US borrowers are increasingly missing payments on home equity lines of credit they took out during the housing bubble, a trend that could deal another blow to the country's biggest banks.
The loans are a problem now because an increasing number are hitting their 10-year anniversary, at which point borrowers usually must start paying down the principal on the loans as well as the interest they had been paying all along.
More than $221 billion of these loans at the largest banks will hit this mark over the next four years, about 40 percent of the home equity lines of credit now outstanding.
For a typical consumer, that shift can translate to their monthly payment more than tripling, a particular burden for the subprime borrowers that often took out these loans. And payments will rise further when the Federal Reserve starts to hike rates, because the loans usually carry floating interest rates.
The number of borrowers missing payments around the 10-year point can double in their eleventh year, data from consumer credit agency Equifax shows. When the loans go bad, banks can lose an eye-popping 90 cents on the dollar, because a home equity line of credit is usually the second mortgage a borrower has. If the bank forecloses, most of the proceeds of the sale pay off the main mortgage, leaving little for the home equity lender.
Related: JPMorgan Deal Won't Close the Books on Mortgage Fraud
There are scenarios where everything works out fine. For example, if economic growth picks up, and home prices rise, borrowers may be able to refinance their main mortgage and their home equity lines of credit into a single new fixed-rate loan. Some borrowers would also be able to repay their loans by selling their homes into a strengthening market.
Once Used Like Credit Cards
But some regulators, rating agencies, and analysts are alarmed. The U.S. Office of the Comptroller of the Currency, a regulator overseeing national banks, has been warning banks about the risk of home equity lines since the spring of 2012. It is pressing banks to quantify their risks and minimize them where possible.
At a conference last month in Washington, D.C., Amy Crews Cutts, the chief economist at consumer credit agency Equifax, told mortgage bankers that an increase in tens of thousands of homeowners' monthly payments on these home equity lines is a pending "wave of disaster."
Banks marketed home equity lines of credit aggressively before the housing bubble burst, and consumers were all too happy to use these loans like a cheaper version of credit card debt, paying for vacations and cars. The big banks, including Bank of America Corp, Wells Fargo & Co, Citigroup Inc, and JPMorgan Chase & Co have more than $10 billion of these home equity lines of credit on their books each, and in some cases much more than that.
How bad home equity lines of credit end up being for banks will hinge on the percentage of loans that default. Analysts struggle to forecast that number. In the best case scenario, losses will edge higher from current levels, and will be entirely manageable. But the worst case scenario for some banks could be bad, eating deeply into their earnings and potentially cutting into their equity levels at a time when banks are under pressure to boost capital levels.
"We just don't know how close people are until they ultimately do hit delinquencies," said Darrin Benhart, the deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency. Banks can get some idea from updated credit scores, but "it's difficult to ferret that risk out," he said.
What is happening with home equity lines of credit illustrates how the mortgage bubble that formed in the years before the financial crisis is still hurting banks, even seven years after it burst. By many measures the mortgage market has yet to recover: The federal government still backs nine out of every ten home loans, 4.6 million foreclosures have been completed, and borrowers with excellent credit scores are still being denied loans.
No Easy Way Out
Banks have some options for reducing their losses. They can encourage borrowers to sign up for a workout program if they will not be able to make their payments. In some cases, they can change the terms of the lines of credit to allow borrowers to pay only interest on their loans for a longer period, or to take longer to repay principal.
A Bank of America spokesman said in a statement that the bank is reaching out to customers more than a year before they have to start repaying principal on their loans, to explain options for refinancing or modifying their loans. But these measures will only help so much, said Crews Cutts. "There's no easy out on this," she said.
Between the end of 2003 and the end of 2007, outstanding debt on banks' home equity lines of credit jumped by 77 percent, to $611.4 billion from $346.1 billion, according to FDIC data, and while not every loan requires borrowers to start repaying principal after ten years, most do. These loans were attractive to banks during the housing boom, in part because lenders thought they could rely on the collateral value of the home to keep rising.
"These are very profitable at the beginning. People will take out these lines and make the early payments that are due," said Anthony Sanders, a professor of real estate finance at George Mason University who used to be a mortgage bond analyst at Deutsche Bank.
Related: Will Rising Mortgage Rates Kill the Recovery?
But after 10 years, a consumer with a $30,000 home equity line of credit and an initial interest rate of 3.25 percent would see their required payment jumping to $293.16 from $81.25, analysts from Fitch Ratings calculate.
That's why the loans are starting to look problematic: For home equity lines of credit made in 2003, missed payments have already started jumping.
Borrowers are delinquent on about 5.6 percent of loans made in 2003 that have hit their 10-year mark, Equifax data show, a figure that the agency estimates could rise to around 6 percent this year. That's a big jump from 2012, when delinquencies for loans from 2003 were closer to 3 percent. This scenario will be increasingly common in the coming years: in 2014, borrowers on $29 billion of these loans at the biggest banks will see their monthly payment jump, followed by $53 billion in 2015, $66 billion in 2016, and $73 billion in 2017.
The Federal Reserve could start raising rates as soon as July 2015, interest-rate futuresmarkets show, which would also lift borrowers' monthly payments. The rising payments that consumers face "is the single largest risk that impacts the home equity book in Citi Holdings," Citigroup finance chief John Gerspach said on an October 16 conference call with analysts.
A high percentage of home equity lines of credit went to people with bad credit to begin with — over 16 percent of the home equity loans made in 2006, for example, went to people with credit scores below 659, seen by many banks as the dividing line between prime and subprime. In 2001, about 12 percent of home equity borrowers were subprime.
Banks are still getting hit by other mortgage problems too, most notably on the legal front.JPMorgan Chase & Co last week agreed to a $13 billion settlement with the U.S. government over charges it overstated the quality of home loans it sold to investors.
Tip of the Iceberg
Banks have differing exposure, and disclose varying levels of information, making it difficult to figure which is most exposed. The majority of home equity lines of credit are held by the biggest banks, said the OCC's Benhart.
At Bank of America, around $8 billion in outstanding home equity balances will reset before 2015 and another $57 billion will reset afterwards but it is unclear which years will have the highest number of resets. JPMorgan Chase said in an October regulatory filing that $9 billion will reset before 2015 and after 2017 and another $22 billion will reset in the intervening years.
At Wells Fargo, $4.5 billion of home equity balances will reset in 2014 and another $25.9 billion will reset between 2015 and 2017. At Citigroup, $1.3 billion in home equity lines of credit will reset in 2014 and another $14.8 billion will reset between 2015 and 2017. Bank of America said that 9 percent of its outstanding home equity lines of credit that have reset were not performing. That kind of a figure would likely be manageable for big banks. But if home equity delinquencies rise to subprime-mortgage-like levels, it could spell trouble.
In terms of loan losses, "What we've seen so far is the tip of the iceberg. It's relatively low in relation to what's coming," Equifax's Crews Cuts said.
