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HELOC Defaults Could Be Next Villain To Victimize Housing Market

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Horror movies often follow a familiar script. The antagonist, typically a ghost, monster or other kind of primal beast, brutalizes a string of unsuspecting victims, causing widespread fear, chaos and death. This villain then retreats, remaining out of sight but never really vanishing entirely, disappearing only long enough to contemplate its next move.

Meanwhile, the movie’s surviving characters are scarred, sometimes emotionally, other times physically. But eventually their frazzled nerves calm and their guard comes down. And, of course, that’s when the villain returns to unleash another round of terror.

Something very similar could be unfolding in the housing market. While not nearly as macabre as a chainsaw-wielding murderer, housing-related defaults - a villain from the not so distant past and a principal driver of the financial crisis - could soon become an issue again.

Every day around the country thousands of borrowers are facing principal payments on home equity lines of credit (HELOCs) that were originated 10 years ago. At the time, the excesses of the mid 2000s were in full bloom and the system was awash in easy credit. The only thing that matched the banks’ willingness to issue such loans was the eagerness with which Americans took them out – often to finance lavish vacations, large boats or other frivolous purchases.

According to Experian, approximately $265 billion worth of HELOC loans were originated between 2005 and 2008. By comparison, between 2000 and 2002 that market was around $20 billion. Up until now, much of the damage from this mounting debt has been contained because borrowers have only been compelled to make interest payments. But now those loans are in or nearing the repayment phase.

That’s significant, because over the last two calendar years there has been a sharp uptick in 90-day delinquencies for borrowers in the repayment phase, Experian says. Also consider that the S&P/Experian Consumer Credit Default Indices showed that the default rate on second mortgages – which include HELOCs – jumped in June over May, from 0.42 percent to 0.55 percent, the biggest monthly increase since 2013.

Whatever happens, we certainly won’t see a repeat of 2008. For one, HELOCs are far less numerous and represent fewer dollars than traditional mortgages. Also, they are typically not bundled together into bonds and sold to outside investors. That means their tentacles don’t stretch quite as far, making a cataclysmic event that cascades throughout the entire financial system a near uncertainty.

Even so, given the fragile state of the economy – which seven years into its recovery remains sensitive to even localized shocks – the impact of another round of housing-related defaults could be significant.  That could spell pain for some investors, as well as some financial institutions, including small regional banks who have large HELOC exposure relative to their overall balance sheet.

But large banks will also feel pressure. Perhaps none more so than Bank of America. Having been bludgeoned by hefty fines and legal fees stemming from its lending practices, the bank, once the nation’s largest in terms of deposits, has struggled in the wake of the financial crisis. While rivals such as JP Morgan Chase and Wells Fargo have nursed themselves back to health and resuscitated their reputations with investors alike, Bank of America’s performance has mainly flat lined, struggling to demonstrate any significant growth across its various business units.

With heightened capital requirements and stricter regulations already in place, much of the banking industry can ill-afford another round of defaults. This is especially true for Bank of America. If this potential mini-crisis is not contained, the bank’s ongoing problems will only become further inflamed.

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Obviously, any disruption in the housing market could also spell doom for the nation’s top home builders. Beazer Homes and Lennar Homes have both outpaced the overall market since the beginning of the year. Another hiccup would merely add to the list of stops and starts such firms have endured since the housing bubble burst.

Meanwhile, in a perverse way, online real estate databases such as Red Fin and Zillow may prosper in the face of HELOC-related disruptions. Opportunity buyers could once again play a dominant role in the market, snatching up steeply discounted properties for investment purposes. That may drive increased traffic to these platforms, providing them an opportunity to demonstrate their value and capture more fees.

Another possibility to consider is that in the long run a rise in HELOC defaults may actually be beneficial for the country as a whole, representing one last – but necessary – setback for the housing market that could ultimately emerge stronger and more stable. Not only would older individuals with declining earning power think twice before assuming new debts, but housing prices would likely be more resilient due to fewer defaults and less overall financing risk built into the system.

That’s the silver lining. Shorter term, though, it’s hard to find much potential good in this scenario, and investors should prepare themselves for the fallout and the potential opportunities beyond.

Steven Dudash is President of IHT Wealth Management, a Chicago-based firm with approximately $650 million in assets under management.