Home Equity Loans Complicate Mortgage Assistance

A foreclosure sign - A foreclosure sign in Miami. With foreclosures at record levels, some investors worry that bank ownership of home equity loans is getting in the way of helping homeowners avoid this scenario. (Joe Raedle / Getty Images)

With foreclosures at record levels, the mortgage industry has been working with more borrowers to reduce their payments and keep them in their homes. But foreclosures keep rising. And some in the industry are worried the banks have some conflicts of interest that are getting in the way of helping homeowners.

Most home mortgages in the U.S. are owned by various investors such as teachers' pension funds, hedge funds and the mortgage giant Fannie Mae. Back before the housing crisis, all kinds of investors bought big bundles of mortgages so they could collect the interest payments from homeowners.

But home equity loans are a different story. These are loans that a homeowner can use to borrow, say, $25,000 to remodel a kitchen. Or they're lines of credit that a homeowner can draw on as needed. The major banks didn't sell off most of these second loans to investors. Instead, the banks held them and kept the income stream for themselves.

(Joe Raedle / Getty Images)

Most people facing foreclosure hold both types of loans — the main mortgages owned by investors, and the home equity loans owned by the big banks.

Investor Concerns Over Second Loans

Investors say the problem is that the banks have much more interest in protecting that $25,000 line of credit than in crafting the best loan workout plan for the homeowner and all the investors involved.

(Joe Raedle/Getty Images)

"It closely resembles the fox guarding the henhouse," says Scott Simon, managing director at PIMCO, an investment firm that manages more than half a trillion dollars' worth of mortgage-backed securities.

The banks are the biggest loan servicers, he says. That means they get to decide which loans to modify, regardless of who owns them. And that creates a conflict of interest.

As a businessman, Simon says he really doesn't like all these foreclosures. They're obviously bad for the homeowner "who gets kicked out on the street," he says. "They're also really bad for anyone who invests in the debt."

Investors take big losses when foreclosures happen. There are legal fees, properties sit vacant and taxes have to be paid. When a house finally gets sold, it goes for a fire-sale price.

Willing To Take Losses

Simon says many investors like him are now willing to take some losses to avoid foreclosures. They want to cut deals with homeowners to lower their payments. He says loan modifications should be happening more frequently because it makes good business sense.

But, he says, home equity loans are part of what's getting in the way.

Simon says a huge number of potential loan workouts for homeowners are getting gummed up. One example, he says, is the Hope for Homeowners program, a foreclosure prevention initiative that the government enacted last year.

"The government had hoped that Hope for Homeowners would do 400,000 loans the first year," he says. In fact, only one borrower has made it through the program and has been refinanced into a new, affordable loan. "Not 100,000 loans — one loan," he says. "Clearly something is occurring that they did not foresee."

There are all kinds of obstacles to loan modifications. For one thing, the industry has been overwhelmed by the volume of people calling up and asking for help.

But Simon says one of the key problems is that the biggest banks each have about $100 billion in home equity loans on their books. And he says the banks have been dragging their feet when it comes to modifying or taking losses on those loans.

Even when homeowners manage to get that first main mortgage modified so that they have lower payments, Simon's worried that the banks are not cutting homeowners similar deals on their second loans.

He says that often means the homeowners are upside down or underwater, meaning they still owe more than their house is worth. And that makes a foreclosure more likely.

"That person still feels awful because they're upside down and they still have a high interest burden because the second loan is typically very expensive," he says. That's a big part of why there are many more foreclosures now, he adds.

The Bank Point Of View

Many banks disagree with investors like Simon. Steve Bailey, the top loan servicing executive at Bank of America, who is in charge of the bank's foreclosure prevention efforts, acknowledges that the industry is focusing more on modifying the bigger first mortgages.

But he says that's what it should be doing. "The focus of modification is to stop whoever would be foreclosing," he says. In most cases it's the people who own the first mortgage who end up foreclosing, he explains. Usually, it wouldn't make sense for the owners of the second mortgage to foreclose because many of these homes are underwater.

The Obama administration has recently put in place incentives to get banks to modify more second or home equity loans. Bailey says Bank of America is participating in that program. He says that means that when a first loan gets modified through the new Obama foreclosure prevention plan, Bank of America must similarly modify the homeowner's second loan if the bank is servicing that second loan. So, that should lead to many more second-loan modifications.

Still, some economists and people inside the industry are skeptical. They don't know if the incentives will be strong enough to get most of the industry doing this on a large scale. So they worry that second loans will continue to weigh the market down.

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