Is home equity lending getting out of hand? That's what many experts are wondering as more and more lenders pile into the market, especially at the lower end.
On the surface, at least, the home equity market has entered a Golden Age. In the first half of this year, the industry exploded with new competitors, new products, and new customers.
But as originations surge - they are now climbing by more than 10% a year - lenders, analysts, and regulators are beginning to worry that it's all too much, too fast.
"I think there are some signs that the industry is getting overheated," said Richard Hartnack, vice chairman with Unionbancal Corp., San Francisco.
To grab market share, banks, finance companies and other lenders have been slashing prices and stretching underwriting standards.
The skirmishing is especially evident in the inherently risky market for so-called B and C home equity loans, which are made to people with blemished credit records. Nearly every week, a major lender announces an initiative in this market.
Once the domain of finance companies, B and C loans are now offered by droves of commercial banks and mortgage companies. The big draw: profit margins that are much fatter than those of traditional mortgages.
The rush into virtually all forms of home equity is clearly starting to hurt credit quality. Nearly 7% of home equity loans backing securities were overdue by at least 30 days as of April, up from 4.8% a year earlier, according to Moody's Investors Service. Though the delinquency rate remains slightly lower than the levels of early 1994, lenders are well aware that the upward trend may continue.
"If you're out there originating paper like a drunken sailor, obviously that's going to come back to haunt you," warns Rob Stata, vice president loan originations for Cityscape Financial Corp., Elmsford, N.Y.
The Office of the Comptroller of the Currency has begun keeping a close watch on banks activities in home equity lending, says Scott Calhoun, the agency's deputy comptroller for risk evaluation.
As more banks try their hand at lending to customers with poor credit records, the OCC has to ensure that they are vigilant about upholding standards, Mr. Calhoun said.
A true meltdown in credit quality would also have broad ramifications for securities markets, because home equity loans are increasingly bundled as securities for investors. And a meltdown, experts say, is not out of the question.
"I'm afraid these things are going to turn into the junk bonds of the '90s," said the risk assessment manager for a major bank.
If a recession hits, he says, home equity borrowers would be especially vulnerable, because many have little or no savings. Their "ability to weather a storm is not great," he said. The situation would be even worse if real estate values collapsed, because lenders' collateral would quickly slip away.
Home equity securitization's popularity on Wall Street has generated a vacuum effect, with lenders rushing to add new employees and products to satisfy investors' appetite.
Issuance of securities backed by home equity loans is expected to double this year from 1995's level. In the first half, $15.68 billion in such securities were issued, compared to just over $18.4 billion in all of 1995.
High-growth mutual funds are common investors in home equity securities, experts say, but banks and private investors are also funding some of these transactions.
Investors are not the only players that would get hurt if the securities crashed. Lenders bundling their loans as securities often seek to entice investors by retaining much of the risk themselves. That is, the lender, rather than investors, absorbs the first losses on the securities.
Bond insurers often are on the hook, too. These firms provide loan-loss protection that allows lenders to get higher credit ratings for the securities.
Bond insurers insist that they are taking proper precautions.
"Before we commit to an underwriting, we are going to have to be very secure with the underlying credit," said John Cathey, vice president of New York-based AMBAC, one of the leading insurers of home equity securities. "We're basically like a rating agency that puts its money where its mouth is."
The risks of home equity lending are illustrated by loans written by Long Beach Mortgage and Quality Mortgage in the early 1990s.
Both companies have seen securities backed by their loans downgraded several times by Duff & Phelps Inc. after the Southern California economy went sour. Large numbers of newly unemployed borrowers defaulted on their loans, leaving lenders with homes worth well under loan value.
Quality lost more than $200,000 reselling one home alone, Duff & Phelps reported, because real estate values in the area had fallen so low. The company experienced losses on nearly 30% of the loans backing 1992 securities.
A combination of plummeting real estate values, overaggressive underwriting, and severe recession could be lethal for the mortgage industry as a whole. For that matter, experts say, any one of those forces alone could cause serious damage.
"All you have to have is a sufficient diminution of real estate values to come face to face with your fears," Mr. Hartnack said.
Complicating matters, the underwriting, origination, and servicing of loans to borrowers with poor credit is nothing like traditional banking business. For example, collecting monthly payments requires far more aggressive tactics and direct contact with consumers.
"It's important that people realize that this is a sector in development," said John Heffern, an analyst with Natwest Securities. "The task here is to avoid the land mines."
Despite the dangers, Wall Street has welcomed the growth of the home equity market with open arms.
"What has really surprised me is how easy it has been for relatively small players to access securitizations," Mr. Heffern said.
Wall Street is turning to home equity securities partly because of disappointments in the market for securities backed by traditional mortgages.
In 1992 and 1993, holders of mortgage-backed securities watched their yields plummet as borrowers took advantage of low interest rates to refinance their loans. Securities backed by the old loans were paid off early, depriving investors of expected returns.
"A lot of investors got really burned," said analyst James Nadler of Fitch Investors Service.
Home equity loans are less vulnerable to interest rate fluctuations, because the borrowers' poor credit and lack of borrowing savvy means they are unable and unlikely to secure a refinanced mortgage at a lower interest rate.
The loans, however, clearly carry credit risk - all the more so as lending standards loosen.
Loan to value ratios keep creeping up throughout the industry, along with allowable debt-to-income levels. Some companies, such as Dallas-based RAC Financial, are offering loans worth up to 125% of a home's value. In effect, these lenders are betting that real estate values will increase sufficiently to cover any losses.
"I sure hope that these guys are right about that," said an executive at one finance company.