Recent developments in home equity lending - includes related articles on consumer satisfaction survey and estimate of aggregate debt

Federal Reserve Bulletin, April, 1998 by Glenn B. Canner, Thomas A. Durkin, Charles A. Luckett

Home prices have also been on the rise again in most parts of the country. Although increases have been moderate compared with those in some earlier boom periods, they have helped boost the total value of the household sector's real estate holdings roughly 20 percent over the past four years. Refinancings of home mortgages have ebbed and surged during the period in tandem with fluctuations in mortgage interest rates, but the peaks in activity have fallen considerably short of the 1993 volume.(14)

Emergence of the Subprime Market

On the whole, then, recent macroeconomic developments have led to robust consumer spending, and strength in the real estate market has encouraged the use of home equity credit to finance part of that spending. Moreover, a new element has given a sharp boost to overall growth in home equity lending over the past couple of years, and that is the vigorous marketing by nonbank lenders to the "subprime" segment of the market--homeowners with relatively low incomes, limited equity, or tarnished credit histories. Loans in this higher-risk segment carry interest rates several percentage points higher than those on "A-quality" home equity loans and typically lift a borrower's total mortgage debt to a high level relative to the value of the home. Some subprime specialists offer to lend amounts that would raise that ratio to 125 percent, and in a few instances, even higher.(15)

Subprime home equity loans are commonly marketed as bill-consolidation loans, particularly as a means to pay off credit card debt. Given their pricing, collateral, and performance characteristics--relatively high rates of charge-off and delinquency (chart 1)--these real-estate secured loans are more akin to unsecured personal loans than to mainstream home equity loans.

Most subprime lenders place heavy reliance on securitization of their loans to fund their operations. Through such means as third-party insurance guarantees or senior/subordinate debt structures, investors in the securities are largely insulated from credit losses; and the securities receive triple-A ratings, yielding returns of only 50 to 150 basis points above Treasury securities of comparable maturity. Ultimately, the home equity lenders bear the bulk of the credit risk, designed to be covered by the sizable margin between the interest rates paid by the subprime borrowers and the yield to the security holders.

Lower Prepayment Risk

One characteristic that has attracted investors to securities backed by home equity loans (generally subprime loans) is that, when interest rates drop significantly, the risk of accelerated prepayments of the loans underlying the securities has been considered to be less than for other mortgage-backed securities.(16) When rates fall, borrowers in the subprime category are not expected to refinance so readily as other mortgagees precisely because their marginal credit status usually bars them from doing so at attractive interest rates.

Borrower reaction to the interest rate declines during the past year seems to support this expectation. A recent report from Standard & Poor's observed that prepayments of securitized home equity loans have risen only slightly when interest rates have dropped sharply, while prepayments of other securitized mortgages have soared.(17) Indeed, the principal factor behind home equity loan prepayments was found to be improvements in the financial positions of the borrowers that enable them to qualify for more attractively priced loans.(18)