A Matter of Second-Trust

This article originally appeared on RealMoney.com on Sept. 3, 2014 at 4:00 p.m. To read more content like this AND see inside Jim Cramer's multi-million dollar portfolio for FREE... Click Here NOW.

Another round of legacy issues in the mortgage industry will soon confront the housing and banking sectors. Adjustable rate first and second loans (most with 10-year resets) that were a large percentage of the loans originated at the height of the housing mania are now approaching their reset dates. The largest concentration of these was for properties financed with jumbo first-trust loans, which means they are mostly on higher-priced properties.

Let's look at the second-trust issue. There are two kinds of second-trust residential mortgages: open-ended and closed-ended.

An open-ended second-trust loan is typically a line of credit with a 30-year amortization and an ability to draw against the line of credit for the first 10 years. During that time, the mortgagor pays interest only at the accrued rate on the portion that's been drawn. At the end of 10 years, the remaining balance is converted to a fully amortizing loan over the remaining 20 years.

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A closed-ended second-trust loan is a fully amortizing fixed-rate loan with a period of 10, 15, 20 or 30 years, although some have 10-year balloons.

The current issue facing the mortgage and housing industries are the open-ended second-trusts that were originated as purchase-money loans in which the entire line of credit was pulled at the closing of the home purchase. There are currently about $500 billion worth of open-ended second-trusts within the U.S. banking system compared with only about $80 billion that are closed-ended. To put that in context, there is about $675 billion of credit card debt and $1.75 trillion of first-trust loans. Credit cards and first-trusts don't have resets after 10 years that send payments up, though. The open-ended second-trusts are a big deal.

It was very common during the housing mania for a purchase-money mortgage structure to be put together as an 80% first-trust and a 10% second-trust for conventional conforming loans, and a 75% first-trust with a 15% second-trust for jumbo loans. In both cases, the borrower put down 10% of the purchase price and avoided having to pay mortgage insurance by capping the first-trust at 75% to 80% of the purchase price. What was also common was to use an open-ended second-trust because the payments were lower than a closed-ended loan, and the borrower only had to qualify for the interest-only payment.

For example, a common purchase-money structure in the mid-2000s was a $700,000 purchase with a 75% first-trust of $525,000 and a 15% second-trust of $105,000. The second-trust would carry an interest-only payment on an adjustable rate basis, usually tied to a U.S. Treasury or Libor index with accrued rates in the 3% range -- 105,000 at 3% interest only is a monthly payment of $262.50 for 10 years. At the end of 10 years, some loans convert to a 20-year fixed rate while others remain adjustable. Even if the accrued rate stayed at 3%, the conversion to a fully amortizing payment causes the second-trust payment to jump by more than 100% to $582.33 for the remaining 20 years. That is a best-case scenario. Conversion to a fixed rate could result in an accrued rate in the 8% range and payments increasing more than threefold to $878.26.

Even as the percentage of non-performing first-trust residential mortgages has been slowly decreasing over the past four years, the default rates on open-ended second-trusts that are concentrated in the money centers, JPMorgan Chase (JPM) , Wells Fargo  (WFC) , Bank of America  (BAC)  and Citigroup  (C) , has been rising. It's also a growing issue at PNC Financial  (PNC) .

The industry average for default rates on open-ended second-trusts when these loans were originated 10 years ago was an insignificant 0.2%. That jumped to a high of about 2.9% in the third quarter of 2012 and is currently holding at about 2.7%. The probability, however, is that the rate of defaults on these loans will begin to increase well above the previous high over the next 24 to 36 months as the 10-year resets kick in. The default rates at the money centers and at PNC are about twice the national average for the banking system overall.

The principal issue for investors is that a defaulted second-trust requires the loan to be charged off and absorbed by loan-loss reserves, which will have to be replenished by earnings. Furthermore, the collateral must also then be liquidated by way of short sale or foreclosure even if the first trust is performing. At this time, I don't know how the lenders are going to manage this situation, but it's going to provide a drag on earnings.

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At the time of publication, Arnold had no positions in the stocks mentioned.

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