The Home Equity Crisis Ahead

Even banks that dodged the subprime bullet face losses from loans based on homes now at risk

by Mara Der Hovanesian

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Subprime mortgages have taken a lot of blame for banks' big losses. But there's another problem lurking behind the mess: home-equity lending.

Buoyed by rising prices, borrowers increasingly tapped into the equity on their properties to finance a new car, renovations, or even a down payment, making equity a key source of consumers' strength. But with the housing market in disarray and prices plunging, the business of home-equity lending is souring. At least $14.7 billion in loans and lines of credit were already delinquent through the end of September—the highest level in a decade. "After subprime, home-equity lending is the biggest problem the industry has right now," says analyst Frederick Cannon of Keefe, Bruyette & Woods.

What's more, there's little that can be done to prevent the pain from the deterioration of this $850 billion market. A lender on a mortgage has the first claim on the underlying property. In the case of foreclosure, it can sell the property and recoup some money. The bank with the home-equity piece has no such collateral and is usually out the money. "The home-equity lender is going to get hosed," says Amy Crews Cutts, deputy chief economist at mortgage giant Freddie Mac (FRE).

JPMorgan Chase (JPM), Washington Mutual (WM), IndyMac (IMB), Countrywide Financial, and others are getting hit. On Jan. 16, JPMorgan announced it set aside an additional $395 million for troubled home-equity products in the last quarter, compared with just $125 million for subprime mortgages. Washington Mutual reported in the latest period that its bad home-equity loans and lines of credit surged by 130% from the end of 2006, forcing the bank to up losses by $967 million. Even lenders of a conservative bent, those that managed to sidestep much of the subprime mess, are getting hammered: Wells Fargo (WFC) took a recent $1.4 billion writedown, largely from home-equity lending.

Piling Higher

Until recently, the preponderance of home-equity lending came in the form of lines of credit. They allowed borrowers to convert their equity into cash to pay down credit-card debt and the like. But as the boom raced on and housing prices soared to unimaginable heights, banks started offering second-lien, or piggyback, loans that buyers could use to finance their down payments. The practice allowed buyers, especially subprime ones, to buy ever-bigger houses they could ill afford. Traditional underwriting standards were thrown out the window, with buyers increasingly borrowing more than the value of their homes. As a result, this segment soared to 14.4% of the home-equity market in 2006, according to industry newsletter Inside Mortgage Finance.

The boom brought about some especially toxic home-equity loans. Homeowners gamed the system, steadily cashing out every bit of equity from their houses—a situation that arose in part because banks didn't track whether borrowers took out subsequent loans from competitors. Another bad practice: a home-equity loan on top of a payment-option adjustable-rate mortgage. Those ARMs allow borrowers to make monthly payments that amount to less than the interest. The principal keeps growing, eroding the equity, which makes it a risky home-equity loan on top of an already risky mortgage.

In a rapidly rising housing market, such practices didn't seem particularly reckless. After all, homeowners could quickly refinance, using newly accumulated equity to pay off a second loan, or even a third. So lenders were confident they would get their money back. "The proposition was that borrowers would refinance and pay this sucker off in six months or a year," says Guy Cecala, publisher of Inside Mortgage Finance. "But the market died."