More Problems With Prime Home-Equity Loans

New data seem to confirm fears that Countrywide Financial is not the only lender facing problems with prime home-equity loans.

Countrywide set off a panic in the stock and bond markets when it said a week ago that 4.6 percent of its prime home-equity loans were delinquent or in foreclosure as of June 30, up sharply from 3.8 percent three months ago and 1.8 percent a year ago.

Although subprime delinquency rates have been soaring, Countrywide was the first major lender to report rising delinquencies among prime borrowers with higher credit scores. But it won't be the last.

Industrywide, the percentage of prime home-equity loans at least 60 days delinquent has more than doubled to 1.14 percent in May from 0.51 percent in May 2006, according to new data from First American LoanPerformance.

Most borrowers use home-equity loans and lines of credit to take cash out of their existing homes or to buy a home when they don't have a big enough down payment to avoid mortgage insurance. In the latter case, the home-equity loan is added to the first mortgage and often called a piggyback. LoanPerformance found rising delinquencies in both types of home-equity loans.

If home-equity delinquencies spread, lenders might continue to raise rates and reduce the amount of money they're willing to lend.

Prime borrowers are still defaulting at a much lower rate than subprime borrowers with low credit scores. There's no strict cutoff, but mortgage companies usually consider borrowers with FICO scores below 620 (on a scale of 350 to 850) to be subprime.

Almost 24 percent of Countrywide's subprime mortgages were delinquent as of June 30, up from 15.3 percent the previous year.

Industrywide, subprime delinquencies roughly doubled to 16.3 percent in May compared with 8.2 percent the previous May, according to LoanPerformance. (Countrywide's rate is not directly comparable to the industry rate.)

Delinquency rates also have been rising for Alt-A loans, which are loans that go to borrowers with prime credit scores but have other nontraditional features, such as no income documentation or 100 percent financing.

Delinquency rates for prime first mortgages, however, have barely budged. Until last week, most analysts weren't focusing on the home-equity market. Countrywide's announcement was the first clear evidence that mortgage problems could spread to prime.

"I don't think (Countrywide's announcement) should have been a surprise, but up until a month and a half ago, the majority of people were saying this was just a subprime problem," says Joshua Rosner, managing director of research firm Graham Fisher & Co.

Joseph Mason, an associate finance professor at Drexel University, expects to see more problems with mortgages that were disguised as prime.

"Much of prime is not really prime. The Alt-A base (has) been found to be really subprime. And much of the subprime has turned out to be flat-out fraud," Mason says.

"Borrowers over-borrowed, brokers over-lent, investment banks oversold performance and rating agencies overrated (mortgage-backed securities). What we thought was quality was not quality," he says.

Rosner and Mason, who have written papers together, argue that banks and other institutions are sitting on large mortgage losses they have not realized because they are relying on faulty valuation models. At some point, they will be forced to realize those losses and the scope of the problem will become clearer.

In the meantime, lenders are adding risk premiums - higher interest rates- to all types of loans, even mortgages.

"There are true prime credits in the economy, not what has been marketed as prime. The market overall is charging a premium for all credits because of the difficulty in sorting out what is truly prime and what is marketed as such," Mason says.

"I just bought a house, moved in last week. I could have gotten a much better rate six months or a year ago," he adds.

Holden Lewis, a senior reporter for Bankrate.com, says it does appear that lenders have been adding a risk premium to home loans.

The interest rate difference between the average prime 30-year fixed-rate mortgage and the 10-year Treasury note was 1.83 percent last week, up from 1.65 percentage points four weeks ago.

The difference between the average $30,000 home-equity loan and the 10-year Treasury was 3.12 percentage points last week compared with 2.95 percentage points four weeks ago.

Rising home-equity defaults could cause lenders to raise rates even higher and demand stiffer terms.

"At some institutions, it's already hard for anyone to get above 90 percent loan to value," Mason says.