The Shoe That Refuses to Drop: Home Equity Losses

The mortgage crisis is once again subverting the traditional understanding of consumers' debt-payment priorities.

A few years ago, eyebrows rose when homeowners began falling behind on their mortgages, risking the loss of their homes, while continuing to service unsecured credit card debts. The new paradox: defaults and loss rates on home equity loans remain low compared with those of first mortgages, which historically were considered safer.

The counterintuitive trend suggests that the staggering losses many had expected the banking industry to suffer on home equity loans will not come to pass.

"If we are going to get into a major increase in [home equity] loan losses at a time when the economy is recovering, it would be an aberration," said Richard Bove, an analyst with Rochdale Securities LLC. "Home equity is a very profitable business because 95 out of every 100 borrowers are still paying their [second] mortgages."

According to Lender Processing Services Inc., the 30-to-89-day delinquency rate on home equity loans held by depositories slid from a peak of 1.78% at the end of 2008 to 1.32% on Dec. 31. For first mortgages, the rate also declined over the same period but less steeply, hovering around 3%.

The differences are starker in the noncurrent rate, which captures loans 90 days overdue or in nonaccrual status. They've flatlined below 2% for home equity while soaring above 9% for firsts.

Why would a consumer continue paying the second mortgage while allowing the first one to slide? One explanation is that strapped borrowers want to remain in good standing as best they can, so they pay as many bills as possible each month. The monthly payments on a second mortgage are typically more affordable than those on the first.

"Since the mortgage is typically the largest payment, it gets missed first," said Piyush Tantia, a research director at the Institute for Quantitative Science at Harvard University.

Also, Tantia said, some borrowers use their home equity lines for day-to-day expenses, and others want to make sure they have the option. By paying those bills, they "are very consciously maintaining any access to credit they have in the form of an unused HELOC line."

Another interpretation is that banks were more conservative in granting home equity loans than they were with first mortgages, even prime ones.

"The vast majority of seconds are performing much better than the first, which means the underwriting had to have been stricter," said Bill Moreland, president of PeerMetrics Inc., a Dallas consulting firm. "We're assuming that everybody who has a HELOC has a first mortgage, and that they're all the people who are in trouble, which is not necessarily the case."

Also, some home equity loans, while secured by a lien on the house, won't necessarily behave as though they are tied to the fortunes of the housing market.

"A ton of those juniors and HELOCs are for small businesses," said Moreland, a former risk manager at Wells Fargo & Co. "A lot of the people who couldn't get a small-business loan got a second mortgage and are funding their business using that second mortgage or home equity line of credit."

Bove said some borrowers also are misinformed and believe paying the home equity loan will somehow delay foreclosure. The government may have fed such misperceptions by failing to address second liens when it started the Home Affordable Modification Program a year ago, he said.

"The consumer believes that if they keep the home equity payment going, something will be done on the first mortgage to assist them in staying in their home," Bove said.

The reluctance of the four largest banking companies, which hold more than half of all home equity loans, to write down principal on those assets has been blamed for the slow pace of loan mods. Those four — Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., and Wells Fargo — also happen to be the top servicers of first mortgages (many of which are held by other parties).

In August, the government unveiled 2MP, a supplemental program to Hamp in which companies agree to reduce a borrower's second-lien payment if the first lien has also been reduced. Since then only B of A has signed for 2MP, compared with 106 servicers participating in Hamp.

Holders of the first liens have been reluctant to accept less than face value without commitments from second-lien holders to do the same, House Financial Services Chairman Barney Frank wrote in a letter to the Big Four last week. He urged them to take principal writedowns on second liens — many of which, he wrote, "have no economic value."

But Shelley Leonard, a senior vice president of consumer lending strategy at Lender Processing Services, said that if banks were forced to write down large amounts of home equity loans, "they would take dents to their capital."

According to her Jacksonville, Fla., company, depository institutions charged off $19 billion of home equity loans last quarter. The figure was more than one and a half times that for first mortgages, which Leonard said makes sense in light of the delinquency trend. "Why would a bank want to write off a loan that is performing?"