The Economics of Second Liens

Ruth Simon has a huge piece in today's WSJ on second liens: home equity loans and lines of credit which are junior to primary mortgages. These things can cause a lot of trouble for homeowners:

"The people in the first position will say, 'Until you get a deal with the second, why should I make a deal with you?'" says Iowa's Mr. Thompson. Second-mortgage holders are often reluctant to approve a short sale or deed in lieu of foreclosure that could wipe out their claims, he adds.

At the same time, the second-mortgage holders often reject offers of as much as $2,000 for loans they've already written off, just because the costs involved in evaluating the offer and releasing the borrower from the lien. So while a second lien might be worthless to the person who owns it, it can make life very difficult indeed for everybody else.

One thing that's interesting to me is that default rates on these second liens, which one might expect to be astronomical at this point, are in fact not all that high. Home equity loan default rates are at 4.65%, while default rates on home-equity lines of credit are only 2.01%. Economy.com estimates that total losses on $1.1 trillion of these loans might total $58 billion; reading the story, recovery values on these loans are negligible, which means that the economy.com estimate implies that eventually about 5.3% of the loans will have to be written off. Which is lower than I might have guessed.

In the mean time, it turns out that I was only half right when I said yesterday that "people have to max out their home equity lines before they default on them". Washington Mutual and Citigroup are already unilaterally reducing the credit lines of borrowers whose credit scores have fallen or whose houses have dropped in value. What's more, Simon reports that "in some cases, servicers are telling borrowers they will take 10 cents on the dollar to settle their claim".

In other words, if you're going to need that money available in your home equity line of credit, you might think about tapping it now, before it disappears. In the worst-case scenario, you'll only need to pay 10% of it back.

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