Unlocking the HELOC Threat BY DENIZ TUDOR AND CRISTIAN DERITIS

Transcription

1 Unlocking the HELOC Threat BY DENIZ TUDOR AND CRISTIAN DERITIS

2 ANALYSIS Unlocking the HELOC Threat BY DENIZ TUDOR AND CRISTIAN DERITIS As the economy steadily improves and household credit stabilizes, lenders and regulators alike are watchful for any signs that could change the positive outlook. For example, market analysts and regulators have recently taken an interest in the rapid expansion of auto lending over the past few years and the potential for rising losses due to lax underwriting. One area that has received some attention but little analytical review is the default risk inherent in home equity lines of credit. In particular, borrowers who took out a HELOC during the housing boom will soon be experiencing large increases in their scheduled monthly payments as they come to the end of their -year interest-only draw periods. The addition of principal as the lines convert to fully amortizing loans will substantially increase monthly payments. Using information extracted from personal credit reports by Equifax and available through the CreditForecast.com data service, we find that payments can increase as much as % or more as loans reset (see Chart ). In addition, an interest rate hike from the Federal Reserve in the second half of the year will make payments even higher with the potential to cause thousands of borrowers to default. Although the risk of default for HELOCs is rising, the increased losses will be manageable and will not spark a financial crisis. Echoes from the past To gauge the potential impact that payment shocks may have on default rates, we consider the performance of pre- originations that have already experienced the end of their draw periods. Using Equifax data in the CreditForecast.com service, we See deritis, Cristian and Pedro Castro, Is Auto Lending Doomed? Regional Financial Review, March. constructed time series of conditional delinquency rates by origination vintage (see Chart ). We find that the impact of the rate-term reset can be quite dramatic, with the delinquency rate on the vintage rising from % immediately before to % immediately after the shock, a 7% increase. The impact on the and vintages is expected to be somewhat lower in magnitude due to projected improvements in the economy under the Moody s Analytics baseline scenario, but it will be significant nonetheless. Moreover, projections under more dire economic scenarios with rising unemployment and declining house prices could take delinquency rates as high as % for the 7 vintage. While the projected increases in conditional delinquency rates are alarming, they need to be examined within the context of the size of the relative exposure of each vintage. For example, a large default rate applied to a small exposure may be less concerning than a small increase in default rates on a large outstanding vintage. Compared with earlier vintages, was a large year for HELOC origination volumes with and 7 tracking only slightly behind (see Chart ). More than $ billion in credit lines were made available in with $ billion of that being drawn at the height of the expansion in. As of the first quarter of, $ billion in balances were outstanding for this vintage versus $8 billion for the vintage. While outstanding balances have retreated dramatically from their peak levels (of between $ billion and $ billion), they remain large exposures with the potential to create devastating consequences if large numbers of borrowers were to default. Payoffs mitigate default risk Digging deeper into the performance of these loans, we see that some of these worries are warranted. Similar to the delinquency rates, annualized conditional default rates Chart : HELOC Payments Set to Double Avg payment amounts by vintage, % of trades MOODY S ANALYTICS / Regional Financial Review / June

3 ANALYSIS Unlocking the HELOC Threat Chart : Jumps in Delinquencies Are Real Delinquency rate by vintage, % of $ volume Chart : Was a Big Year for Originations Outstanding HELOC balances by vintage, $ bil Chart : HELOC Default Rates Spike Annualized conditional default rate by vintage, % of $ volume Chart : Performance Varies by Credit Score Annualized default rate for vintage, % of $ volume < show a spike of up to % as vintages reach the end of their draw periods (see Chart ). We also find that borrowers with lower credit scores tend to be more susceptible to payment shocks than prime borrowers. The performance of subprime borrowers (with credit scores <) were on average.7% worse than prime borrowers (with credit scores >7) in terms of annualized conditional default rates for the vintage in (see Chart ). While default rates on boom-era vintages are expected to rise appreciably, the realized default volume should remain relatively low at an annualized rate of less than $ billion per year (see Chart ). Payment shocks will be an issue for specific borrowers and lenders, but will be unlikely to trigger widespread distress as a result. Under the Moody s Analytics baseline scenario, improvements in the labor market along with increases in wage growth, disposable income and household wealth should offset much of the impact of the shocks., A key mitigating, factor to the increase in default volumes is 8, prepayment. Often, overlooked when considering the impact of, payment shocks on, conditional delinquency and default rates is the fact that prepayment rates also spike dramatically around the time that HELOCs come to the end of their draw periods. Looking at vintages originated prior to, we observe that payoff rates increased by multiples of up to more than four times the rate at the time of the shock to an annualized conditional prepayment rate of % to % (see Chart 7). Clearly some borrowers have Chart : Default Volumes Relatively Low Annualized gross default volume, $ mil the means to pay off their HELOCs but are rationally taking advantage of the cheap, taxdeductible financing that a HELOC may provide during its draw period. Rather than accept the higher payments when the loan resets, these borrowers either extinguish the debt directly or may refinance it along with their MOODY S ANALYTICS / Regional Financial Review / June

4 ANALYSIS Unlocking the HELOC Threat Chart 7: As Payoffs Spike at End of Draw Annualized conditional payoff rate by vintage, % of # volume Chart 8: Highest Defaults in Huntington Annualized default rate, vintage, % of $ volume to.7 >.7 to. >. to. Chart 9: West s Subprime Borrowers Struggle Annualized default rate, vintage, <, % of $ volume 7 Chart : House Price Increases Will Lower Risk House price change, % change from, Q 8 to.8 >.8 to. >. to. - to > to > to Sources: FHFA, Freddie Mac, Fannie Mae, Moody's Analytics first mortgages. For post- vintages, we expect a similar pattern of payoff to continue with the potential for payoff rates to reach as high as 8% of the number of outstanding accounts and 7% of the outstanding balances. Rising interest rates may provide even greater motivation for borrowers to reduce or refinance their debt provided they have the ability to do so. All defaults are local Geographically, the highest dollar default rates for the vintage are expected in Nevada, Wisconsin and Florida. In terms of metro areas, Huntington WV, Green Bay WI, and El Paso TX are expected to have the highest annualized dollar default rates in, at %, % and %, respectively (see Chart 8). The highest default rates will be associated with borrowers with credit scores below in Wyoming, New Mexico and Oregon (see Chart 9), dampening growth prospects in general and for house prices specifically (see Chart ). Rising house prices in many jurisdictions will lower the risk that HELOC borrowers will default overall, but lenders will want to keep an eye on areas with a high percentage of underwater loans such as Nevada, Rhode Island and Michigan to avoid surprises. Policy options abound 9 Given the concentration of HELOCs in bank portfolios, lenders have actively mitigated against the risk of rising losses by cutting credit lines and offering to modify loans to prevent borrowers from defaulting. Federal programs such as the Short Refinance program, Home Affordable Refinance program, or Making Home Affordable Program have been introduced to provide borrowers with options as well. Specifically, the Short Refinance program allows qualified borrowers to refinance into a new Federal Housing Administration loan with a reduction in owed principal based on the current market value of the home. The Home Affordable Refinance Program provides an option for borrowers who are current on their mortgage payments but have been unable to get traditional refinancing due to a decline in the value of their home to lock in low interest rates. Finally, the Making Home Affordable program is targeted at borrowers who are having a tough time making mortgage payments due to increases in expenses and/or a reduction in income. Participants in this program may have their interest rates lowered or loan terms extended in order to reduce their monthly payments to a manageable level. The availability of these programs should offset some of the risks posed by rising monthly payments. Lenders abhor a credit vacuum As we look to the future, the reasons that pushed consumers to take out HELOCs dur- MOODY S ANALYTICS / Regional Financial Review / June

5 ANALYSIS Unlocking the HELOC Threat Chart : HELOC Volumes Still Contracting Outstanding account balances, % change yr ago Auto First mortgage Student Bankcard HELOC Chart : HELOC Defaults Comparatively Low Default, % of $ volume. Auto Bankcard HELOC Student loan First mortgage ing the boom years such as financing day-today consumption, college, medical expenses, or consolidating credit card debt have shifted as lenders have tightened their lending programs. Bankcards and other forms of consumer borrowing have increased as a result. Outstanding balances on HELOCs began to fall in 9. Although the speed of contraction slowed in, we expect portfolios will shrink through as write-offs exceed new originations. Bankcard balance growth exceeded that of HELOCs in late as a result of the shift in lending behavior such that HELOCs are no longer the biggest nonmortgage category. This is despite the potential to deduct HELOC interest payments from income taxes, as opposed to credit card interest. New HELOC borrowers are using their lines for more traditional reasons: to provide financing for home improvement projects and as an easily accessible source of emergency funds. Utilization rates for HELOCs reflect these trends, falling steadily since peaking at % in 9. This trend should persist in the short run with utilization rates falling below % in. Other lending products benefit Tightening of credit standards since the Great Recession will all but eliminate concerns over payment shocks in the future. Since 9, close to 9% of all HELOC loans have been given to prime borrowers with credit scores higher than 7, as compared with 7% previously. This change in trend is already having an impact on other consumer credit products. Credit-impaired borrowers are getting more of their credit from retailers, finance companies, peer-to-peer lenders, and other nontraditional lenders given tighter standards on home equity loans and general purpose credit cards. These trends may change somewhat as the Great Recession becomes a distant memory, but new legislation and capital requirements will make it difficult for traditional lenders to fully serve these borrowers. We expect that most of the HELOC loans going forward will be extended to prime borrowers, leading to tepid growth in balances. Compared with other lines of business such as auto, student loans, bankcard and first mortgage HELOCs have not constituted a large portion of outstanding balance growth since late (see Chart ). Delinquency and default rates on HELOCs, although still a bit higher compared with pre-crisis levels, are comparatively low and trending downward, which should put worries around payment shocks in perspective (see Chart ). Nonetheless, credit card, auto and mortgage lenders need to pay close attention to HELOC resets given that upcoming payment shocks might affect borrowers ability to repay other debt obligations. Lenders may want to think twice before extending more credit to a borrower with a boom-era HELOC as a result. HELOC lenders need to understand and quantify their exposures for prudent risk management and to satisfy regulatory demands. Regulators are actively monitoring lenders communications to borrowers with upcoming HELOC resets in an attempt to stave off a wave of losses. To this end, lenders are increasingly leveraging tools and data to identify borrowers who are more likely to default. Monitoring of credit scores along with regional trends in unemployment and household wealth are important to this end. Short-term risks with upside potential The threat that payment shocks could lead to a sharp uptick in defaults is real but unlikely given that the economy is improving and lenders have been actively pursuing loss mitigation strategies on their portfolios. While a faster than expected recovery in house prices and an improving labor market are upside risks, a rapid increase in interest rates is a threat to the forecast that would lead to higher losses on HELOC portfolios. Outstanding HELOC balances will decline in the near future as the last remnants of the mortgage crisis are finally put to rest. Declines in volumes due to the reset of large origination vintages from, and 7 will dwarf new HELOC originations during this timeframe, but the trend will reverse in the latter part of the decade as rising house prices and equity levels will encourage lenders to return to the market. Regional banks and credit unions that largely avoided the fallout of the Great Recession will be particularly well-positioned to meet growing demand. But fears of a return to the heyday of the housing boom in the short run are unwarranted. Lending standards will remain tight as regulatory oversight and the lack of a securitization market force lenders to be vigilant. MOODY S ANALYTICS / Regional Financial Review / June

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