The Home Equity Crisis Ahead

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And a dramatic drop in prices started wiping out the value of many of these loans. Say a buyer purchased a home for $300,000, taking out a mortgage for $240,000 and a piggyback loan for $60,000 to cover the down payment. If the price of the house then dropped by 20%, to $240,000, the equity evaporates.

That's what's now happening in some of the hardest-hit states such as Florida and California. So banks are getting stuck with home-equity loans that are worthless. That's because borrowers who don't have any equity in their homes are more likely to walk away entirely. Standard & Poor's (which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP)) looked at investment pools, analyzing the performance of 640,000 first mortgages with a piggyback loan attached to them. They found that those loans are 43% more likely to go into default than stand-alone mortgages.

As a result, banks are scrambling to change their ways. Some are implementing stricter underwriting standards, ensuring that new borrowers have plenty of skin in the game by putting up more cash. Chase, for example, which tightened standards several times in 2007, lowered how much it would lend to borrowers in California and Florida by 10%. "Given our current underwriting standards, we wouldn't have done 30% of the home-equity loans we originated in 2006," says Thomas A. Kelly, a spokesman at Chase.

Banks also contend that most of the problem loans and lines of credit came from third-party brokers and wholesalers, which they say did a poor job assessing borrowers' ability to repay. Wells calculates that independent brokers, which represented just 7% of its home-equity lending, accounted for 25% of its third-quarter losses. So Wells and other lenders are now refusing to buy home-equity products from that group.

Meanwhile, the list of casualties is expanding to those who own and insure investment pools filled with home-equity loans. One of the worst-performing assets in E*Trade's (ETFC) $17 billion investment portfolio: bonds backed by home-equity loans. After more than a third of the bonds were downgraded to junk, the online broker in late November sold the troubled bonds and other investments to hedge fund Citadel.

Radian Guaranty (RDN), which lost business to the banks when home-equity loans that doubled as down payments reduced the need for their mortgage insurance, started insuring securities backed by home-equity loans instead. In the latest quarter, it announced losses of $1.1 billion related to those deals. "We essentially stopped writing this business," Radian's Mark Casale said in a recent call with investors. "Unfortunately, we're still feeling the effects."

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Der Hovanesian is Banking editor for BusinessWeek in New York .