Rising interest rates have prompted borrowers who have low-rate first mortgages to seek additional funds through home equity loans (home equity lines of credit and second mortgage loans).
As a result, more attention has gone to the securitization of home equity loans.
In view of the potential growth in this market, Fitch has expanded its criteria for rating home equity loan pools.
Historically, commercial banks and consumer finance companies were the largest participants in the second-lien market.
Commercial banks typically focused on "A" quality borrowers, while consumer finance companies attracted slightly riskier borrowers with good to average credit.
Increasingly, traditional home equity lenders face competition from first mortgage lenders, entering the second-lien market to offset lost volume due to rising interest rates.
Product offerings generally are more innovative than in the past and attract a broader range of borrowers with good to inferior credit histories.
When rating first mortgage loan pools, Fitch uses its Texas depression study as a benchmark.
The study shows that original loan-to-value ratio, reflecting the size of the borrower's down payment, is the primary indicator of default risk. When rating home equity loan pools, the borrower's credit profile becomes more important.
Therefore, Fitch's default assumptions depend on the origination guidelines and lending strategies of each originator. Particular emphasis will be placed on the borrower's combined loan-to-value ratio, debt-to-income ratio, and credit history.
The recovery analysis takes into account the property's geographic location, the loan's lien position, the size of the second lien relative to total indebtedness (second-lien ratio), carrying and foreclosure costs, and property characteristics.
In formulating its home equity loan criteria, Fitch reviewed historical delinquency statistics of home equity loans originated by banks and finance companies.
Fitch found that bank delinquencies -- including 60- and 90-day delinquencies, foreclosures, and real-estate-owned properties -- were equal to or better than the average "A" quality first mortgage loan portfolio. Finance company delinquencies two or more payments past due were 1.0 times to 4.5 times greater than the average "A" quality first mortgage portfolio.
Therefore, Fitch adjusted its 15% base frequency-of-foreclosure assumption for the average "A" quality first mortgage loan with 70% to 75% loan-to-value ratio by multiples of 1 to 4.5.
The multiples reflect that home equity transactions typically have a weighted average combined loan-to-value ratio of about 65%. Equity protection, while mitigating losses on defaults, does not ensure repayment.
The borrower's ability to pay is instead determined by its credit profile.
Therefore, Fitch individually reviews each originator's underwriting guidelines and lending strategies.
In particular, Fitch expects the lender to review the borrower's debt-to-income ratio and the type, severity, frequency, and period of delinquent debts, including previous foreclosures or bankruptcies, with emphasis on the payment characteristics of any prior mortgage debt.
Fitch also increases default expectations to reflect the loan type, including adjustable-rate mortgage loans, balloon mortgage loans, limited documentation programs, and investor properties.
Loss severity is a function of the property's geographic location, the second-lien ratio, and foreclosure and carrying costs.
Fitch divided the country into 75 metropolitan, state, and multistate regions.
This segmentation reflects the similarity of the underlying economies, the regions' geographic proximity, and the geographic distribution of housing markets.
A market-value decline expectation has been assigned to each region based on its underlying economic stability as measured by an analysis of industry diversification, economic interdependence, employment growth patterns, economic trends, and residential building levels.
These market-value-decline assumptions are the same as used in its analysis of first mortgage loans.
To determine the loss, Fitch reduces the property value by the market-value decline, deducts foreclosure and carrying costs as well as the senior mortgage balance, then determines what amount, if any, remains to pay off the balance of the home equity loan.
When market values decline, any equity the borrower has in the property takes the first loss.
When the borrower's equity is depleted, the second mortgage loan begins taking losses. However, the second mortgage has a greater chance of recovery with a high second-lien ratio than a lower second-lien ratio, given the same combined loan-to-value ratio.
As a result, losses as a percentage of the loan will be smaller, requiring less credit enhancement.
A key factor in evaluating and rating a home equity transaction is the quality of the operations of the originator and servicer.
Fitch tailors its operations analysis to each originator's lending strategy and the credit characteristics of its product. In particular, Fitch focuses on certain functions where the risks of home equity lending and servicing are concentrated, namely underwriting, appraisal analysis, quality control, and default management.
Underwriters should have strong consumer finance backgrounds, or a thorough training process should be in place. Lending authority should be established.
If the company uses an artificial intelligence system to assist in loan analysis, Fitch reviews the model and discusses approval/reject ratios, credit scores, and underwriter involvement.
Due to the high volume of applications analyzed, the lower average balance, and the need for quick turnaround, home equity lenders obtain drive-by appraisals, basing their valuation on an exterior inspection, comparative analysis, and market research.
Fitch believes that, generally, drive-by appraisals return a more conservative property value than full inspections, mainly because internal improvements are not taken into consideration.
Conservative appraisals are especially important on home equity loans, considering the absence of selling price, when determining market values.
Fitch reviews the originator's process for approving and monitoring appraiser performance. References should be checked, licenses verified annually, and a sample of each appraiser's work should be reviewed prior to approval.
Quality control is a critical factor in Fitch's review of home equity lending.
Although the quality control program may not be as intense as that established by first mortgage lenders, it still plays an important role.
Fitch's analysis of default management also differs depending on the type of institution and its borrower profile.
The collection process should take into consideration the borrower's credit quality. As credit quality decreases, the intensity of the collection process should increase.
Home equity loan collections require an active relationship with the borrower.
Collectors' first priority should be to establish the reason for default as well as to determine whether the delinquency can be resolved.
With higher-credit-risk borrowers, the collection process should begin earlier in the delinquency period.
In addition, the servicer should use the more experienced collectors for the longer-term delinquencies and for higher-risk borrowers.
In all cases, the servicer must have established procedures that detail the collection process. Fitch closely monitors the servicer's adherence to these procedures.
The potential for workouts should be reviewed to determine whether foreclosure can be avoided.
If the collector is unable to resolve the delinquency, the loan should be moved as quickly as possible to foreclosure. A foreclosure committee should be established to ensure that all possible outlets have been examined.
During foreclosure, the servicer normally works closely with the first mortgage provider to determine the borrower's status.
The home equity servicer should obtain an updated property value either through a broker's price opinion or a new appraisal.
The servicer then can determine whether to satisfy the first mortgage and sell the property if there is adequate value or whether the loan should be written off if no recovery is expected.
This report was prepared by analysts Michele J. Loesch, Mary Sue Lundy, and Kevin Duignan of Fitch Investors Service, New York. It has been slightly condensed from the version distributed to Fitch clients.
