Ann Wagner and her five children are losing their house.
Recently divorced, Wagner fell behind on $360-a-month payments on a second-trust deed. The payments were more than she could afford when combined with the $425-a-month due on the first trust deed. The house is being sold at foreclosure.
Gary Weiner lent $40,000 to a southern California family through Vista Financial Inc., a California mortgage broker specializing in matching up investors and borrowers. Although the borrower allegedly paid off the loan ahead of time -- to Vista -- Weiner has yet to get his money back.
The problems encountered by Wagner and Weiner represent two growing sources of concern about the booming business in second-trust deeds, a business that is nationwide in scope but particularly hot in California.
Once considered a social stigma and a source of loans only for the financially distressed, second-trust deeds are becoming popular and generally accepted as many homeowners like the Wagners tap their home equity.
The nation's roughly 55 million homeowners have $1.89 trillion in equity, an average of $34,000 each, the National Association of Realtors says.
But as the situation with Wagner and Weiner illustrate, dangers exist in this growing market.
Homeowners who borrow too much money face the possibility of losing their homes -- a problem intensified by the burden of interest rates that in some cases amount, in effect, to as much as 35 percent a year.
At the same time, individual investors, attracted by yields generally between 17 percent and 25 percent, could lose their money. The potential for fraud has already attracted the attention of the Securities and Exchange Commission, which recently signed a contest decree with one southern California mortgage broker with a $100 million trust deed operation. The SEC alleged that the broker had engaged in deceptive practices.
"I am concerned about the blind flight into second-trust deeds as both debt and as an investment," says Anthony M. Frank, chairman of United Financial Corp. "There could be a lot of people in trouble down the road."
Despite the risks, borrowers are using second-trust deed money to remodel their homes, buy more real estate, pay college tuition, invest in a business or consolidate bill payments. For this money, they are paying unusually high interest rates -- now between 17 percent and 25 percent, plus loan fees, or "points," which can eat up 15 percent of the loan itself. That can work out to an effective annual interest rate of as much as 35 percent. Because of these fees, a homeowner may need to borrow $35,000 to end up with $30,000.
With the house considered good collateral, some lenders consider the borrower's credit unimportant.
"We don't look at your credit because if your credit is good, you might not need the money. Your credit card with us is the equity in your house," Gary Judis, president of Aames Home Loans of Southern California, said in an interview. Judis, also president of the California Independent Mortgage Brokers Association, refers to an old saying: "A banker is a fellow who gives you an umbrella on a sunny day and takes it away when it's raining." Aames, Judis says, is equipped to handle the rainy days.
Second-trust deeds offer a key advantage to the homeowner -- a tax-free way of pulling money out of the house. Of course, any interest paid on the loan is tax deductible. Generally, the homeowner can spend the money as he or she pleases, since many lenders -- happy to have the security of the house as collateral -- ask no questions about the use of the money.
With a second-trust deed, the property is the collateral for the loan. Thus, if the borrower fails to make the payments, the lender can foreclose and sell the house to get his or her money back. The lender with the first trust deed gets reimbursed first, then the second-trust deed lender and so on. Any leftover money is returned to the homeowner. Trust deeds are often referred to as mortgages, but there are technical differences.
"Seconds are a rational response to inflation in the housing market," says Kenneth Rosen, an economist at the University of California at Berkeley. "People would rather have cash in their hand than in their house." But he warns that each borrower should consider his or her financial position before taking out a loan.
"Second-trust deeds are a good basis for home improvement loans that enhance the value of the house," said Raymond Jallow, senior vice president and chief economist at United California Bank.
For example, Conway Collis, who purchased his house in the Venice district of Los Angeles in 1977 for $65,000, is delighted with the new hot tub, remodeled kitchen and extra bathroom added onto his house. Figuring that his house was worth more than $130,000 even before the improvements, he borrowed $30,000 on a second-trust deed from a bank.
Although Jallow is generally positive about second-trust deeds, he is concerned that some homeowners are using the money to invest in other real estate, a phenomenon that could further fuel housing inflation, ultimately producing artificially high prices and a potential for a future price collapse.
Members of one suburban Los Angeles family, who last year needed $95,000 as a down payment on a 12-unit apartment building, are now in over their heads. Their house, purchased in 1976, was valued at more than $300,000 and so the increase in equity served as collateral for the $95,000 second-trust deed.
With the downturn in the economy, the wife's income from selling jewerly has dropped sharply, and the family at one point fell behind on its monthly payments. Still having difficulty, they plan to borrow even more money against their equity -- this time getting a third-trust deed -- and use this money to make payments on the second.
But ultimately, if the familiy's income fails to rise, they will be forced to sell their house to repay all these loans -- or face foreclosure. In short, it is a financial treadmill from which escape is difficult.
The treadmill caught Joseph and Clarice Wyatt, a Placerville, Calif., couple who in 1967 needed $1,000 to make some home improvements. Eventually, they won $200,000 in punitive damages from Union Home Loans in a case finally decided by the California Supreme Court in 1979.
In its decision, the state Supreme Court said that substantial evidence existed to show that Union was engaged in a scheme to trap and defraud the Wyatts.
The court said that "once trapped by the unexpected large balloon payment due at the end of the first loan," the Wyatts found themselves forced to refinance the loan. This permitted the repetitive collection of brokerage fees and late charges from the Wyatts, depleting their resources and moving foreclosure ever closer, the court concluded.
Because the Wyatts' monthly payment covered only the interest on their loan, at the end they still owned all the principal in what is called a "ballon payment," court documents show. First trust deeds in contrast, are "self-amortizing"; that is, the principal is paid off during the life of the loan.
Despite some changes in the law since the Wyatt loan, consumer advocates contend that similar experiences are happening to other borrowers who are perhaps unsophisticated and unrealistic about what they can afford to repay. With interest rates so high now, many borrowers are getting loans that call for interest payments only because they cannot afford to also pay off some of the principal each month. Then at the end of the loan, the homeowner, must come up with the balloon payment.
Despite the risks, home foreclosures historically have been fewer than l percent. These statistics, however, do not indicate how many people, who are forced to sell their houses before they lose them because they had difficulty making the payments. And with the enormous growth in second-trust deeds just in the last two years, many borrowers will face balloon payments in coming years.
Many of the borrowers are two-income families, says Mike Salkin, an economist with Bank of America, and problems could arise if a serious recession develops and many families lose one wage earner.
The increase in the value of California real estate and the rise in demand for second-trust deeds has brought competition to the mortgage brokers, who have historically dominated the market. Many lenders -- banks, savings and loans, finance companies, thrift and loans -- now offer second-trust deeds.
Savings and loan associations, many of which have pulled back from making long-term, fixed-rate first-trust deeds because of the volatility in interest rates, are the newest group to enter in a big way.
Explains Monroe Morgan, senior vice president with Great Western Savings and Loan Association. "We are searching for ways to have more flexible interest rate mortgages. Second-trust deeds have shorter maturities and so we can adjust rates more quickly." At Great Western, for example, second-trust deeds typically mature in five years, in contrast to 30 years for first-trust deeds.
Home Savings and Loan Association, the largest in the nation, also offeres seconds and has curtailed its first-trust deed lending, limiting new firsts only to existing customers and to new loans for owner-occupied homes in minority areas.
Because banks and savings and loans generally have the most stringent credit requirements, they usually charge the lowest rates.
Finance companies, lured by the security of using the house as collateral, are moving away from their traditional pattern of lending on consumer items such as furniture and appliances. Between 1978 and 1979, their volume of second mortgages and second-trust deeds rose 75 percent, compared to a 10 percent hike in other types of personal loans, according to a study by the National Consumer Finance Association. At the end of 1979, finance companies held $11.7 billion in second mortages, and William Moroney, a spokesman for the Washington-based trade group, estimates that the figure almost doubled to $20 billion by the end of 1980.
Because of the new laws making it easier to escape creditors by declaring bankruptcy, Moroney says, "anyone who can is edging away from unsecured credit to secured credit." With a second-trust deed, or mortgage, the lender has the house as collateral and unlike a credit card bill, the debt cannot be discharged by bankruptcy. (In many cases, homeowners who keep up their monthly payments on any loans secured by their houses can keep the houses and still go bankrupt. But if they fall behind, they are subject to foreclosure).
When obtaining a second-trust deed, consumers have some rights designed to protect their interests.
Under truth-in-lending laws, borrowers have three days after signing the loan papers in which to decide against taking out the loan. In some cases, they may still have to pay various miscellaneous costs such as an appraisal fee on their houses. State laws regarding lien sale contracts, where homeowners pledge their houses as collateral to purchase items such as a burglar alarm, have been strengthened to assure that consumers are aware of their actions.
Because balloon payments with large amounts coming due at the end of the loan term can be dangerous, state law requires that balloon payments can only be tacked onto loans more than six years in length unless the loan is more than $10,000. Some consumer advocates think the dollar limit should be raised because $10,000 is in most cases a small-second-trust deed today.
"Balloon payments are the real danger," says Irvine P. Dungan, the Sacramento, Calif., attorney who represented the Wyatts and still has cases pending against some mortgage brokers. "The broker refuses to extend the loan forcing the people to refinance with him or go somewhere else, sell the house or go through foreclosure."
The SEC is attempting to police some aspects of the second-trust deed business. In early January, the commission announced that it had signed a consent decree with the Western Sierra Group of San Bernadino, Calif., in connection with a $100-million trust-deed operation.
In a civil lawsuit, the SEC alleged that many investors who thought they were investing in second-trust deeds were in fact getting third-, fourth- and fifth-trust deeds. In addition, the SEC charged that Western Sierra falsely claimed that the amount of loans on any property would not exceed 70 percent of the fair market value. Without admitting or denying the charges, Western Sierra agreed to take a variety of actions designed to protect investors.
The SEC's claim of jurisdiction in this case stemmed from its contention that Western Sierra was selling a "security," subjet to SEC anti-fraud and registration regulations. Because of the large amounts of money and numbers of investors involved, the SEC is committing manpower and resources into further investigating the second-trust deed market, says Michael Stewart, the regional administrator for the Los Angeles area.