With the worst of the mortgage lending crisis apparently over, banks are eager to revive home equity lending. But a different market is unfolding in the wake of the housing downturn, with caution and selectivity replacing the former gold rush mentality.
It is within this context that many institutions are revisiting home equity pricing, or the internal decision process used to set market rates.
A recent 10-bank survey by our company revealed five major issues in home equity loan pricing, including: compensating for risk; measuring performance; calculating internal funding costs and required returns; responding to local market variations; and ensuring adequate staffing, expertise and overall management coordination.
Pricing floors. Some banks have discovered that up to half of their home equity loan portfolios may not be adequately priced to compensate for ongoing credit risk. A top priority is to either introduce or cement risk-adjusted performance metrics, such as risk-adjusted return on capital.
Improved analytics should then be used to evaluate the current book of business before installing safeguards into the loan origination process.
Such safeguards include strategies to minimize so-called adverse selection, or an overload of subpar accounts. Overly low prices, for example, can turn balance growth into a self-defeating exercise by attracting a flood of high-risk credits. Conversely, overly high prices can put off the most creditworthy borrowers, tempting them to take their business elsewhere. Ultimately, a pricing strategy is needed for each major risk tier.
Risk-adjusted metrics also provide an advance warning system. Some situations should be avoided altogether.
Performance measurement. Each bank needs to develop a picture of economic returns that fully reflects the cost of capital. It is also helpful to anticipate balance use and repayment risk over the expected life of the account.
Too often today, banks are not pricing to achieve adequate returns on accounts that have high risk potential over the life of the borrowing cycle. This sort of "hollow growth" is especially self-defeating in light of the up-front costs entailed in acquiring new business.
Future industry leaders will base their decisions on a fully risk-adjusted life-of-loan view of profitability (e.g. net present value, multiperiod economic profit, etc.). This level of precision, coupled with explicit calculations of price elasticity of demand, will enable leaders to identify and exploit "pricing windows" within which growth and profit objectives can be optimized.
Funds transfer pricing. An arcane yet critical exercise in home equity lending is determining the full cost of providing credit, including funding, production and required returns on equity. The challenge starts with "funds transfer pricing." Combining current market rate benchmarks with allowances for possible future volatility in rates and borrower behavior, FTP forms the foundation estimate of what it will cost the institution to fund a loan.
While it might seem that competitors of equal sophistication would often arrive at similar estimates for FTP, a far different reality emerged from the survey findings. This past spring, for example, there was an FTP dispersion of 327 basis points on home equity lines of credit among survey participants.
Given the dispersion magnitude and potential competitive consequences, it appears that many banks would benefit from a thorough review of their FTP methodologies.
Pricing segmentation. Learning to systematically vary prices by local market, risk tier and customer behavioral segment represents a significant near-term opportunity. The case for "granularity," or detailed pricing variation, is underscored by research findings that home equity lenders often encounter competitive pricing variations of 100 to 150 basis points between the various markets they serve.
An added dimension of regional variation is local market risk. Instead of one pricing framework for an entire state, it may be better to refine strategies for the more stable markets and, at least temporarily, avoid many others altogether.
Progressive players also are refining risk-based pricing for tightly defined customer segments. The goal is to test and then deploy various combinations of market and customer metrics that help to identify distinct customer groups and the appropriate pricing strategy for each. Metrics include lien position; balance tier; combined loan-to-value ratio; risk tier; geography; and depth of overall customer relationship with the bank.
Staffing, resources, management. The survey indicated that home equity pricing teams often are understaffed. A single person may carry the entire daily workload. Meanwhile, major components of loan pricing models — and even the models themselves — are frequently controlled by the risk, treasury and finance groups.
In such circumstances, overtaxed pricing teams have trouble riding herd on all of the inputs supplied from outside their area. Lenders wind up going to market with cobbled-together prices based on stale data. This is a critical vulnerability at a time of market unrest.
Along with other priorities, therefore, home equity lenders also need to improve the overall management of their pricing activities. The goal is to establish a solid analytical framework, clarify roles and responsibilities among the various areas that have an influence on pricing, and instill a sense of focus and urgency so that decisions are timely and accurate.