Home equity lending has been a mainstay of retail banking profitability over the last five years, providing double-digit growth that seemed irresistible in peak market conditions. As housing prices soared, banks concentrated on sales campaigns and loaded up on home equity balances and lines of credit, with little concern about credit risk.
But like a California wildfire, risk exposure is now racing through the home equity lending industry, leaving a far different landscape for institutions to navigate. As home prices fall and delinquencies soar, lenders are scurrying into defense mode.
In these trying times, lenders are quickly implementing three traditional defensive measures: beefing up collections teams, tightening credit access, and stepping up borrower surveillance on basics such as credit scores and loan-to-value ratios. Yet institutions will need far more than these prudent steps to navigate the current crisis.
Representing the best thinking of perhaps 25 years ago, basic risk defenses are a good starting point but ultimately inadequate in dealing with today's far more complicated marketplace. They also fail to capitalize on significant advances in marketing and risk management, as exemplified in the credit card industry.
As a result, lenders that go no further than old-fashioned tightening will miss out on three major opportunities: 1) tapping selective growth opportunities with new and established customers; 2) advance detection of impending delinquencies; and 3) marketing-flavored collections techniques that help the institution to focus its efforts and gain "first-in-line" repayments stance vis-à-vis other borrowers.
Thus the retail sophistication that seemed unnecessary during the roaring home equity lending market has become indispensible to dig out from the current crisis. The question is whether individual institutions will commit to improving their capabilities even as the storm rages, or whether old-style hunkering down will become an actual impediment to lender progress and overall market recovery.
The main reason why old risk solutions no longer work is that old safeguards no longer are in place. Most people who purchased their first home before 1990, for example, had to meet three standards in order to obtain a mortgage. First, applicants had to make a substantial cash down payment, generally at least 20%. Second, terms could not exceed 30 years and never allowed for negative amortization. Third, the monthly payment (including taxes, principal and interest) could not exceed slightly more than a fourth of the borrower's adjusted gross income. Any variation from these terms required either a co-signer or the purchase of mortgage insurance (or both).
While these requirements did nothing to protect against the interest-rate risk associated with funding long-term mortgages with short-term deposits (which sank countless thrifts in the late '80s and early '90s), they did a great job of protecting against credit risk. Residential mortgage lenders could largely avoid default-related losses given their first-lien-holder status and secured excess collateral position, and there was far less need for sophisticated credit risk management and targeted marketing.
Simplicity went by the wayside, however, as the economy emerged from the '91-'92 recession. The whole atmosphere of household lending changed as credit card companies adopted carpet-bombing approaches to direct marketing, introduced new pricing schemes involving "teaser," promotional and balance transfer pricing, and aggressively adopted alternative marketing channels including the Internet. Unlike local lenders, the card players honed their skills in a game dominated by the law of large numbers and mass-market economics.
At the same time, each of the three safeguards for mortgage loan approval was compromised. The industry expanded aggressively into the high loan-to-value market, granting second-and even third-liens that went well beyond historical LTV ceilings, and also permitted mortgage borrowing to be used for the consolidation of consumer debt. And as real estate values rose in nearly every market with no end in sight, lenders began offering 100-percent financing. It was assumed that housing would continue to appreciate indefinitely, permitting even weak borrowers to build homeowner equity that would cushion against loss.
Meanwhile, "exotic" mortgage products began appearing. Repayment terms ballooned to 40, 50 or even 100 years. To increase loan affordability in the early going, borrowers were permitted to pay less than the accrued monthly interest obligation and add the difference to the loan balance. Another sales tactic involved the widespread use of low introductory rates with multi-year step up adjustments. Finally, the explosion of "low doc" loans requiring no income verification removed the last of the basic credit controls, allowing borrowers to massively overburden their monthly budgets.
The relaxation of all of these basic controls might have raised more red flags had it not been for innovations in the securitization markets. The development of new mortgage-backed securities products and complex derivatives allowed originators to sell the risk and spread it among an expanding pool of institutional investors. In addition, the financial markets began wildly overstating the diversification benefits of mortgage pools, assigning investment-grade ratings to bundled high-risk assets. This financial alchemy enabled a massive extension of credit to the subprime market.
Through it all, local ties between lenders and borrowers eroded as the mortgage market evolved. Marketers and originators backed by large national players began to leverage broad-scale direct marketing, and the ubiquity of the Web trumpeted new borrower-friendly products. Ease of access and aggressive pricing became central to the value proposition, and lenders and brokers focused on passing risk along to the securities markets, as opposed to managing it themselves.
To be sure, many lenders will say the questionable mortgage lending innovations of the last 10 years provide all the more reason for across-the-board tightening now. The trap in that response, however, is that various groups of borrowers are in very different circumstances. Absent an analytical understanding of differences in customer segments, crisis-mode initiatives are sure to translate into lost opportunities for profitable growth with solid borrowers, lost opportunities to anticipate and cap loss exposure with distressed borrowers, and lost opportunities for effective repayment negotiations in a world where delinquent households generally have multiple creditors standing in line.
Most banks would not double a line of credit in the current environment, or offer a great rate at a time when margins are under assault. These and other growth initiatives would never fly in broad-based marketing campaigns for home equity lines of credit, yet they can make all the difference when selectively applied. Among current customers, for example, Novantas analysis indicates there typically is a ten-fold difference in the range of risk-adjusted relationship profitability. Lenders moan about the fact that weak borrowers were allowed to fly under the radar, yet they often allow the most promising customers to do so as well.
To tap hidden internal growth opportunities, the first order of business is to conduct a comprehensive review of the customer base, a step that either remains to be taken or is in need of analytical refinement at many institutions. Observed behavior-balances, transactions, payments and account multiplicity-can be combined with externally supplied data to paint a compelling portrait of prime customers, setting the stage for targeted offers that have solid underwriting and profitability characteristics.
A further growth avenue lies with analytically guided campaigns to acquire new customers, an area of expertise long dominated by the credit card companies. One payoff is improved risk-based pricing. Along with establishing more appropriate rates for higher-risk customer segments, targeted pricing allows the provider to identify instances in which lower and much more competitive rates are justified. While such techniques are in use today, segment definitions remain crude and much of the targeting benefit is lost.
Targeted pricing also helps the lender to manage tradeoffs between balance formation and account profitability. At a time when many lenders still are imposing uniform loan rates across their distribution networks, advanced players are learning to vary pricing by regional marketplace, type of product and type of customer. Using calculations of price elasticity of demand, these lenders are developing a scientific understanding of how to acquire and retain balances at the best possible margin.
Besides undertaking more sophisticated growth initiatives, risk intervention techniques must also be improved in today's environment. Increasingly, we have seen that the interval when distressed debtors hurt themselves and lenders the most is during the downward spiral that often follows the onset of repayment difficulties. Though there are warning signs, lenders often do not heed them, and distressed borrowers dig themselves even more deeply into debt.
There are many reasons why consumers keep spending beyond their limits. But for lenders, the end result is the same. Downward spiral borrowing, unchecked by early identification and lender intervention, is the most loss-prone activity in the portfolio. This is another example of how traditional risk management steps such as the frequent refreshment of credit scores and careful monitoring of monthly payments, while important, do not provide the full measure of protection. The higher path includes a much more analytically comprehensive form of monitoring that identifies unsound borrowing at its onset, providing time for the lender to intervene.
Among progressive lenders, proactive risk exposure management includes monitoring usage of credit lines, borrower life events, financing activities with other providers, and the total account behavior with the financial institution, including both assets and liabilities. Combined with current repayment behavior and credit scores, this information enables lenders to identify and manage open credit lines and loans at high risk. The goal is to work with overloaded borrowers before their situations worsen.
In a much simpler world, credit applications were more heavily screened and borrowers carried less debt on non-essentials, had fewer creditors and felt a much higher sense of moral obligation to repay. Though never easy, the collections process on delinquent loans was at least more straightforward, with the typical response to a credit downturn being the addition of more collections staff to work the phones and the mail.
Unfortunately today, many distressed borrowers feel relatively uninhibited about picking their own repayment priorities, even playing various creditors against each other. Something as simple as retaining rewards points, for example, can inspire people to stay current on some accounts while falling behind on others. At a more serious level, people see their theoretical "home equity" being wiped out as home prices fall, and start to question whether they should even attempt to repay property-secured advances used to finance education, trips and recreational vehicles, and consolidate credit card debt.
Welcome to the era of nuanced repayment negotiations. Fortunately, people arrive at delinquency in a variety of circumstances, providing lots of room for various kinds of negotiating tactics and workouts. To take advantage, however, the lender needs a methodical understanding of varying customer profiles, and the kinds of outreaches that work best in various circumstances. Troubled borrowers having substantial remaining assets, few credit lines and deep ties to the institution, for example, present a very different profile than debtors in the exact opposite condition.
Following a path forged by the credit card companies, progressive home equity lenders are beginning to finely analyze the delinquent customer base to identify patterns and profiles among various clusters of accounts.
Along with developing tailored recovery campaigns for each segment, leaders also are adopting the test-and-learn techniques honed by the card companies, so that lessons learned from each round of activity can be scientifically identified and incorporated into the next wave for continuous improvement.
Many home equity lenders are at the onset of building the staff expertise and information systems capabilities needed to take advantage of advanced risk management opportunities. But at this critical juncture, there is little justification for delay.
Increasingly, the winners in home equity lending will be those who can identify and tap selective opportunities, including winning new business, expanding relationships with established customers, anticipating and capping loss exposure, and effectively negotiating with distressed borrowers for repayment.
Emulating the credit card industry in continuous risk management process improvement, leaders will use analytically-derived customer insights to gain distinct advantages over more traditional players stuck in the simplistic mode of tightening down.
Richard Tambor and Annetta Cortez are managing directors in the New York office of Novantas LLC, a management consultancy. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.americanbanker.com/usb.html/ http://www.sourcemedia.com/