Amortizing HELOCs – Alarming Sign for the US Mortgage Market
Sutherland Banking Insights
July 2014
Amortizing HELOCs – Alarming Sign for the US Mortgage Market Overview Home equity lines of credit (HELOCs) are going to be the next big crisis that may hit the US housing market owing to the end of their draw period, high volume of resetting HELOCs and rise in interest rates. HELOCs, which were sold aggressively during 2004-07, had a 10-year period during which borrowers were free to use the line of credit and pay only the interest component of the loan. But from 2014, a large number of HELOCs are reaching their 10-year draw period and are resetting, which will result into significantly increased monthly payments for the borrowers. Apart from the interest payments, the second lien will amortize and the borrowers will have to start paying both interest and principal. US home equity market began to shrink in 2007 and declined by 80% year-on year (y-o-y) in 2008 and 2009. The market improved slightly in 2013 compared to 2012, though the volumes of both loans and lines of credit remain about 90% below the 2006 levels and even below the origination volume in 2010. Despite 2013 being a good year for the mortgage market, the Mortgage Bankers Association estimates a 54% y-o-y decline in mortgage applications as of March 2014, primarily due to reduction in refinance applications (down 65% y-o-y) and purchase applications (down 18% y-o-y). The declining trend in the first three months of 2014 has worried experts looking for driving factors for the mortgage demand in the future. For them, to an extent, the spurt in demand will come from Home Equity. The future demand in the mortgage market is expected to be driven by home equity lending as • with recovery in house prices and rise in interest rates, existing homeowners are gaining back equity in their homes that they can borrow against; • this will incentivize them to go for a home equity loan rather than to move or refinance; • rates for 30-year fixed-rate mortgages are expected to be in the range of 4.5-5.5% in 2014; and • about half of all current outstanding mortgages have rates below 4.5%, which is a huge disincentive to either move or refinance with rising interest rates However, the home equity market will become tough as under the new mortgage lending rules, the mortgage lenders are being asked to comply with two new requirements, i.e. Ability to Repay over the entire period of loan and Qualified Mortgages.
Impact of Amortizing HELOCs on Delinquency At an overall level, the home equity market is witnessing low delinquency. However, with the HELOCs that have started amortizing, there is an increase in new delinquent loans. Currently, only 10-15% of the second lien HELOCs are nearing to the end of draw period. This leaves a large chunk of the market at risk of payment defaults in the next few years. According to the Office of Comptroller of the Currency (OCC), 60% of all HELOC balances will amortize during 2014-17 and reset to higher payments, which may lead to increase in delinquencies and thereby credit losses for banks. According to the OCC estimates, about USD167 Bn in HELOCs held by large national banks will reset during 2014-17.
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On the consumer front, monthly payments will grow by 300-400%, especially for the subprime borrowers. These payments are expected to increase further as they have floating interest rates. While the interest rates were kept low for last four to five years to aid the economic recovery, they are now stated to go up in the near future. This significant and sudden increase in monthly outflows will further create a risk of defaults on payments. A word of caution for the homeowners and real estate investors: check your lines of credit and be prepared for the additional payments. Homeowners having equity might refinance at a fixed rate while the interest rates are low, however, this will not work for those who are underwater (owe more on home than it is currently worth) or have less equity. The impact of defaults is difficult for the analyst to gauge. If the defaults are managed, things may be fine; however, they may be troublesome if they start impacting the earnings and cuts into banks’ equity levels, especially when they are under pressure to raise their capital levels. The situation is alarming not only for the borrowers but for the lenders as well as they need to make tough decisions once the borrowers start defaulting. Some of the options with the lenders could be to foreclose on a property, refinance which can be risky, or modify the terms of the loan bearing the loss. However, with about 20-25% of America’s homeowners already underwater, refinancing such loans would not be possible. The timing of this could not have been any wrong to add to the misery of the banks. The credit has now started to loosen and many first-time homebuyers are qualifying for mortgage programs which were very conservatively designed since 2008. With banks witnessing new defaults or losses on loan, the credit market which was earlier loosening up will again tighten up. This will further result in a lesser number of borrowers qualifying for the mortgage and home equity loans, which would be worrying for the housing market and small businesses needing additional capital.
Impact of Amortizing HELOCs on the Servicing Market The year 2013 witnessed continued acquisition of mortgage servicing rights (MSRs) driven by slow recovery in the mortgage market, new loan originations and banks’ effort to minimize their MSR exposure and free up their portfolio of the delinquent loans. Once an operational issue, servicing now has become a compliance issue and is subject to regulatory enforcement after the new guidelines issued by the Consumer Financial Protection Bureau (CFPB). Increased regulatory burden and legal liabilities associated with CFPB’s new servicing rules, combined with Basel III’s negative capital treatment of mortgage servicing assets, may lead; • • •
some banks to sell mortgages in the secondary market; other banks to divest their servicing portfolios; and servicers to employ sub servicers or component servicers to improve the economic value of their servicing rights.
The mortgage crisis has forced many banks to make public exits from the wholesale home equity lending business and retail & consumer direct channels as well. Following the upcoming crisis that may emerge due to default in payments, some players will exit, leading to further consolidation across the industry. But for others, the right strategy will be to find solutions to capitalize on market changes.
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Banks have some options for reducing their losses. One of them is to encourage borrowers to sign up for a program if they will not be able to make their payments. In some cases, banks can change the terms of the lines of credit to allow borrowers to pay only interest on their loans for a longer period, or to take longer to repay principal. According to a spokesperson from Bank of America (BOfA), BOfA is reaching out to customers, more than a year before they have to start repaying principal on their loans, to explain options for refinancing or modifying their loans. Balancing compliance and profitability is one of the biggest challenges for the lenders. While compliance to regulations is important, and penalties otherwise can be huge, maintaining compliance will be costly. It leaves the lenders with two options, i.e. either risk penalties or add workforce to meet or comply with the regulations, both of which can significantly impact profitability. These labor-intensive tasks have come up at a time when the banks are laying off mortgage and servicing staff. OCC has been appealing to the banks to reach out to borrowers proactively and restructure the HELOCs as the draw period is coming to an end. Banks are trying to reach out to the borrowers, with HELOCs resetting in 2014, to give them refinancing options or extend their existing terms. They have started calling borrowers to inform them about the rate reset on the horizon and other options banks have for them. While reaching out to the borrowers is a labor-intensive task, banks also face an issue of freeing up their task force from loan origination towards loan modifications. For instance, to give an extension to the interest-only period on the HELOC to the borrower, the banks have to contact them, get their agreement on the revised terms, and get the modified agreements signed. Some lenders view this situation as a growth opportunity. They are using public records to identify borrowers with a HELOC from a specific competitor and are directing targeted marketing campaigns, while few of them are identifying existing customers who have an expiring HELOC with a competitor. Identifying all the pending HELOCs that are resetting and taking appropriate action has become a challenge to execute for the servicer at a time of constrained budgets and regulatory compliances. The lenders or servicers are looking for the solutions that can identify all liens on the property, evaluate borrower performance on appropriate expiration strategy (i.e., renew, extend, invitation to apply, close). It is a tedious process including notifying the borrower, filling up new applications, and getting new documents notarized and back to the lender to ensure regularity compliance.
Outsourcing Solution Approach Fighting the crisis with limited resources and time, the US banks and mortgage lenders are pushed to outsource some of their tedious work in servicing mortgages to BPO firms in countries like India and the Philippines. They prefer to leverage the experience of technology firms in India and other BPO destination countries than to hire people in the US. Outsourcing process related to mortgage and foreclosure work to foreign countries has helped them cut down costs and comply with regulatory norms.
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Though currently, the banks are outsourcing only a part of their servicing operations, tougher regulations for home loans may push them to outsource other back-office functions to bring down operating costs and also to shift liability and risk to the BPOs.
Conclusion While consumers face the risk of increased monthly payments with a large portfolio of HELOCs resetting during 2014-17, lenders dread imminent defaults. In such situation, to mitigate their losses, banks need to identify the borrowers having troubles in handling the increased monthly payments and those may be looking for the refinancing option. The lenders can defer the problem for a while by modifying the troublesome HELOCs, however, if they want to get the HELOCs monkey off their back they need to look for creative and efficient solutions. One such solution can be found through automating technology and through outsourcing, especially the compliance reviews. The idea is to have an outsourced experienced team tracking regulatory changes and compliances, allowing the institutions to focus on their core business – originating and servicing loans.
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