Home Equity Loans: Source of Systemic Risk?

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.

From Minyanville:

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.

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  1. Anonymous

    Re: 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….

    Here is an example of County of Santa Cruz holding $13 million in what seems to be an SIV:

    The bulk of the remaining SIV assets could be protected by deeper pockets by next week, as pressure grows on Citi to back its Beta Finance, Sedna Finance, and Five Finance programs. Today, Rabobank said it will support its $​7.​6 billion Tango Finance, taking it onto its balance sheet, reports Reuters. “The Tango portfolio is high quality with only minimal exposure to CDOs of ABS,” said the bank. HSBC has already said it will support its Cullinan Finance and Asscher Finance programs, and WestLB has pledged to back its Harrier Finance Funding. Standard Chartered, Bank of Montreal are also all expected to support their Whistlejacket Funding and Links Finance programs, respectively. Both SIV assets overall and money market holdings in SIVs have decreased dramatically over the past two months, with SIVs now totalling less than $​300 billion, as programs liquidate or move holdings onto bank balance sheets. See also, today’​s WSJ story, “‘​Super Fund’ for SIVs”.

    Re: County of Santa Cruz TREASURER-TAX COLLECTOR 701 Ocean Street, Room 150 P.O. Box 1817 Santa Cruz. California 95061 Fred Keeley Treasurer-Tax Collector reasur ‘ (831) 454-2450 FAX: (831) 454-2257 April 17,2006 Board of Supervisors County of Santa Cruz 701 Ocean Street Santa Cruz. CA 95060

    Fred Keeley Treasurer – Tax Collector

    TREASURY OVERSIGHT COMMISSION Chairperson: Bob Shepherd Public MemberAlternate: L. Scott Osborne

    Santa Cruz County Treasurer’s Portfolio as of March 31, 2007


    Whistlejacket12,942,854.175.38%13,000,000.0012,945,010.002.23%40%03/22/0705/01/07A1+ / P1

    Re: DESCRIPTION OF INVESTMENT INSTRUMENTS The investment activities of County Treasurers are restricted by state law to a select group of government securities and prime money market instruments. To reduce the risk inherent in any one instrument, state law further limits the percentage of the county’s portfolio that can be invested in any one type of security. The types of securities available to the County Treasurer can be divided into three main categories: 1) U.S. Treasury bills, notes and bonds. They are guaranteed by the U.S. Government and are considered to have no credit risk. They also typically have the lowest yield of the securities available for investing. 2) Securities issued by U.S. Government Agencies and Instrumentalities. These securities consist mostly of notes and debentures of agencies and government sponsored corporations. They are not guaranteed by the U.S. government and therefore have some credit risk. Their yield is typically higher than U.S. Treasury securities. 3) Prime money market securities. These consist of securities such as bankers’ acceptances, certificates of deposit, commercial paper and municipal bonds. The yield is typically higher than the other types of securities in which the county invests but the risk is also higher. Through diversification and purchasing only highly rated paper, the credit risk is kept to an acceptable minimum. Each of the securities in these three categories is subject to market risk if sold prior to maturity

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