Home Equity Line of Credit (HELOC) abuse was a massive stimulus to our economy, and now it is one of the leading causes of foreclosure. Today, we are going to take a detailed look at this phenomenon and the implications for future lending.
Irvine Home Address … 25 ROSE TRELLIS Irvine, CA 92603
Resale Home Price …… $1,267,000
{book1}
He hears the ticking of the clocks
And walks along with a parrot that talks,
Hunts her down by the waterfront docks where the sailers all come in.
Maybe she'll pick him out again, how long must he wait
Once more for a simple twist of fate.
People tell me it's a sin
To know and feel too much within.
I still believe she was my twin, but I lost the ring.
She was born in spring, but I was born too late
Blame it on a simple twist of fate.
Simple Twist of Fate — Bob Dylan
There is a simple truth about the housing market; people are going to buy and sell homes when is suits their life's circumstances. Unlike many of the readers of this blog, few base their decisions on market dynamics, and even when they do, each sets their own risk parameters.
The main factor separating those who benefited from the housing bubble from those who did not was a Simple Twist of Fate; for some it was time to sell or buy, and Fate either enriched or destroyed them.
I have often wondered if I had made different decisions during the bubble if I would have been caught up in the frenzy. Although I don't believe I could have fully ingested kool aid, I probably would have behaved like most of my cohorts and increased my loan balance. I consider those who did this with fixed rate financing and still managed to lower their payments as the sly ones. That is as far as I would have gone, but I probably would have taken some of the free money.
The conditions that spawned the rally of The Great Housing Bubble are gone, and we will not see rapid appreciation and a HELOC-fueled economy for decades. I believe we are embarking on a 20-30 year cycle of slowing rising interest rates as we stay one step behind inflation the entire journey. In an environment of increasing financing costs, mortgage equity withdrawal is rare because there is little equity available, and the cost of accessing and spending that equity is high — the opposite of what people have become accustomed to over the last 20-30 years.
It is important to me for people to realize HELOC spending is not coming back. Many buyers operative today are basing their decisions on poor information, they believe that if they can just get into a home, they will get to live off the HELOC money like everyone did in the 00s — they may have to wait a few years, but most buyers are certain HELOC money is on its way. It's not. As long as buyers are making buying decisions based on poor information, they will likely overpay and be unhappy with the results later on.
HELOC Abuse Grading System
I was looking back on the abundance of HELOC abuse stories from last year, and since I know we are going to see many, many more of these disasters over the next several years, I have developed a simple grading system that will tell you at a glance information about the borrower. By devoting this post to the grading sysem, in the future when you see a small graphic that labels the owner a "Grade D HELOC abuser," you will know a great deal about how they lived and how they managed their debt.
As I contemplated a grading system, I wanted something visually intuitive so I developed the graphic above. The origin point to the left represents the total loan balance on the day the property was purchased. The lines emanating from the origin extend to the right with an angle of trajectory that either pays down a mortgage or adds to it.
Each HELOC grade is separated by a psychological or behavioral threshold, and each one has observable results — you can compare the current mortgage balance with the original one and see how quickly the debt went up or down.
HELOC Abuse Grade A
Most people who borrow money do so because they need it. There is a limitation to how quickly they can repay the money, and the limit at the bottom of Grade A is the pinnacle of borrower prudence.
I probably shouldn't call this HELOC abuse at all because in order to earn an A, a debtor must pay off a mortgage faster than a 30-year amortization schedule. This should not be a difficult hurdle to jump over; in fact, prior to the housing bubble, most borrowers were forced to toe this line by conservative lenders.
The major difficulty in earning an A comes from deferred maintenance and renovation. People tend to borrow for major improvements with the justification it adds value to the property. Added value is debatable, but added debt is certain. Few people pay down their mortgage faster than a 30-year rate, and fewer manage to maintain that trajectory. Kudos and special recognition are in order for those who accomplish this difficult task.
HELOC Abuse Grade B
Earning a B in this system requires a debtor to at least hold the line on the total debt. Anyone who does better than treading water — which puts all interest-only borrowers on the line — can earn a B. As previously noted, prior to the bubble, few borrowers were near this threshold and most of the market earned a B for debt management.
Since lenders lost billions allowing copious amounts of mortgage equity withdrawal, since prices are no longer rising, and since the cost of money (interest rates) is likely to rise, borrowers of the future will be forced to earn a B as lenders drop their C, D, E and F customers.
Earning a B is a badge of honor; the scarlet letters are coming next….
HELOC Abuse Grade C 
I hate to give borrowers in this category a "passing" grade, but this is the reality for most Americans. Growing credit card or mortgage debt slowly generally can be compensated for through home price appreciation, and although I consider this a bad idea, I can't really call it HELOC abuse, just foolish HELOC use. Is there a distinction there? I will let you decide.
Financial planners will tell you that most people fail to budget properly for unexpected expenses (they don't save), so when they fall behind a little each month, they put the balance on a credit card and hope they can pay it back with a tax return — or during the bubble with a visit to the housing ATM.
People are still going to manage their bills this way going forward, and there will be pressures to "liberate" this equity to pay for these expenses. The money changers will continue to peddle this nonsense as sophisticated financial management. It is a stupid way to manage debt, and I give it a C.
HELOC Abuse Grade D
The transition between a grade C and a grade D is somewhat subjective, but it is hinged to an idea; once borrowers start knowingly increasing their loan balance to spend appreciation as a matter of habit, once they start expecting appreciation and HELOC money as a reliable source of income, they have moved from what some may consider legitimate use of HELOCs to Ponzi Scheme financing and ultimately a foreclosure implosion. This Ponzi borrowing limit is an invisible threshold borrowers do not realize they have crossed, but once they accept using debt to pay debt as a concept, they have crossed over to the Dark Side.
The top of the range of D graded HELOC abusers is the limit of each borrowers self delusion when it comes to how much appreciation they feel comfortable spending without losing their homes. People who earn a D still planned to keep their homes, they were merely misguided by their own ignorance and the incessant Siren's Song of kool aid intoxication. These are the sheeple; like the rats St. Patrick cast into the sea, each borrower followed the Piper to their underwater mortgage and a watery foreclosure.
HELOC Abuse Grade E
Most of the HELOC abuse posts I have done have been Grade E abusers because they are entertaining. When someone borrows and spends a $1,000,000, it is dramatic, and as an outside observer, you have to wonder what they spent all that money on.
Somewhere beyond the limit of self delusion, a borrower makes another psychological leap, they no longer worry about the consequences of their actions and they spend, spend, spend. This grading category spans the continuum from thoughtless spending to foolish and reckless spending where the borrower exercises no restraint at all.
HELOC abusers who get an E had to make an effort to spend. It takes time and effort to really spend beyond ones means one small transaction at a time. How many dinners out, trips to Vegas and other indulgences does it take to consume $1,000,000? I don't know, but grade E abusers try to find out.
HELOC Abuse Grade F 
Grade F HELOC abusers are the creme de la creme of their craft. These people are not maxing out their debt to spend recklessly — although I am sure much reckless spending occurred — grade F HELOC abusers are openly gaming the system to flip properties or strip equity while passing the risks on to lenders.
Another group that falls in this category are the Land Barons, as they are described at the Coto Housing Blog. People who stripped the equity from one property to acquire others build a massive Ponzi structure. Back in February of 2009, I profiled the holdings of one such land Baron in Everybody Wants to Own the World.
The upper limit of this boundary is determined by lender greed as reflected through their underwriting standards. During the housing bubble, this line was pushed so far as to create categories C, D, E and F. Since most of these people are going to lose their homes, expect to see lenders lower the trajectory of this line significantly.
Grade F HELOC abusers are the ones who benefited the most from the housing bubble. All Grade D, E, and F borrowers either have or will lose their homes. The grade F borrowers got to extract the most value out of their equity before the market collapsed. Any borrower who had any psychological restraint — even the clueless ones who get an E — are worse off than those who spent with the greatest abandon.
When you contemplate the wide range of bad behaviors that were encouraged during the Great Housing Bubble, do you think we will have future issues with moral hazard? I do.
{book4}
Irvine Home Address … 25 ROSE TRELLIS Irvine, CA 92603
Resale Home Price … $1,267,000
Income Requirement ……. $272,289
Downpayment Needed … $253,400
20% Down Conventional
Home Purchase Price … $1,274,000
Home Purchase Date …. 11/24/2004
Net Gain (Loss) ………. $(83,020)
Percent Change ………. -0.5%
Annual Appreciation … -0.1%
Mortgage Interest Rate ………. 5.33%
Monthly Mortgage Payment … $5,647
Monthly Cash Outlays ………… $7,640
Monthly Cost of Ownership … $5,630
Property Details for 25 ROSE TRELLIS Irvine, CA 92603
Beds 3
Baths 3 full 1 part baths
Size 2,650 sq ft
($478 / sq ft)
Lot Size 4,792 sq ft
Year Built 2004
Days on Market 3
Listing Updated 12/31/2009
MLS Number S599997
Property Type Single Family, Residential
Community Turtle Ridge
Tract Ledg
According to the listing agent, this listing is a bank owned (foreclosed) property.
Bank Owned Property With Spectactular City Lights Views. Upgraded 3 bedroom home with distressed hard wood flooring downstairs. Kitchen has a large center island, Granite counters and a breakfast nook. Each bedroom has its own bathroom with a guest half bath downstairs. Outstanding City views from master bedroom upstairs with two french doors to two juliet balconies. Upstairs laundry. Nice size Casita with full bath for your guests downstairs. An upgraded epoxy flooring in Garage. This community is guard gated 24 hrs with resort like association amenities that includes a Gym, Club House, Parks, picnic areas and two pools. Walking and biking trails everywhere with views of the city and the ocean. Agents, bring you clients to see this resort like area and this outstanding home. Don't miss out!
IMO, cropping the bottom half of the sunset photograph would be an improvement. The sunset is pretty; the black blob below is not.
upgraded epoxy flooring? Does epoxy flooring come in a standard and upgraded form?
bring you clients… correct you grammar…
Spectactular?
The lender is trying to break even and get late 2004 pricing. If they can find a qualified buyer, the property will sell.
What if somebody maxed out HELOC to buy gold in 2007 and then sold gold to pay off HELOC in 2009? Grade F for gaming the system or garde A for paying mortgage sooner?
Anyone perceptive enough to time that right deserves the A.
More likely just dumb luck.
Large majority are unable to time the market that well, the ones that do are often lucky (unable to repeat such prescient market calls).
Grade F for taking unnecessary risk.
Gold is less risky than residential real estate.
High liquidity. No taxes, repairs, maintenance, mello roos, HOA fees, fires, earthquakes, floods or 6% RE agent commission. It is unaffected by local crime rates, school ratings, pollution and nuclear plants.
Gold is almost perfect. Nothing to worry except new gold mines and recurring gold bubbles.
You are correct if it was dumb luck — which it would be if it actually happened.
If someone could foresee the chain of events correctly and act upon it, it would not be a grade F unecessary risk, it would be the necessary risk in order to pull off the trade.
This is a topic I have been thinking about lately. I recently got the book, The Greatest Trade Ever about Paulson’s shorting the subprime market. He took a huge risk based on his insight and won. Was he lucky or brilliant?
Maybe they shorted Fannie Mae?
I know some who paid off the whole house with the loan money turned to investment money, but most lost the investment.
Best abuse was refinance to make it non-recourse and pocket the money. Banks were issuing inovative put-options instead of making real loans.
House price goes up, we both win.
House price goes down, we cry for bailout, stick the govt with the bill. We both win and taxpayers get stuck with the bill.
How The Housing Bubble Destroyed Our Future
“… there was so much money to be made in derivatives and credit—largely arising from the underlying housing boom—that many of the smartest people got drawn into these areas rather than tech innovation. Basically, we got lots of questionable financial innovation instead of technological, medical, or environmental innovation.
If all of this had worked out to make us fabulously wealthy, there might not be much to complain about. The tech, green and bio-tech communities would just sound like special interests complaining their favored projects weren’t capturing as much attention and wealth as the enthusiasts think is deserved.
But that’s not what happened. The dearth of technological innovation is largely attributable to government regulations and a loose money policy that led to massive malinvestment. Sectors of the economy unrelated to housing were deprived of needed capital and talent, while the great quicksand of the housing boom sucked down everything.”
I think financial innovation gets short shrift in these arguments. Remember there was a bust from the Internet bubble, but lots of those innovations are still around and benefitting us. The depth and sophistication of finance is a boon, it just went too far. There are plenty of behind-the-scenes innovations that no one outside the industry knows or appreciates. That being said, you need some balance in there in allocating human capital and it got disrupted a bit.
Certainly banks would have innovated themselves right out of existence (and many did) if the Fed and Treasury hadn’t bailed them out with taxpayer money. We no longer have a free market economy, but a crony capitalist system controlled by the government.
Well, I’m trying to make it clear that there was plenty of good financial innovation going on. It’s at the point where that term has become so synonymous with abuse that it’s lost it’s meaning. Innovation that works well include the securitization of hard assets like steel and other commodities to free up cashflow for production businesses. Others include linking seamless credit facilities for cross-border transactions and shipping that allow small businesses to import more efficiently. This stuff lowers friction costs and keeps inflation low, benefitting everyone really.
As far as all these conspiracy claims, you’ve got to be careful not to get sucked into them based on emotional appeal. Believe it or not, congress is more concerned about votes that enable them to keep their jobs than the limited donations they can get from any one PAC or business. The system here works a lot better than other countries, but desparate folks feel better when there’s someone to blame. In reality, bad stuff happens to well-meaning people all the time.
Look at what happen to the US steel industry.
Crude oil was manipulated to $150/bl.
Farmers and ranchers, who are not vertically intergrated are lossing on each hog sold ($25), while record profits are being made by the middleman. That’s real inovation.
Most of what you’ve describle are the result of trade laws and computer networks. Just in time supplies in mfg. was a 1970’s Japanese technique and has nothing to do with financial inovation.
Really? Define “financial innovation” for me. Good luck because even the Surpreme Court can’t seem to get its arms around that one. Innovation interconnects lots of technologies and computers were a large part of the good and bad innovation surrounding CDO’s and derivatives.
On whether what I described is just a “rehash” you might want to look at all the issued patents that say otherwise. I worked in the field a long time as a patent attorney and saw the innovation directly. I didn’t get my information from watered-down mainstream media written by a bunch of English-lit grads who avoided algebra like it was the swine flu.
Much of US patent laws and ruling are artifical barriers to entry and where given like water for already in practice methods. Your beloved Sumpreme Court is re-eamining much of the issued patents that were broad and covered existing practices.
In the patent office, it was easier to issue a patent than fight an applicant, who was appealing.
Laws are artificial barriers to all kinds of behavior. Laws against theft are an artificial barrier that we choose to observe out of fairness. Oh, and patents are much, much easier to deny than grant – grants have dropped from 70% to 40% of applications over the past ten years.
Let’s take of the tin foil hat and return to the point of the whole discussion. Some “financial innovation” is a good thing for people and the economy. Because some innovation has resulted in unpleasant things, we shouldn’t pan all of it. I’m just looking to get people to consider some of the subtleties here.
Of course if you want to be the crazy guy shaking his cane in the parking lot, then go right ahead. I’m done.
ElricSeven,
I don’t know if you have seen some of the writings I did on CDOs, but you might find it interesting.
The Credit Bubble – Part 1
The Credit Bubble – Part 2
I made the same point that you have; structured finance is not the problem, it is what was put into structured finance vehicles that created the problem. I proposed methods to help rejuvenate these markets or at least reform them.
IR is right, it’s not the tools that are the problem, it’s *how* they are used. And right now they are being used to manipulate the market in order to keep the ponzy scheme alive, bubbly and all on the taxpayer’s dime. All this BS about healthcare and underwear bombers are just smoke screens to keep you from looking behind the curtain to see whose really in charge of the country.
The other scams in accounting such as internet bubble, caused misalignment of resources while enriching WS and leakage into the computer industry. Money leaked into the computer industry to discover and development new technology and intrastructure. Computers, programs, routers, network wiring, cable and optics.
The financial inovation was just a scam to move or transfer wealth. Very little money was used to invent new technology. Possible computers to move money with a keystroke and automated bookkeeping systems for self-directed trading. However, these were mostly from other industries. The inovation was more of creating new scams and getting the govt to back them. What are the “plenty of behind-the-seenes inovation” were created and unappreacited?
When WS does it, it’s called inovation. When done in other industries, crimial charges would likely be filed.
WS is futher backed stopped by govt. bailouts for loss. Socialization of loss and privatization of profits. It’s even more immoral when short-term profits are privatized via bonus and long-term loss are but on the backs of pension plans.
IR,
Interesting commentary asking yourself how much, if any, of the MEW apple you might have eaten…. I have wondered the same thing about myself had I purchased early in the cycle.
I always find it interesting how many MLS photos of REOs show fancy pool tables, large screen entertainment centers and above ground hot tubs…I mean “spas”. It’s almost like folks were running out of stuff to buy so they said “give me one of everything.” I think I saw a Richard Pryor movie like that back in the 80’s.
Nice property if you’re not hung up on curb appeal. The front of the house looks like the back of my apartment – the balcony just needs a wet suit and a unicycle.
Yeah, it’s one of those “all-garage” fronts that are pretty darned ugly.
A monthly $410 HOA fee for a SFR is just excessive, IMHO. What on earth does the HOA spend that much money on?
Geotpf,
HOA is used as a method to get around Prop. 13. HOA can be used to maintain the street (repair and cleaning), roadway landscape and watering, pools, tennis court, club houses, “parks” and other things which normally pay for “public” usage. Since it’s gated, guard service will be needed. Lots of stuff. My landlord is paying $450 per month condo HOA, but not even close to the facilities at T.Ridge.
If you have a big family and use the facilities, it’s not that bad compared to multiple gym memberships. Many of the HOA ones are much nicer than the monthly/yearly paid gyms in Irvine.
Some HOAs pay for front yard landscape and roof repair, but I don’t think front yard landscrape and roof is included in this T. Ridge HOA. Any Turtle Ridger want to comment on this?
Soylent Green Is People,
Excellent Financial Inovation in using a robotic ATM process. Did your company patent the process?
For a condo, I can understand a fee that high. That covers things like replacing the roof and maintaining the grounds. But for a fully detached house, the fee really should be a lot less. Things like replacing the roof are the homeowner’s responsibility.
As we structured 1st TD loans our company told us to offer a concurrent closing HELOC – which we would be paid on the entire, undrawn amount on a percentage basis so natch, we sold a great deal of HELOC’s. The best one we had (best as in EPIC FAIL)was a HELOC that automatically increased each year based on AVM’s. In other words, the quality control process was replaced by a robotic ATM process. These HELOCs were sold with an emphatic “Your line can never be decreased!” as if trees grew to the sun. Ahhh 2005… good times… good times!
How much would this help prop up “prices”?
– Gov. backs $10,000 homebuyer tax credit –
http://lansner.freedomblogging.com/2010/01/06/gov-backs-10000-homebuyer-tax-credit/50815/#comments
$18k goverment money is 3 1/2% down on $515k, no recourse. We can get in the game for nothing down?
Hmm… I wonder why the outside pics were taken in the evening? Could it possibly be so you wouldn’t see a bunch of cars cruising by at 100 miles an hour along the 73 tollway located a few hundred yards from your $1.25 million “resort like area”?
Lot Size (Sq. Ft.): 4,792
HOA Fee #1: $410
Thsi — for a million dollars or so?