Minyanville has a post on three potential sources of systemic risk that have been largely overlooked by the media and in the markets. Numbers two and three on the list – downgrades to monoline insurers damaging municipal credit and counterparty risk in derivatives markets – have been covered in this blog. But the first, the impact of rising defaults on home equity loans, is one we haven’t considered.
A year ago, Moody’s had warned that home equity default were rising and had reached the 7% level. Per the Minyanville post, 60 day delinquencies are now at 16.5% Ouch. Wells Fargo, so far the biggest home lender to be comparatively unscathed by the mortgage mess, just announced will be taking a $1.4 billion writedown on home equity loans in the fourth quarter.
It’s an interesting point, but not fully persuasive without providing the size of the market. I spent some time on Google and on the Fed’s website and didn’t come up with current figures. The best I could come up with was a size of $216 billion as of January 2003, and that outstandings had tripled in three years. Let’s assume due to the combination of aggressive marketing and rapid price appreciation that HELOCs grew threefold since then. That’s likely to be a high estimate. That takes you to just over $650 billion in total outstandings. If you assume 15% default and 100% loss (these are second mortgages in a declining price environment), you have a bit north of $100 billion in losses, These are all generous assumptions, so say it’s a $50 to $100 billion problem.
I don’t see that as a systemic event in and of itself. However, the way it might be is via the distribution of the losses. They are going to hit the same intermediaries that are suffering due to the subprime and developing commercial loan crisis. So this could be a straw that breaks the camel’s back, a blow to firms sufficiently impaired that they can’t take another hit.
The first is home equity credit. Beyond the alarming 16.5% 60 day delinquency statistic reported by Moody’s last week on home equity credit nationwide at the end of June, there is the question of collateral coverage. Generally speaking, home equity loans represent a junior mortgage. In the old days, home equity loans were obtainable for just some portion of the appreciation of home values, but in this credit cycle, home equity lines provided credit up to 110% of a home’s value at peak valuation.
Given the deflation in home values, I believe that many home equity loans today represent at best partially secured credit, if not unsecured credit. To my knowledge, few home equity lines were either underwritten or priced with this in mind. As a result, I believe that home equity loan losses will far exceed even the most current pessimistic forecasts. And not to frighten, but if unsecured credit card losses levels are running close to their 4.00% 60+ day delinquency rates, what does this suggest for home equity loans with their current 16.5% 60+ day delinquency rate? Clearly well above the 1-2% loss levels (and reserves) currently being forecast by banks.