC), home equity lines of credit soared 77% from 2003 through the end of 2007, from $346.1 billion to $611.4 billion.
And the dollar amounts of the loans affected will rise dramatically each year through 2017 - $29 billion of these loans reset in 2014, $53 billion in 2015, $66 billion in 2016, and $73 billion in 2017.
That's why Amy Crews Cuts, the chief economist at the consumer credit agency Equifax, called the looming increases a "wave of disaster" at a conference in Washington last month.
The Housing Market Bubble Revisited: Defaults and Foreclosures
While we know how many home equity loans will reset, and how large they are, what no one knows for sure is how many of these loans will end up in default, which would result in foreclosures.
The key is the percentage of borrowers who default, and the early trend is not encouraging...
According to Equifax, home equity loan delinquencies have already jumped from 3% last year to 5.6%, and the agency says that could soon rise to 6%.
Bank of America Corp. (NYSE: BAC), which has $65 billion worth of home equity loans resetting in the next several years, said 9% of those that have already reset are not performing.
Delinquency rates that high could hurt the Big Banks, but the fear is that they could go higher, perhaps even approaching the 20% rates for subprime mortgages at the height of the housing market bubble.
Equifax's Crews Cuts thinks the loan losses could hit the banks hard.
"What we've seen so far is the tip of the iceberg. It's relatively low in relation to what's coming," she said.
While the banks keep reserves to cover bad loans, financial regulators have urged them to add to those reserves to prepare for more defaults on home equity loans. But it's hard to know how much to set aside when the scope of the problem is so devilishly hard to predict.
"We just don't know how close people are until they ultimately do hit delinquencies," Darrin Benhart, the deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency, told Reuters. Updated credit scores offer some clues, but "it's difficult to ferret that risk out," he said.
And any loans that do go bad will go spectacularly bad. Because home equity loans are almost always second mortgages, most of the money from a foreclosure goes to pay off the first mortgage. That means a bank can lose as much as 90 cents on the dollar on the sour home equity loan.
While most of the banks that hold these loans will be able to absorb the losses, it will take a bite out of their earnings and drain much-needed capital at a time when regulators have raised capital requirements.
Bad Home Equity Loans Leave Few Options
Another complication with home equity loan defaults is that the banks don't have very many options for helping the borrowers.
They can let the borrower simply keep paying only the interest on the loan, and so retain the lower monthly payment, or they can extend the term of the loan to reduce the monthly payment.
Banks can also offer to refinance the loan, but that option only works if the borrower is creditworthy under the new, tougher standards and has sufficient equity in the home. Even now, one in seven homeowners with a mortgage is underwater.
And then there's the threat of rising interest rates, which will also make loan repayments higher.
While the severity of the problem won't be known for years, its implications for the banking industry and the housing market mean investors definitely need to stay tuned.
There's an even bigger threat to the housing market than the "bubble" in home equity loans. The improving numbers in existing home sales aren't quite what they seem. Money Morning's Shah Gilani explains what's really going on and why it could completely unravel the so-called recovery in U.S. housing...
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Elliott Wave International:
Borrowers Face "Wave of Disaster" for Home Equity Loans