Finding that some credit risk management practices for home equity lending "have not kept pace with the product's rapid growth and eased underwriting standards," federal bank, thrift, and credit union regulators issued new guidelines on May 16 in regard to home equity loans and home equity lines of credit.
A few days later, Federal Reserve Board Chairman Alan Greenspan spoke to the Conference on Housing, Mortgage Finance, and the Macroeconomy, about housing's government-sponsored enterprises (GSEs). "Financial instability, coupled with the higher interest rates it creates, is the most formidable barrier to the growth, if not the level, of homeownership," Greenspan concluded. "Huge, highly leveraged GSEs subject to significant interest rate risk are not conducive to the long-term financial stability that a nation of homeowners requires."
The Fed Chairman's and the bank regulators' statements suggest considerable concern about the current housing finance market, particularly as interest rates continue to rise. The issue is whether consumers themselves should be concerned about current lending practices.
Most Consumers Expect Higher Interest Rates
Three in four consumers expect interest rates to go up over the next six months, according to a May 2-5 Gallup Poll*.
Many Consumers Have Variable-Rate Credit
The May 2005 Experian/Gallup Personal Credit Index survey** shows 23% of homeowners have a home equity loan and 22% have a home equity line of credit. More than one in five people with home equity loans (22%), and half of those with home equity lines, have a variable interest rate. In addition, 13% of those with home mortgage loans have a variable interest rate.
Some Investors Are Concerned
Half of all investors say the "cost of housing" is hurting the current investment climate "a lot" (26%) or "a little" (25%), according to the May UBS/Gallup Index of Investor Optimism poll***.
Reason for Concern
Greenspan's concern about the housing GSEs comes at a time when these companies and their regulators have shown some management weaknesses. Also, most observers agree with today's consumers that interest rates will head higher in the months ahead. The GSEs' problem is that they have built huge long-term portfolios. This portfolio strategy has benefited their stockholders, while also placing them at considerable interest rate risk. To the degree the GSEs have difficulty managing that risk, these giant savings-and-loan-like entities expose the entire financial system to instability, and expose taxpayers to potential loss.
The more widespread concern among regulators is focused on another type of housing finance excess: home equity funding. Regulators note the rapid growth of such loans as a proportion of financial institution portfolios and point to the following high-risk lending practices:
- interest-only features
- limited or no documentation loans
- higher loan-to-value and debt-to-income ratios
- the use of automated valuation models for appraisals
- the growth of loan broker and third-party loans
Although home equity losses have been low to this point, the regulators fear this type of high-risk lending could create significant losses in an environment in which interest rates are rising. This is particularly the case for variable-rate loans, which can produce significant payment increases for highly invested consumers.
Bottom Line
Today's housing market presents some significant challenges to consumers. The price surges in some markets lead many consumers to fear they must buy a home now before they lose the ability. This environment creates enormous pressure for consumers to accept extremely leveraged financing with the hope that their incomes will catch up with their housing costs over time. In many cases, borrowers are taking out first mortgages coupled with the type of high-risk loans that concern financial regulators.
Before undertaking these types of transactions, consumers should consider the regulators' concerns and not assume today's mortgage financing vehicles will be good for them or their lenders. Instead, potential homebuyers need to consider their ability to handle their payments over time -- particularly if they take out variable-rate financing.
*Results are based on telephone interviews with 1,005 national adults, aged 18 and older, conducted May 2-5, 2005. For results based on the total sample of national adults, one can say with 95% confidence that the margin of sampling error is ±3 percentage points.
**Results are based on telephone interviews with 781 national adults, aged 18 and older, conducted April 18-24, 2005. For results based on the total sample of national adults, one can say with 95% confidence that the margin of sampling error is ±4 percentage points.
***Results are based on telephone interviews with 802 investors, aged 18 and older, conducted May 1-15, 2005. For results based on the total sample of investors, one can say with 95% confidence that the margin of sampling error is ±4 percentage points.
