HELOC Losses are Increasing and Will Reduce Access to the American Dream

Implications: In their first quarter results, several banking organizations reported stunning losses and provisions generated by these loans, with predictions of much more to come in future quarters. Indeed, national banks, which hold about half of all home equity loans, sustained as much loss from this type of credit in the first quarter of this year than they did in all of 2007.  Home equity lending has grown dramatically in recent years, more than doubling since 2002 to about $1.1 trillion outstanding!

Analysis:  To provide some perspective, that total is about 12 percent the size of the roughly $9.5 trillion dollars in first mortgages outstanding.  Unlike the many first mortgages sold to third parties, home equity loans almost always stay on the balance sheet of the lenders that originate them, which means they keep all the credit risk. And by definition, because they nearly always stand behind first mortgages, home equity loans tend to be riskier.  How this all happened is old news but worth summarizing.   Rapid house price appreciation generated lots of home equity for millions of homeowners nationwide. Interest rates were low generally, and the secured nature of home equity loans made interest rates on this product considerably lower than interest rates on other types of consumer credit. And tax deductibility for the first $100,000 borrowed was just one more attraction.

 Relaxed  underwriting standards helped more people to qualify for loans, and more people to qualify for significantly larger loans.  Many loans were made with limited verification of a borrower’s assets, employment, or income. Higher debt-to-income ratios became the norm.   Finally, a number of lenders began using brokers and third-party correspondents to ramp up their market share numbers quickly and with relatively lower costs or at least that’s what they thought at the time.  Putting it in very candid language--retail bankers became lazy and now there future customer base has been eroded by that outsourcing action. While engaging third party origination channels is not a problem by itself;at least not if the relationships are managed appropriately. When they are not, however, the risk of loss can increase significantly. It’s now apparent that a number of lenders did not manage the broker and correspondent relationships nearly as well as they should have, making loans from these third party channels considerably riskier than loans originated through their own retail offices. In short, there were a number of relaxed underwriting practices that significantly contributed to the rapid growth in home equity lending.

Fully one half of the HELOCs are held by national retail banks.  The exposure figures are growing each quarter.  Looked at in dollar terms, losses on all home equity loans, including HELOCs and junior home equity liens, rose from $273 million in the first quarter of 2007 to almost $2.4 billion in the first three months of 2008 representing almost a nine-fold increase. And the largest home equity lenders are now saying that they expect losses to continue to escalate in 2008 and beyond.

The American Dream may be alive and well,but for many it will remain just that---a dream whose attainment has been made more difficult by the very lenders who were depended upon to achieve it!