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San Francisco Regional Outlook, First Quarter 1999

In Focus This Quarter High Loan-to-Value Lending: A New Frontier in Home Equity Lending High loan-to-value (HLTV) loans are typically junior liens on owner-occupied single-family residences, but there is limited collateral protection because the combined loan amounts often exceed the value of the home. Nonbank, specialty lenders have dominated this line of business, and their growth has been fueled by strong demand for asset-backed securities collateralized by HLTV loans. Insured depository institution involvement in HLTV lending has been increasing, and opportunities for further involvement opened up when market turmoil resulted in a contraction of HLTV specialists. HLTV lending involves unique risks because it combines characteristics of both secured home equity lending and unsecured consumer lending. Just a few years ago, it would have been difficult to imagine a mainstream lender writing a home equity loan in excess of the equity that the consumer had in his or her home. However, intense competition and declining profit margins in traditional home equity lending have lenders looking to boost volume and profits by relaxing underwriting standards. At the same time, consumers are signaling their desire to transfer their credit card balances to lower-costing home equity loans. These trends have given lenders, including insured depository institutions, the impetus to enter the HLTV home equity market. Furthermore, new opportunities have opened up for insured depository institutions to get involved in HLTV lending as a result of turmoil in the equity and asset-backed securities market, which resulted in a severe liquidity crisis that effectively sidelined many HLTV specialists. HLTV Lending Taps Consumers' Desire to Shift Credit Card Debt into Home Equity Loans For the better part of the 1990s, credit card lending was dubbed the Wild West of consumer credit. This title was earned, in part, by lenders' aggressive marketing and solicitation of their cards and consumers' willingness to push their holdings of credit card debt to record high levels. After several years of double-digit growth in credit card outstandings, the growth has slowed. However, this slowdown does not necessarily mean that the Wild West has been tamed. In fact, home equity lenders are blazing new frontiers in consumer credit. Chart 1 shows that the originations of home equity loans for asset-backed securitizations have surpassed the originations of credit card loans over the past two years. Chart 1 It could be said that the home equity industry owes its resurgence to the boom in credit card lending that preceded it, because today's home equity borrowers primarily use these loans to consolidate their outstanding debt. A survey by the Consumer Bankers Association found that, whereas in 1991 home improvement was the primary reason for taking out a home equity loan, debt consolidation is now the primary reason, with 40 percent of borrowers using a home equity loan for this purpose in 1997. This shift also is evidenced by another recent survey by Brittain Associates, Inc., which estimated that during a 24-month period ending June 1998, 4.2 million households converted $26 billion in credit card debt to home equity mortgage debt. Given the high levels of credit card debt on households' balance sheets, it should be no surprise that consumers with other borrowing options are looking for ways to consolidate their debt and reduce their borrowing costs. HLTV Loans Are Hybrid Loans HLTV loans are considered hybrid loans and can be thought of as a marriage between secured lending and unsecured credit card loans. HLTV loans are typically junior liens on owner-occupied single-family residences where the combined loan amounts exceed the value of the home—sometimes by as much as 125 to 150 percent. Some lenders also make HLTV first mortgages, which enable consumers to finance their down payment and closing costs and consolidate other debts. In return for pledging their home as collateral, borrowers are charged lower rates of interest than on unsecured consumer loans. Even at 125 to 150 percent loan-to-value, the rates on HLTV loans generally are lower than credit card loans. In 1997, the average rate on an HLTV was 13 to 14 percent, whereas the average rate on a credit card loan was 16 percent. Because HLTV loans carry lower interest rates and are long-term loans (15 to 30 years), the monthly payment on one is often considerably less than the total monthly payments on the loans that were paid off in the consolidation. HLTV loans also appeal to consumers because they can benefit from the tax deductibility on a portion of their interest payments. Current IRS rules allow interest to be deducted on that portion of the loan that is equal to or less than the value of the home at the time the loan is closed. The primary disadvantage of converting unsecured credit card and other consumer debt to an HLTV loan is that in the event of default, the borrower could lose his or her home. However, many consumers burdened by the high cost of unsecured consumer debt apparently have viewed the chance to lower their monthly payments as worth the risk. HLTV loans have been particularly popular in California, where property value declines in the early 1990s left homeowners with little or no equity in their homes. The inset box shows the typical characteristics of an HLTV loan and an HLTV borrower. Typical HLTV Borrower Characteristics Annual Income $60,000 Job Tenure 5 years Age Late thirties FICO Score 680 Outstanding Nonmortage Debt $20,000 First Mortgage Amount $110,000 Property Value $130,000 Typical HLTV Loan Characteristics Amount $30,000 Contract Interest Rate 13 to 14% Term 25 years Loan to Value 110% Notes: HLTV = high-loan-to-value; FICO=Fair, Isaac Company Source: General Accounting Office, based on interviews with public and private officials Underwriting of HLTV Loans Emphasizes the Borrower's Credit Quality Because of their limited or nonexistent collateral protection, HLTV loans typically are considered unsecured loans and the emphasis in underwriting is on the borrower's credit quality rather than on collateral value. Large HLTV lenders use credit scoring to underwrite their loans, and a major component of their scoring is a credit bureau or Fair, Isaac Company (FICO) score. Other important factors are the borrower's debt-to-income ratio, mortgage credit history, consumer credit history, bankruptcies, foreclosures, notice of defaults, deeds in lieu of foreclosure, and repossessions. HLTV loans are not necessarily subprime loans; the term "subprime" refers to the credit quality of the borrower rather than the margin of collateral protection. Instead, many lenders assert that HLTV loans are made to "prime" borrowers and can point to the fact that FICO scores on HLTV loans have been rising, averaging approximately 689 in 1998. Scores above 680 are generally associated with "A" credit quality; however, the average ignores the fact that major HLTV lenders allow FICO scores to go much lower, typically as low as 620.1 Standard & Poor's recently reported that performance problems clearly exist on loans for which the borrower's FICO score is below 650.2 1 H.T. Katz and G.T. Costello, Fitch IBCA Credit Rating Company. "Securitization of 125 LTV Mortgages." Structured Finance Special Report, March 4, 1998. Underwriting guidelines summary matrices are provided for seven large HLTV lenders. 2 "High LTV Security Performance Expected to Improve as FICO Scores Rise and FHA Title 1 Loans Disappear." Inside MBS & ABS, November 13, 1998, p. 9. The agencies that rate asset-backed securities collateralized by HLTV loans offer another perspective on the credit quality of HLTV borrowers. Moody's has described HLTV borrowers as in the "A–" to "B" grades, and Standard & Poor's has characterized the loans as "A–" to "B+" in terms of credit quality. Any grade below A can be considered subprime. Indeed, according to Mortgage Information Corp., the bulk of subprime mortgage activity occurs in the A- category. However, some analysts have preferred to characterize HLTV borrowers as squarely in between the subprime and prime designations. Whatever the label given to the quality of borrowers, they typically have a large amount of high-cost revolving debt, and converting this debt into a second lien on their home is an attractive alternative. They also might have some degree of poor credit performance. Table 1 shows the underwriting criteria used by one of the largest HLTV lenders. Because underwriting classification systems are not uniformly applied among HLTV lenders, this table should be viewed only as a guide. Fueled by Easy Access to Capital, HLTV Loans Have Grown Rapidly On the basis of the volume of loans securitized, the HLTV loan market has expanded rapidly over the past several years (see Chart 2). Originations have grown from $1 billion in 1995 to $8 billion in 1997 and are expected to be around $12 billion in 1998. Chart 2 Nonbank, specialty finance companies presently dominate the HLTV market, and their easy access to capital has been an important factor behind their growth. These specialists depend on their ability to securitize the loans and sell them in the asset-backed securities market. Strong investor demand for all kinds of asset-backed securities has allowed HLTV lenders to raise a substantial amount of funding without a strong degree of corporate credit quality. However, their reliance on the asset-backed securities market to fund operations exposes them to liquidity risk if demand for these securities declines. A healthy initial public offering market also has fueled the growth of these specialty lenders, and gain-on-sale accounting has allowed lenders to establish an earnings track record and attract debt and equity investors. Gain-on-sale accounting requires securitizers to calculate and record a gain on sale from securitizations; however, the use of gain-on-sale accounting exposes lenders to prepayment risk. If the securitized loans prepay at a faster rate than the assumption used to calculate the gain, the company could be forced to take a write-down, which can affect earnings, liquidity, and capitalization. Institutions that invest in securities collateralized by HLTV loans also are exposed to prepayment risk. (For more information on gain-on-sale accounting, see "Gain-on-Sale Accounting Can Result in Unstable Capital Ratios and Volatile Earnings" in Regional Outlook, second quarter 1998.) In addition to the easy access to capital, favorable economic conditions also have encouraged HLTV lending. The long economic expansion has brought about the return of home price appreciation to nearly all parts of the country, which has encouraged HLTV lending because rising home values serve to reduce lender and investor exposure fairly quickly. The median sales price of existing single-family residences has increased an average of 4.39 percent per year since 1995, according to the National Association of Realtors. Market Turmoil Hit HLTV Specialty Lenders Hard The market volatility that began last summer illustrated the importance of liquidity risk and prepayment risk. HLTV specialists were faced with a liquidity crunch when they were hit hard in the equity downturn, in many cases significantly harder than the general market. Investors retreated from HLTV lenders and their asset-backed securities, in part as a result of a "flight to quality" as the Asian crisis spilled over into other global markets. A core of investors participating in the HLTV market also exited the market when prepayments occurred at faster rates than anticipated, largely a result of lower market interest rates, and forced lenders to take write-downs of interest-only residuals. Another factor in the investor retreat from this market was the growing skepticism concerning the performance of HLTV loans during an economic downturn. When investor demand for asset-backed securities dried up, HLTV lenders were unable to securitize their loans profitably. This situation created a severe liquidity crisis for specialty lenders who relied heavily upon this source of funding. As a result, some lenders were forced to put themselves up for sale, and others were forced to undergo massive restructuring. HLTV Lending Presents Unique Risks to Home Equity Lenders In addition to the risks associated with the securitization of HLTV loans (liquidity and prepayment risk), HLTV lending poses some unique risks for lenders who hold these loans in their portfolio, service them, or guaranty the performance of asset-backed securities. Because HLTV loans are a relatively new product, their credit risk is untested and could be affected by the following factors: Increased rate of default. Data on the performance of HLTV loans are limited; however, the loss potential is starting to become visible when vintage analysis is performed. Chart 3, below, shows that when recent vintages are adjusted for seasoning, charge-off rates on HLTV loans are increasing at a rapid rate. Both the severity and frequency of default are much higher than for traditional A-quality home equity loans and are even higher than subprime home equity loans. The fact that charge-offs are higher than subprime loans suggests that the credit quality of HLTV borrowers is not too different from subprime borrowers and that when default occurs, the loss is more severe because of the lack of collateral protection. Lenders who do not accurately forecast the magnitude and costs of default associated with HLTV loans, or who make underwriting mistakes, might find that this line of business is not as profitable as anticipated. Chart 3 Lenders that rapidly increase HLTV exposures might consider the use of vintage analysis, also called "static pool" analysis, as a means of evaluating loan portfolio performance. This technique is effective when there is rapid growth, which can make it more difficult to accurately track delinquency and default trends when only an average delinquency or default ratio is calculated. Refer to "Subprime Lending: A Time for Caution" in Regional Outlook, third quarter 1997, for additional discussion on vintage analysis. Untested performance in a recession. HLTV lending has existed for only a few years and has yet to be tested by economic recession. The rapid rise in charge-offs on HLTV loans has occurred in a relatively robust economic environment, and the losses during an economic downturn could be considerably higher than anticipated. Moody's has asserted that losses will mimic those of credit cards, and losses on credit card loans are usually higher than other consumer mortgage-related products. HLTV lenders' heavy reliance on credit-scoring models raises further questions about how these loans might perform in a recession because these models are largely unproven in a recession as well. To improve the accuracy of credit-scoring models and the model's ability to appropriately price the risk assumed, lenders can continually test and refine credit-scoring models to ensure that actual performance approximates projections. Changes in the borrower's financial condition present a greater risk to HLTV lenders than in other types of secured lending, which introduces additional credit risks. In the event of default, the lender is likely to suffer a complete loss because foreclosure is probably infeasible and the size of HLTV loans is much larger than other types of unsecured or partially secured loans. Therefore, adverse changes in the borrower's financial condition are very important and can be affected by the following factors: Debt reloading. The primary reason consumers take out an HLTV loan is to consolidate credit card and other high-cost consumer debt. However, lenders cannot prevent HLTV borrowers from running up additional credit card debt after the loan is made. Consequently, these loans might serve to only postpone or amplify credit problems. A recent survey by Brittain Associates, Inc., indicates that a large percentage of borrowers who take out home equity loans proceed to run up credit card debt shortly thereafter. Their survey of over 6,000 borrowers who used home equity loans to consolidate their debts revealed that only 30 percent of those borrowers remained free of credit card debt one year later. Long-term exposure. Consumer loans typically have been made on a short-term basis; however, HLTV loans are made for terms up to 30 years. Therefore, the credit quality on an HLTV loan is more vulnerable to catastrophic events such as borrower job loss, illness, or divorce. Furthermore, the term of these loans far exceeds the predictive power of FICO scores, which have proven to be predictive for about a two-year period according to Moody's. Because of their fixed terms and limited collateral protection, there are some unique operational risks associated with servicing and collecting an HLTV loan. Servicing and collecting an HLTV loan differs somewhat from servicing and collecting both secured lending and credit card lending because of the following factors: Limited default remedies. The servicing and collecting of HLTV loans are complicated by the fact that the threat of foreclosure is not as severe as in traditional secured lending. According to Moody's, HLTV lenders must adopt a collection strategy similar to credit card lenders that will require early intervention and the ability to "talk" the borrower into making a payment without resorting to foreclosure. However, unlike credit card lenders, HLTV lenders have less flexibility in collection because lines cannot be adjusted and interest rates cannot be raised. The different demands for servicing and collecting these loans, compared with traditional and subprime home equity loans, could strain institutions that do not have an adequate investment or expertise in collecting these loans. According to Moody's, HLTV lenders generally write off their loans as a loss once they become 180 days delinquent. In contrast, subprime lenders go through a lengthy foreclosure procedure. The speedier resolution of HLTV loans is reflected in a lower level of delinquencies in HLTV portfolios compared with subprime portfolios (see Chart 4, below). Chart 4 Limited borrower flexibility and motivation. After a borrower has taken out an HLTV loan, opportunities to refinance are limited, and selling the home often is not feasible because of the large amount of cash needed at closing. As a result, counseling borrowers might prove to be harder than in credit card lending. Also, with negative equity in their homes, borrowers might have less incentive and ability to work with the lender to bring the loan current than to allow foreclosure. Insured Depository Institution Involvement in HLTV Lending Is Increasing Insured depository institution involvement in HLTV lending reportedly has been growing. Their precise involvement is difficult to quantify because these loans are not delineated in bank or thrift Call Reports. However, one indication of their growing involvement is cited in the Consumer Bankers Association 1998 home equity loan study. Twenty-five percent of respondents to its survey offered home equity loans with loan-to-values in excess of 100 percent, up from only 5.8 percent one year earlier. Banks and thrifts can become involved in HLTV lending by using a variety of strategies. They can lend directly to HLTV borrowers or purchase HLTV loans from loan brokers and hold them in portfolio. Institutions also can originate the loans and securitize them or sell them to another company that will securitize them. A more indirect way for insured depository institutions to get involved in this market is to lend to HLTV specialty lenders in the form of warehouse lines. Institutions also can service HLTV loans or invest in asset-backed securities secured by HLTV loans. In light of the contraction of HLTV specialists, the question arises as to whether banks will view this as an opportunity to further expand their presence in HLTV lending, given that consumer demand for these products is still strong. Recent press reports indicate that this is happening, as some insured depository institutions recently have piloted HLTV lending programs by buying loans and keeping them in portfolio.3 Another way that banks have recently become involved in HLTV lending is by investing in HLTV specialists. Many HLTV specialists have been looking for opportunities to affiliate with firms that have plentiful and stable sources of liquidity ("deep pockets"), and insured depository institutions have been viewed as ideal candidates. Several of the largest HLTV specialists have an insured depository institution as an affiliate. 3 Timmons, H. "Banks Poised to Move in as High-LTV Lenders Fall." American Banker, October 28, 1998. Insured Depository Institutions Are Subject to Real Estate Lending Standards Unlike many of the specialty finance companies, insured depository institutions are subject to regulations prescribed by the federal supervisory agencies. In 1992, the federal banking and thrift supervisory agencies finalized a uniform regulation and interagency guidelines for real estate. The regulation, in part, requires institutions to adopt and maintain written policies that establish appropriate limits and standards for all real estate loans, including HLTV loans. When a bank adopts a policy, the regulation requires consideration of the Interagency Guidelines for Real Estate Lending Policies. These guidelines state that institutions should establish their own internal loan-to-value limits for real estate loans; however, they also indicate that the internal limits should not exceed 90 percent on a home equity loan.4 The guidelines recognize that it might be appropriate to deviate from these guidelines and state that loans made in exception to these guidelines should be identified in the institution's records and reported to the board of directors at least quarterly. Furthermore, the guidelines state that the aggregate amount of all loans in excess of the supervisory loan-to-value limits should not exceed 100 percent of total capital. 4 The guidelines state, "A loan-to-value limit has not been established for permanent mortgage or home equity loans on owner-occupied, 1- to 4-family residential property. However, for any such loan with a loan-to-value ratio that equals or exceeds 90 percent at origination, an institution should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral." Competition from HLTV Loans Is Driving a Loosening in Underwriting on Other Home Equity Loans Even for insured depository institutions not directly involved in the HLTV market, the competition posed by this product already is evident in the underwriting of other types of home equity products. The Office of the Comptroller of the Currency reported in its latest survey of the 77 largest national banks in the country that underwriting on home equity loans has been loosening for three years, a time period that corresponds with the life of the HLTV market. They reported that in 1998, the percentage of banks tightening standards on credit card loans is nearly matched by the percentage of banks loosening their underwriting standards on home equity loans. Competition was cited as the primary reason for loosening home equity standards, and an easing of collateral requirements was the primary method. Conclusion HLTV lending has provided a new option for consumers to work their way out from under burdensome credit card debt. It also has provided lenders with a new and potentially profitable line of business. Insured depository institution involvement in this line of business is growing and could continue to grow, especially if liquidity problems that have affected HLTV specialists continue. As with any line of business, success is dependent upon understanding the particular nature of the HLTV business and making the appropriate commitment of resources and expertise. With HLTV lending, there are unique risks involved because of the compound nature of these loans, which contain characteristics of both a secured home equity loan and an unsecured consumer loan. The risks involved in HLTV lending are further heightened by the fact that the performance of these loans is largely untested in an adverse economic environment. Diane Ellis, Senior Financial Analyst Regional Outlook Information Return to Regional Outlook main page