Improving Home Equity Risk Management Practices
Sullivan, Mary Beth, The RMA Journal
With market risk rising and compliance requirements likely to expand, home equity lenders must act now to improve their risk management capabilities by enhancing underwriting guidelines, continually evaluating market risk, tightening internal review processes, and taking steps to mitigate inadvertent risks. This article tells why--and how.
In many markets across the U.S., the risks are high for home equity lenders. Economic conditions are changing, housing price appreciation continues at a record pace in many markets, new and more aggressive competitors are entering the market, and regulators are paying increasing attention to lender activities.
Indicators of Trouble on the Horizon
The U.S. consumer has been on a spending spree in recent years, and this spree has been financed largely by tapping into the equity in homes. The low-interest-rate environment, increase in housing values, and proliferation of competitors resulted in record numbers of consumers opening home equity lines of credit (HELOCs). In fact, from 1999 through 2004, the rate of growth in HELOC outstandings was over five times the rate in the previous five-year period (see Figure 1). As consumers leverage the equity in their homes, the relative amount of total equity has fallen significantly in recent years; home equity as a percent of real estate assets was 70% in 1985 but is now below 55%.
This increase in HELOC use across the U.S. helped push consumer debt at year-end 2004 to near $10 trillion and climbing--a record level when measured against disposable income (see Figure 2). The monthly debt service obligation of homeowners has risen significantly in recent years, an especially worrisome development given that it has occurred during a period of historically low interest rates.
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More Americans in recent surveys now claim concern over their debt levels, but as a group they show no signs of restraint in their spending. To the extent that homeowners used home equity borrowing to restructure debt (i.e., mortgage refis or HELOCs replacing higher-cost credit card or auto debt), their economic vulnerability declined. However, in many cases homeowners simply added new debt, and restructuring merely provided additional financial capacity to leverage themselves.
For some consumers, higher debt payment obligations couldn't come at a worse time. In many markets across the U.S., incomes are not rising fast enough to keep pace with increased debt burdens. Consumers have had the luxury of low interest rates for many years, and many consumers have treated their homes like ATMs, pulling out cash to finance spending and finance small businesses. But interest rates will continue to teaser rates and aggressive backend repricing (i.e., if the consumer misses a payment, the interest rate skyrockets), clearly entail different vulnerabilities for households than existed previously. Such practices have not been in place long enough to determine their impact on households in different economic cycles, but some households will undoubtedly find themselves in trouble.
Home Prices Under Pressure in Many Markets
The gap between home values and key underlying fundamentals such as personal income and job growth is greater than ever. As interest rates rise, there will be downward pressure on housing prices. Because consumer spending behavior is tied to perceived wealth and home equity represents the largest asset for most homeowners, households will consume less, face higher costs for financing, and, in highly valued real estate markets, will come to expect lower future home-price appreciation. In addition, increased housing supply in many markets will put further downward pressure on home prices. In November 2004, the supply of new houses on the market nationally was the highest since February 2003.
While sales of pre-owned homes remain robust, there is already some evidence that 2005 may be the year for a correction in some markets across the country. …