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The Coming Home Equity Line of Credit Crisis |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. Will HELOCs Trigger the Next Financial Crisis? 2. Millions of HELOCs to Reset in the Next Few Years 3. 4Q GDP Revised Higher Than Expected to 1%... But 4. The Worst Kind of Upward Revision to 4Q GDP 5. Consumer Confidence & Business Optimism Fading 6. Special Report: Understanding & Maximizing Your 401(K) Overview A crisis is brewing in the Home Equity Line of Credit (HELOC) market. HELOCs became all the rage back in the bubble-era years from late 2004 to early 2008 when home prices were skyrocketing. Millions of homeowners couldn’t resist the temptation to borrow against their rapidly increasing home equity, and banks and mortgage lenders were all too happy to accommodate. HELOCs were typically structured with a 10-year interest-only payment plan. Yet after 10 years, the borrower had to start paying interest and principal, which means that monthly payments soar by hundreds or even thousands of dollars. That’s where we are now, and most home prices are far below where they were at the peak. How serious is this crisis? We don’t know for sure, but I’ll give you the numbers today. While we don’t hear much about the HELOC dilemma in the financial media, I want my clients and readers to know what we’re facing. Following that discussion, I will highlight some recent economic reports including last Friday’s surprising 4Q GDP report, which was better than expected on the surface, but worse than expected under the surface. We’ll also look at the latest disappointing consumer confidence and fading small business optimism numbers. It should be an interesting letter. Will HELOCs Trigger the Next Financial Crisis? A decade after homeowners used a soaring real estate market to go on a borrowing binge against their own home equity, many across the country are now falling behind on their payments. This looming crisis threatens to leave banks on the hook for hundreds of billions of dollars. Borrowers who took out Home Equity Lines of Credit, or HELOCs, when home prices were near their peaks in 2004-2008 are struggling to keep up as principal finally comes due after years of interest-only payments. With a HELOC, consumers borrow against the equity they have in their home. Typically, HELOCs are structured such that the borrower makes interest-only payments for the first 10 years. After that, the borrower has to begin to pay back the principal as well as interest. The following chart illustrates the number of HELOCs that were originated each quarter during the bubble years from late 2004 to early 2009. The chart is a little hard to read (I apologize), but the explosion in HELOCs began when the red line started to move significantly higher in late 2004. It peaked in the first half of 2009.
When the HELOC interest-only payments end and the borrower has to pay interest plus principal, the homeowner’s monthly payment will automatically increase by hundreds or even thousands of dollars a month. For the earliest HELOCs, the 10-year interest-only period has already come to an end. The problem is that millions more Americans will see their monthly mortgage payments skyrocket in the next few years. From the beginning of 2005 to the end of 2007, roughly 10.8 million HELOCs were originated. In the 4Q of 2005 alone, nearly $130 billion of HELOCs were issued. The average amount of a HELOC loan in those three months was more than $130,000. When the sub-prime market began to collapse in the spring of 2007, originations of HELOCs continued unabated for more than a year through the middle of 2008. According to Equifax, the total of outstanding HELOCs did not peak until late 2009 at $672 billion of cumulative issuance. Some of these bubble-era HELOCs were taken out by homebuyers as so-called “piggy-back” second mortgages at the time of purchase. This enabled them to purchase a home with little or no down payment. However, the vast majority were originated after the home purchase – usually within two years. Millions of homeowners were not content with taking out a single HELOC. Many subsequently refinanced their HELOCs – some more than once – to take advantage of rising home values and pry still more cash out of their house. Between 2004 and 2006, roughly six million HELOCs were refinanced around the country. California was the center of this HELOC madness. HELOCs lured in millions of homeowners between 2004 and 2008 because the interest-only monthly payment was not very much – often only a few hundred dollars a month. Why worry about the fact that in 10 years the loan would become fully amortized when home values were soaring by double digits? Now we have a potential crisis on our hands. Millions of HELOCs to Reset in the Next Few Years So, do we know how many bubble-era HELOCs will be recasting into fully amortizing loans in the next few years? Estimates vary widely. Obviously, HELOCs that originated in 2004 and 2005 have already reset. Those originated in 2006-2008 will be resetting between now and the end of 2018. According to Equifax, there are roughly 4.2 million HELOCs still outstanding from the four peak-bubble years. Equifax estimates that there were a combined total of 11.2 million HELOCs outstanding in August 2015 with a remaining balance of roughly $500 billion. The question is, how ugly can it get? Let’s examine the situation of a real borrower whose plight was discussed in an article in the Los Angeles Times. The homeowner took out a $167,000 HELOC in 2006 on his Huntington Beach, California condo. Last year he received a notice from his mortgage servicer that his HELOC would convert to a fully amortizing loan in July 2016, and his monthly payment will soar from $400 to more than $1,100. The shocked homeowner said, “We both now live on fixed income and will not be able to make the payment.” So this homeowner will almost certainly have to sell his home sometime this year. There are millions of others who are in the same boat. It remains to be seen if the coming HELOC blow-up will lead to the next financial crisis, as potentially millions of American homeowners have to sell their homes or default on their loans and see their homes foreclosed upon by their lenders. In many parts of the country, home prices are still not back to their bubble-era valuations. So this could cause serious problems for banks, S&Ls and other financial institutions that originated – and still own – very large amounts of HELOCs. I don’t see much written about this potential crisis in the financial media, so I wanted to bring it to my readers’ attention today. Keep in mind that the above is just a brief summary of a very complicated issue. 4Q GDP Revised Higher Than Expected to 1%... But In its second estimate, the Commerce Department reported on Friday that 4Q GDP rose at an annual rate of 1.0%, up from 0.7% in its initial estimate at the end of January. The 1% estimate was considerably higher than the pre-report consensus for a downward revision to only 0.4%. Commerce noted that the upward revision reflected positive contributions from personal consumption expenditures (PCE), residential fixed investment and federal government spending. Negative contributions included exports, nonresidential fixed investment, state and local government spending and private inventory investment.
While Friday’s GDP report was revised upward to 1% in the 4Q, it was still significantly lower than the 2% growth rate in the 3Q of last year. The deceleration in real GDP in the 4Q primarily reflected a slower increase in consumer spending and downturns in non-residential fixed investment, in state and local government spending and in exports. Personal Consumption Expenditures – purchases by US residents of goods and services – increased 1.2% in the 4Q, compared with an increase of 2.2% in the 3Q. So while consumer spending did increase in the 4Q, the rate of growth slowed significantly from the 3Q. Based on Friday’s estimate, the US economy grew by 2.4% for all of 2015, the same rate it expanded in 2014. Based on a Bloomberg survey of economists late last week, the economy is expected to rebound to around 2.0% for the 1Q of 2016. The Worst Kind of Upward Revision to 4Q GDP While last Friday’s GDP report was considerably stronger than the pre-report consensus of only 0.4%, the internals of the report were actually quite disappointing. In looking at the details, we find that the better than expected number was almost entirely due to a larger stockpiling of inventories that could weigh on the economy in the months just ahead. The value of inventories, which adds to GDP, rose by $81.7 billion in the 4Q instead of $68.6 billion as initially reported in late January. As such, companies may have to cut back on production and purchases to get inventories back in line. Inventory stockpiling is not the way you want to expand the economy. Some suggested that the upward revision was largely due to a technical alteration in how inventories are calculated, but it also suggests that companies got stuck with more unsold goods than they expected. Consumers and businesses both cut back on spending toward the end of last year. Business investment in equipment sank a surprising 6.6% in the 4Q. Elsewhere, imports to the US fell 0.6% in the 4Q, down from the government’s initial estimate of a 1.1% advance. Most of the import revision reflected a slowdown in goods shipments to the US. That’s consistent with a slowdown in consumer spending. Exports also declined in the 4Q. Spending by state and local governments declined at a 1.4% annualized pace in the 4Q. That’s a deeper decline than the initially estimated 0.6% decrease. For all these reasons, last Friday’s GDP report was much less encouraging than the headline number of 1% suggested. Consumer Confidence & Business Optimism Fading Consumer confidence fell to its lowest level in seven months in February as Americans grew more pessimistic about business conditions and their personal finances. The Consumer Confidence Index unexpectedly plunged from a reading of 97.8 in January to 92.2 in February in the latest report out last Tuesday.
The pre-report consensus called for little change last month but was clearly out of step. The Conference Board which conducts the confidence survey noted: “Consumers' short-term outlook grew more pessimistic, with consumers expressing greater apprehension about business conditions, their personal financial situation, and to a lesser degree, labor market prospects.” I have a different theory for the surprise plunge in the Confidence Index. The stock market has been on a wild ride this year amid worries about the global economy. The S&P 500 Index lost over 9% of its value at one point. Numerous other equity markets around the world fell 20% or more. While the S&P 500 has recovered some of that 9% loss in recent weeks, the Conference Board survey found that more Americans are expecting further price declines in the weeks and months to come. A growing number of Americans fear that we are headed for another financial crisis, and many in the financial media are fanning such worries. In a separate survey from the Conference Board, we can see that small business optimism has plunged lower since the beginning of last year. Let’s take a look at small business sentiment by way of the National Federation of Independent Business (NFIB) Small Business Optimism Index (plotted in red below – data is through January).
Frankly, I don’t see how we get economic growth of 2.0%-2.5% that so many are predicting for 2016 with consumer confidence slumping and small business optimism plunging. We saw GDP growth of only 2.4% in 2014 when consumer confidence and business optimism were trending significantly higher, and again in 2015 thanks largely to inventory stockpiling. If these two trends don’t reverse soon, we may be looking at GDP growth of only 1% this year. The Fed is no doubt aware of this dilemma, and that’s why I don’t think Yellen & Company will raise the Fed Funds rate anytime soon. We will revisit this issue but I will leave it there for today. Special Report: UNDERSTANDING & MAXIMIZING YOUR 401(K) 401(k)s and other retirement savings vehicles can be complicated in the first place, and the investment options may be difficult to evaluate in the second place. What we have done in recent months is to put together a straightforward Special Report to help our clients and readers better understand their 401(k)s and how to make decisions about the investment options that are available to them. Understanding & Maximizing Your 401(k) addresses such issues as:
If you have a 401(k), there is no reason not to take advantage of this FREE Special Report. We have written the Report in easy-to-understand language, and we are thrilled to be able to make this invaluable tool available to my clients and readers. DOWNLOAD YOUR FREE 401(k) SPECIAL REPORT And feel free to share this Special Report with anyone you believe could benefit from it. All the best,
Gary D. Halbert
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