Trouble on the Home Front

Borrowers are mortgaged to the hilt, and lenders that have been offering easy credit may be out on a limb

Despite a booming stock market, falling unemployment, and healthy wage growth throughout the 1990s, homeowners overwhelmingly opted to defer paying down their mortgage debt. Instead, they consistently added to it, driving the amount of such debt outstanding to a record $5.4 trillion. One in every four homeowners has a second mortgage. And four out of five homeowners who refinanced last year opted to increase the size of their mortgages, says Freddie Mac.

The trend shows no sign of slowing. Now, most banks regularly make offers to lend up to 100% of a home's value, and borrowers are mortgaging their homes to the hilt. They're taking out second mortgages, or refinancing their first mortgages into larger loans, known as "cash out refis" in record numbers. Borrowers use the cash to pay bills, make home improvements, or even take vacations. The Fed's Apr. 18 rate cut should spawn a new slew of refinancings, and lenders expect nearly half of these to be "cash out" loans.

"EXCESSIVE RISKS." The result: American homeowners are sitting on the smallest cushion of equity they've ever had--just as layoffs begin to pump up unemployment. And banks, which have increasingly pushed second-mortgage products and cash-out refinancings to a wider range of customers, may find themselves vulnerable if home prices start to fall and unemployment continues to rise. "A not insignificant portion of these loans are going to go delinquent, and then default," says Mark M. Zandi, chief economist at Inc. "The problem is, we haven't seen the dark side yet." Adds Gerard S. Cassidy, a bank analyst for Tucker Anthony Sutro Capital Markets: "The evidence from Silicon Valley and Washington (D.C.) suggests that the real estate problems for banks are about to become severe."

Already, banks have ratcheted up loan loss reserves and taken billions in writedowns for bad commercial loans. Now, some bankers fear the same problems are looming for banks' consumer loan portfolios, the bulk of which are mortgage-related. There's no doubt that some lenders have taken "excessive risks," says Richard M. Kovacevich, CEO of Wells Fargo & Co. "They were just assuming, as they did on the commercial side, that the economy was going to keep going up, and that's not true."

Banks have plunged into making second mortgages and home loans to borrowers with less-than-perfect credit to offset shrinking profits on plain-vanilla mortgages. So the volume of such loans has more than tripled to $750 billion since 1993, says SMR Research. The unprecedented volume and leverage means that "there are sectors and customer segments that are overextended," says John Pownall, finance manager in Bank of America's mortgage group.

What isn't certain, though, is where the trouble will strike. "Leverage is only a problem if people get into economic difficulty and home prices decline," says David Berson, Fannie Mae's chief economist. Banks with geographically diverse home equity and mortgage portfolios are less likely to falter, as home prices fluctuate regionally, not nationally.

So far, bankers say they aren't worried, even if home prices fall. "Look at past cycles--property deflation does not cause people to stop paying on their loans, unemployment does," says Doreen Woo Ho, president of home-equity lending for Wells Fargo. The San Francisco bank made $18.4 billion in home-equity loans last year, up 40% from 1999.

Second mortgages, of course, have been around for decades. But what's new is the speed with which banks can now make them. Many lenders use automated credit underwriting systems--which combine credit history, income, and home value to determine how much of a loan to extend--so low-level branch officials can make new loans within minutes. Plus, the Internet has made it very easy for new borrowers to apply.

Generally carrying interest rates in the 8% to 13% range, far below the 20% rates on many credit cards, second mortgages are popular with borrowers who've maxed out their plastic. They simply roll their credit-card debt into new home loans, lowering their monthly payments and getting a tax break. Furthermore, banks and finance companies have relaxed loan amounts, allowing homeowners to borrow 95%, 100%, or even 125% of their home's appraised value. Even the appraisals themselves are often automated, using computer models rather than human inspectors.

In some cases, homeowners can get credit with mind-boggling ease. For example, DeepGreen Bank, a Seattle-based lender, will make second-mortgage loans as large as $250,000, for a total loan-to-value ratio of 100%. Online application takes five minutes and approval takes two. Once borrowers are approved, the bank will wire a $25,000 advance to their checking account in 20 minutes. DeepGreen CEO Jerome J. Selitto says he only lends to borrowers with the best credit history and calls it "the smarter way to borrow." Maybe so, but it certainly lasts longer--borrowers make interest-payments-only on the loan for the first five years, and after that the loan is amortized over 25. That could be a long 30 years, unless home prices keep going up. If not, some homeowners with second mortgages could owe more than their house is worth.

When a borrower defaults, second-mortgage lenders, led by the likes of JP Morgan Chase (JPM ), Wells Fargo (WFC ), and Bank of America (BAC ), don't get anything until the first mortgage lender has been paid. Rather than repossessing homes to recoup what's owed to them, second-mortgage lenders may just swallow losses. "It is politically unrealistic to assume a bunch of banks would seize homes if we went into a recession," says Michael Mayo, a banking analyst at Prudential Securities Inc.

Luckily for banks, home sales and prices haven't yet stalled. But it may be just a matter of time before they do, because downturns in residential real estate usually happen months after the economy begins to soften. That's when borrowers--and their bankers--could rue the mountain of debt they've built.

By Heather Timmons in New York

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