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In Focus This Quarter:
The U.S. Consumer Sector
Home Equity Lending: Growth and Innovation Alter the Risk Profile
Amid these longer term changes in the marketplace, the current environment offers the additional challenges of rising short-term interest rates and the likelihood that home price gains will eventually level off in some of the nation's pricier home markets.1 As a result of these trends, it is increasingly uncertain whether the traditionally low credit losses associated with home equity lending will remain a permanent attribute of this line of business. In any event, the changes being wrought by the marketplace are requiring both lenders and borrowers to think about home equity products in new ways. (See the inset box for information on HELOCs versus home equity loans.)
Home Equity Lending: HELOCs versus Home Equity Loans
Over the past 20 years, the composition of household debt has shifted decidedly in favor of mortgage debt. Chart 1 shows that mortgage debt has risen from 64 percent of total household debt in 1985 to a new high of more than 72 percent in 2003. While the relative use of mortgage debt has risen and fallen over time in response to such factors as home prices and mortgage interest rates, the general trend since the mid-1980s has been upward. One important factor in this long-term trend was the Tax Reform Act of 1986, which eliminated the tax deduction for consumer credit and expanded the home mortgage interest deduction. Since 1986, cumulative inflation-adjusted growth in household mortgage debt has been 151 percent, compared with growth of 88 percent in nonmortgage consumer credit.
Recently, preference by households for mortgage debt has become even more pronounced. Since the end of 2000, total mortgage debt owed by households has soared by $2.25 trillion, or 47 percent. Two principal factors account for this recent increase in mortgage indebtedness: a rapid accumulation of owners' equity in residential real estate and a sustained decline in mortgage rates to historic lows.
The equity held by U.S. households in their homes has also risen sharply of late (by almost $2.2 trillion since 2000) as homeownership has spread and home prices have surged. The percentage of U.S. households that own their own homes reached a record high of 69.3 percent in second quarter 2004, reflecting the addition of more than 12 million new homeowner households in the past ten years. This increased demand for housing, in turn, has helped push home prices higher. The repeat-sale home price index of the Office of Federal Housing Enterprise Oversight (OFHEO) rose by nearly one-third from 2000 to 2003, and none of the 331 individual U.S. metropolitan areas covered by the OFHEO index has seen an annual price decline since 2000.
As home prices have surged, home construction has remained brisk. The annual number of new homes started has exceeded 1.5 million units in every year since 2000, rising steadily during that time to an 18-year high of 1.85 million units in 2003.
Sustained low mortgage interest rates have provided the backdrop for rising mortgage indebtedness, rising home prices, and rapid home construction. An industry standard measure of mortgage rates is the Freddie Mac contract rate for 30-year conventional mortgages. Between the inception of this series in 1971 and mid-2002, the Freddie Mac contract rate had never dipped below 6.5 percent. However, this rate has remained below 6.5 percent in every month since June 2002, dipping briefly to an all-time low of 5.23 percent in June 2003.
Such historically low mortgage rates not only have prompted households to take on mortgage debt to buy new homes but have spurred record volumes of mortgage refinancing. Homeowners have taken advantage of historically low interest rates to consolidate mortgages and refinance at lower rates, often taking cash out. The Mortgage Bankers Association (MBA) Mortgage Refinance Index climbed to all-time records in 2001, 2002, and 2003. As mortgage rates bottomed out, refinancing volumes peaked in June 2003, but they have fallen sharply since then. From June 2003 to June 2004, 30-year fixed mortgage rates increased more than 100 basis points, and the MBA refinance index dropped to its lowest point in two years. Indeed, the MBA recently forecast that the dollar volume of refinancings would decline 57 percent in 2004 from a record $2.5 trillion in 2003.2Home Equity Lending Becomes a Preferred Vehicle
Both during and since the 2002-03 boom in mortgage refinancings, HELOCs have experienced explosive growth (see Chart 2). The average annualized quarterly rate of growth of HELOCs carried on the books of FDIC-insured institutions since the end of 2000 has been 30.2 percent. HELOCs are now the fastest growing asset class on financial institutions' balance sheets and comprise 7 percent of bank loan portfolios, up from 3 percent in 2000.
The rationale for homeowners' greater use of HELOCs is straightforward. With consumer spending outpacing income growth in the 2000s, homeowners have turned increasingly to home equity lending as a substitute for consumer credit to finance new consumption, reduce outstanding debt, or purchase a home in a two-loan package deal.3 The appeal over other more costly credit alternatives derives from the significant advantages of comparatively low interest rates, tax deductibility, and easy availability, since income and cash flow tests matter less for determining credit lines than for credit cards or auto loans. Furthermore, because HELOCs offer the flexibility to draw money only as needed and the convenience of a revolving credit line, borrowers favor HELOCs more and more over closed-end home equity loans.4 For these reasons, many homeowners are converting the equity in their home into cash through home equity borrowing and making this kind of transaction an increasingly important part of their household finances. With the dramatic decline in mortgage refinancing volumes since mid-2003, a homeowner would more likely choose to tap home equity through a draw on a HELOC rather than extract cash as part of a refinancing.
A rising volume of HELOC debt also has a rationale from the lender's perspective. Mortgage lenders are looking to home equity products to replace loan volumes that have declined in the wake of the refinancing boom. According to America's Community Bankers' 2004 Real Estate Lending Survey, 56 percent of survey respondents expected single-family residential loan production to decline this year as the refinancing boom slows; however, by a larger margin (64 percent), they expected an increase in home equity lending (see Chart 3).5 Clearly, lenders anticipate that consumers will turn more to home equity lending as refinancing activity wanes.
The challenge for lenders in this post-refinance period is not only to lift production of new HELOCs but also to get customers to draw more against existing lines. Although HELOC outstandings totaled $415.8 billion in second quarter 2004, this represented only half of the total approved borrowing limits, or commitments, on those lines. The utilization rate for HELOCs was almost 49 percent as of second quarter 2004, leaving $435 billion sitting untapped in committed home equity lines extended by banks (see Chart 4). This untapped amount represents a substantial source of potential fee income for lenders and available cash for consumers.
New Incentives to Boost Home Equity Borrowing
Not only are many of these structures floating-rate products and thus exposed to rising interest rates, but many also have a loss experience that has been untested by a general downturn in the housing market. For example, interest-only loans often require a balloon, or lump-sum, payment when the term of the loan ends. Home equity disclosures do not require the creditor to disclose the amount of any balloon payment that will result under the terms of the plan. In addition, payments on some loans may not cover the interest due so negative amortization will occur, resulting in the loan balance increasing rather than decreasing and the borrower repaying a much larger loan amount in the long run. Lenders who extend HELOCs with a credit limit that automatically increases as the home appreciates or a credit line based on future value are gambling that home prices will continue to increase. Finally, HELOC borrowers who increase their draws may not be aware that the higher their use of this revolving line of credit, the more it negatively affects their credit score.
Underwriting Practices for HELOCs
Because of the tremendous growth of HELOC lending in recent years, concern has arisen that home equity underwriting practices have eased. Indeed, home equity products exhibited the greatest increase in risk, according to the 2003 Survey of Credit Underwriting Practices conducted by the Office of the Comptroller of the Currency (OCC). Although the performance of home equity loans remains strong, as demonstrated by low delinquency rates, the survey noted that "banks need to be alert to the risks that are introduced when high growth is coupled with liberalized underwriting."6
The OCC's reference to liberalized underwriting methods may allude to underwriting methods that are increasingly used by home equity lenders but may carry certain modeling risk due to the absence of a significant housing market downturn in over a decade and a mild recession in 2001. In 2003, 44 percent of lenders used auto-decisioning (defined as systematic credit decisioning with no manual intervention) in support of credit underwriting, up from 13 percent in 1999, and 84 percent used credit scoring, up from 68 percent in 1999.7
Lenders should be especially cognizant of underwriting practices during a period of change in the macroeconomic environment. The two biggest issues here that bring up questions are interest rates and home prices. Specifically, how fast and how far will interest rates rise during the present period of tightening monetary policy? Also, when will home prices ultimately level off, and could they actually decline in certain high-priced metropolitan areas? Because HELOC interest rates are typically tied to benchmark short-term interest rates, rising rates make it more expensive for borrowers to service their debt. Higher rates could also dampen demand on the part of new homebuyers, thereby slowing the rate of home price increases. Should home prices stagnate or fall, the most important effect for lenders could well be an erosion in the equity position of some homeowners that will marginally reduce their incentive to repay the HELOC.
Lenders should also be aware of HELOC use. Drawdown rates for HELOCs are edging up, from 44.4 percent in first quarter 2000 to 48.3 percent in first quarter 2004. However, these utilization rates remain well below the peak of 60.7 percent reached in first quarter 1991. The utilization rate is an important metric for lenders to watch, because a rise could indicate that consumers are drawing more on HELOCs for spendable cash and are in a weaker position to repay the loans.
Credit Performance Remains Strong...
...But Most Loans Are New
Subprime Borrowers Present Credit Concerns
Risk Management Considerations
Although the underwriting techniques typically applied to HELOC loans make good use of available quantitative data and modeling techniques, there is evidence that risks are rising. Besides rapid growth and new lending techniques, a changing macroeconomic environment also poses challenges. The recent period of historically low interest rates and rapidly increasing home prices was particularly conducive to the use of HELOC credit by homeowners and to their ability to service that debt. However, to the extent that these conditions give way to a period of higher interest rates and stable or falling home prices, loan performance could deteriorate in the future. Uncertainty about future loan performance is heightened by the fact that HELOC portfolios remain highly unseasoned at present. Given these uncertainties, lenders and borrowers should not automatically assume that their historical loss experience is an accurate guide to future repayment ability. To the extent possible, it makes sense in this environment to estimate how loss projections might change under a less advantageous set of market conditions.
Cynthia Angell, Senior Financial Economist
1 See "A Turning Point Ahead? National and Regional Trends in Residential Real Estate Markets" in this issue.
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