Second mortgages came into vogue in a powerful way during the past few years, as borrowers were encouraged by their lenders to use them in lieu of the traditional down payment. But now, the rules have changed, and homeowners are being pushed from the skillet into the open fire.

During the most recent housing boom, huge numbers of homebuyers did something that would have been considered unthinkable in earlier years. Instead of using their savings to make a down payment on the purchase of a home, and start out with some equity on the books, they borrowed the down payment in the form of a second mortgage from their loan company.

The lender was hyper-extended by the added risk of two loans with no equity cushion to fall back on in the event of borrower default. The homeowner risked owing more than the house was worth if the market softened. Unfortunately, both scenarios happened in an industrial strength manner...and it created a trap.

No way out

The easiest way out of that mess was to refinance into a completely new first mortgage, with a better interest rate and more manageable payments. By saving money through the refinance, the homeowner could pay off the smaller second "piggyback" loan and eliminate it.

That effectively put the homeowner into a more normal financial situation that was standard business before these high-risk loan strategies came into fashion about 10 years ago. Back then, lenders typically required cash down payments of at least 10 or 15 percent for conventional loans backed by Fannie Mae, which agrees to buy mortgages that meet its underwriting guidelines.

Fannie Mae tightening belt

Then lenders got a little crazy, homeowners became more naive or reckless, and investors neglected to examine their own asset portfolios. The mortgage market imploded, and Fannie Mae is now gasping for breath. To get the wind back into its sails, it's decided to run a tighter ship by drastically altering its underwriting policies. The agency no longer permits mortgage refinancings from distressed markets (and almost all markets now fall into that category) if any of the money would be used to pay off a second mortgage.

Fannie Mae makes exceptions for borrowers who have at least 25 percent equity. But hardly anyone wanting to refinance to avoid foreclosure has that. In California, most homes have lost about 30 percent of their value in the past two years, for example, so 25 percent equity is now equal to about 5 percent negative equity. Adding insult to injury, second mortgage lenders also changed their rules, and now they require that homeowners get their consent before they can refinance a first mortgage. In other words, if you try to refinance your most burdensome mortgage, the lender may say that you first have to repay the entire second mortgage.

Scores of homeowners aren't allowed to refinance to avoid foreclosure, despite the refinance rescue rhetoric from lenders and politicians. A bad situation has only gotten increasingly worse this year, with no end in sight.

Published on June 28, 2008