A study released by TransUnion on Thursday shows that the fear of a second housing bubble is basically fear of the unknown. People are afraid of risks that remain unidentified yet, they don’t understand the mechanisms by which these risks could manifest; they can’t foresee the imminence of the risk and they can’t assess it clearly. Therefore, one feels helpless without the possibility to adopt strategies for risk avoidance or mitigation.
This threat lurking in the “dark” may be giving you a hard time: you have no clue about it, you don’t understand it and even if you did understand, you lack the knowledge and means to defend yourself against it. The TransUnion study sheds a little light on this big and scary monster, reducing confusion.
The risks of a second housing bubble as seen by TransUnion could be the consequence of too many HELOCs (Home Equity Lines of Credit) that will be at the end of their draw period over the coming years. While in the draw period the loans require only interest payments, after the draw period, the loan amortization will begin causing a significant increase in the monthly payments.
The TransUnion study aimed to determine how exposed markets are to these maturing HELOC loans, how lenders can efficiently measure existing risks and mitigate future ones and how mortgages with amortized payments are being handled by consumers.
Home Equity Lines of Credit are very numerous. As of December 2013, 15.9 million U.S. consumers totaled a $474 billion debt in HELOCs. Yet, compared to other loans, the balance of HELOC loans is small. Figures are huge: $1 trillion in student debt, $7 billion in credit card balances and $8 billion in auto loans.
The largest HELOC volume ($220 billion) was originated between 2005 and 2007. The structure of HELOCs allows borrowers to draw on the line of credit for 5, 7 or even 10 years. During this period, the borrower is making interest-only payments at a variable rate that is usually calculated based on the prime lending rate. The loan is locked at the end of the draw (EOD) period and then amortization of the loan begins for 10 or 15 years more.
The pay down has begun on some of the loans originated during the boom period; yet, most of these loans had 5 to 10-year draw periods and more than 55% had 10-year draws. According to TransUnion, by the end of 2013, 92.4% of outstanding loans had not reached EOD yet. This represents an outstanding $438 billion debt for which the amortization will begin over the next few years. 52% of these loans have outstanding balances of $100,000 or more, and only 5% of them have balances under $20,000.
To illustrate why this situation is alarming TransUnion uses as an example a HELOC with an $80,000 balance. The monthly payment on the loan during the draw period would be $468, for a 7% APR. The borrower also has the option of borrowing from the HELOC to make the payment. At the EOD moment, the loan turns into a 15-year amortizing loan with a $719 monthly payment. The draw is no longer available and the payment will have increased with $252 per month.
This “rate shock” rings the alarm bell to lenders who fear that borrowers may default on such HELOCs. An even more serious effect would be the domino effect of the rate shock as borrowers will become unable to pay other loans as well.
According to TransUnion, the risk could be even higher given the fact that some lenders tended to favor specific draw periods for loans of certain sizes.
The study used information from 46,000 Home Equity Lines of Credit with an EOD in 2012 to assess borrowers’ default on these loans over the following 12 months. The analysis moved beyond HELOCs, looking into other loan products too. TransUnion checked the borrowers’ ability to handle shock payment, the value of credit scores and the cumulative impact of loan to value ratios on consumer performance on credit cards, auto loans and mortgages after end of draw period.
The credit scores analysis showed that 26% of Home Equity Lines of Credit were held by non-prime borrowers with scores below 680 (according to TransUnion VantageScores), while 60% had scores higher than 720.
In order to analyze the ability to absorb payment shock, TransUnion created a metric from its credit card records. They determined an Aggregated Excess Payment (AEP) metric which expressed the total payments made on cards minus the minimum payment due. By using the AEP metric, TransUnion could determine that 40% of consumers with HELOC balances had a low capacity to absorb shock payment (i.e. less than $500).
To assess the borrowers’ ability to exit the loan, TransUnion used the combined loan to value ratio (CLTV) of the loan to estimate the ease of refinancing or selling the house. 29% of HELOC borrowers had balances with more than 90% CLTV. This translates in a very limited or inexistent exit value.
All the three metrics indicate risk, with CLTV being more moderate than AEP and credit scores. To complete the analysis, TransUnion looked into interaction effects as well. From the 40% of borrowers with insufficient AEP, only 24.1% have prime credit score. From the 28% borrowers with non-prime credit scores, only 11% have sufficient AEP. Consequently, according to TransUnion’s analysis, 18.5% of the population is exposed to a second housing bubble.
The final conclusion of the study is that between 11% and 19% of HELOC balances could be at risk after EOD. In the next few years, $79 billion of balances on Home Equity Lines of Credit could be at risk of default.
The TransUnion study further showed that the issues raising concern over a possible second housing bubble could be identified, anticipated and measured for efficient risk management. Consumers who are more likely to default on HELOCs can be identified based on credit scores. The study has also made available the metrics that could serve for determining the consumers’ capacity to absorb shock after EOD. Risks will be reduced by increasing employment figures and by the growing home values.