What’s the next shoe to drop in the daisy chain (or is that circle jerk) of financial crises? Yesterday I talked about how banks were expected to reduce credit by as much as a whopping$2 trillion.
Banks are in desperate need of liquid cash right now from a basic solvency perspective. With all these writeoffs from subprime loans now and far more derivative time bombs waiting in the wings, banks know that getting caught without enough cash to operate is a distinct possibility. When you’re leveraged 30 to 1 or more, losing 3% of your worth in a write off or stock loss can be enough to finish you…ask Bear Stearns.
So, banks are seriously cutting back on loans…and now we learn that banks want existing loans paid off before they loan anything else, more specifically home equity loans.
Americans owe a staggering $1.1 trillion on home equity loans — and banks are increasingly worried they may not get some of that money back.
To get it, many lenders are taking the extraordinary step of preventing some people from selling their homes or refinancing their mortgages unless they pay off all or part of their home equity loans first. In the past, when home prices were not falling, lenders did not resort to these measures.
Such tactics are impeding efforts by policy makers to help struggling homeowners get easier terms on their mortgages and stem the rising tide of foreclosures. But at a time when each day seems to bring more bad news for the financial industry, lenders defend the hard-nosed maneuvers as a way to keep their own losses from deepening.
It is a remarkable turnabout for the many Americans who have come to regard a home as an A.T.M. with three bedrooms and 1.5 baths. When times were good, they borrowed against their homes to pay for all sorts of things, from new cars to college educations to a home theater.
Lenders also encouraged many aspiring homeowners to take out not one but two mortgages simultaneously — ordinary ones plus “piggyback” loans — to avoid putting any cash down.
The result is a nation that only half-owns its homes. While homeownership climbed to record heights in recent years, home equity — the value of the properties minus the mortgages against them — has fallen below 50 percent for the first time, according to the Federal Reserve.
Now keep in mind that home prices have fallen as much as 20% from this time last year, meaning Americans are losing that equity at a staggering pace, trillions of dollars in equity have been wiped out in just the last few years alone. Prices are expected to continue to plummet this year. Equity will continue to get wiped out, and those loans Americans took out will become more and more of a serious problem for both the banks and homeowners.
Lenders holding first mortgages get first dibs on borrowers’ cash or on the homes should people fall behind on their payments. Banks that made home equity loans are second in line. This arrangement sometimes pits one lender against another.
When borrowers default on their mortgages, lenders foreclose and sell the homes to recoup their money. But when homes sell for less than the value of their mortgages and home equity loans — a situation known as a short sale — lenders with first liens must be compensated fully before holders of second or third liens get a dime.
In places like California, Nevada, Arizona and Florida, where home prices have fallen significantly, second-lien holders can be left with little or nothing once first mortgages are paid.
In December, 5.7 percent of home equity lines of credit were delinquent or in default, up from 4.5 percent in 2006, according to Moody’s Economy.com.
Lenders and investors who hold home equity loans are not giving up easily, however. Instead, they are opposing short sales. And some banks holding second liens are also opposing refinancings for first mortgages, a little-used power they have under the law, in an effort to force borrowers to pay down their loans.
So that second or even third mortgage is now turning into a nightmare. When home equity was booming when housing prices went up, it was fine. You saw ads on TV all the time. “Refi now! Historically low rates!”
Now the bill is due and is increasing. All the lenders want to be paid in full and they know that homeowners are in over their heads. They’re going to increasingly walk away and let the lenders fight it out to the death over the scraps and a foreclosed home that will simply continue to decrease in value.
When deals cannot be worked out, second-lien holders can pursue the outstanding balance even after foreclosure, sometimes through collection agencies. The soured home equity debts can linger on credit records and make it harder for people to borrow in the future.
Experts say it is in everyone’s interest to settle these loans, but doing so is not always easy. Consider Randy and Dawn McLain of Phoenix. The couple decided to sell their home after falling behind on their first mortgage from Chase and a home equity line of credit from CitiFinancial last year, after Randy McLain retired because of a back injury. The couple owed $370,000 in total.
After three months, the couple found a buyer willing to pay about $300,000 for their home — a figure representing an 18 percent decline in the value of their home since January 2007, when they took out their home equity credit line. (Single-family home prices in Phoenix have fallen about 18 percent since the summer of 2006, according to the Standard & Poor’s Case-Shiller index.)
CitiFinancial, which was owed $95,500, rejected the offer because it would have paid off the first mortgage in full but would have left it with a mere $1,000, after fees and closing costs, on the credit line. The real estate agents who worked on the sale say that deal is still better than the one the lender would get if the home was foreclosed on and sold at an auction in a few months.
“If it goes into foreclosure, which it is very likely to do anyway, you wouldn’t get anything,” said J. D. Dougherty, a real estate agent who represented the buyer on the transaction.
We’re talking trillions of dollars worth of home equity loans that may potentially not ever be paid back, particularly with home equity falling like a rock. More mortgage lenders and banks are going to be ravaged by this down the road. As banks start going under, people will spend less and start taking out their deposits. The FDIC does cover deposits up to $100,000 but in a paycheck to paycheck, post-Katrina world are you willing to bet on your Federal government’s speed and accuracy on getting that money to you should your bank fold tomorrow when you’ve got bills due this week?
Nor is anyone else. Banks fold, bank runs start, then the really unpleasant things start happening. Yes, confidence in the banks and our government would prevent these from happening to an extent, but…again, we’re stuck with Bush.
So either these mortgage lenders (companies that are increasingly parts of banks) get bailed out, costing taxpayers trillions, or these companies go under and take trillions in jobs and business out the economy..at the cost to everyone.
The loss in equity at this point is a given. The Greenspan housing bubble is going to end up costing us trillions no matter how you look at it. The question is if the system will survive such a staggering loss, and how long the losses will damage the US economy. How many more dominoes will fall? If too many go down at once, the system may never recover without a massive reset that would take years.
If too much damage is done, the financial system will go terminal and all bets are off. Bank runs would be just the beginning. Over-leveraged companies will fall by the boatload as the system shakes out, and the end results could be a catastrophic depression scenario if too many banks go under. As it stands, we’re looking at a year-long or more recession that would be very deep, and that’s only if everything goes to a best case level.
Your standard of living is about to change. In some cases, the change will be dramatic. In other cases it will be a slow and steady erosion of your buying power, to the point where like the proverbial frog in the pot, you won’t notice you’re being boiled until it’s too late.
Either way, my advice stands:
Be prepared.