Monday, May 16, 2005

Agencies Take Aim on Housing Bubble

by Bill McBride on 5/16/2005 04:32:00 PM

Today, the Office of the Comptroller of the Currency, the FED, the FDIC and other agencies issued a new credit risk management guidance for home equity lending.

UPDATE: See MarketWatch's Rex Nutting: "Lenders warned of home equity risks"
UPDATE2: WaPo: U.S. Warns Lenders To Elevate Standards

In the late '90s, the FED was criticized for not using higher margin requirements as a tool to prick the stock market bubble. Economist Simon Kwan of the San Francisco Federal Reserve Bank argued that using margin requirements as a policy tool would not be effective, because "Investors can use financial derivatives to obtain exposure to equities without owning stocks, and they also can substitute margin credit with other types of credit."

These arguments do not apply to the housing bubble: investors cannot use derivatives to invest in homes, and rarely are other sources of credit sufficient for a home purchase. Today the various agencies have acted and tightened lending requirements, primarily to protect lending institutions, but indirectly to prick the housing bubble.

In the guidance, the agencies point to several "product, risk management, and underwriting risk factors and trends that have attracted scrutiny":

· Interest-only features that require no amortization of principal for a protracted period;

· Limited or no documentation of a borrower’s assets, employment, and income (known as "low doc" or "no doc" lending);

· Higher loan-to-value (LTV) and debt-to- income (DTI) ratios;

· Lower credit risk scores for underwriting home equity loans;

· Greater use of automated valuation models (AVMs) and other collateral evaluation tools for the development of appraisals and evaluations; and

· An increase in the number of transactions generated through a loan broker or other third party.
All of these areas of concern are addressed with tighter lending requirements in the various provisions of the new guideline. These include tighter controls to detect mortgage fraud, better controls on third party originations, more stringent appraisal guidelines and more.

Probably the two most important provisions concern HELOCs (home equity lines of credit) and HLTV (High Loan to Value) loans. With the HLTV loans, the agencies remarked that "in recent examinations, supervisory staff has noted several instances of noncompliance with the supervisory loan-to-value limits ..." In addition to more controls to address this noncompliance, they added a new requirement:
"Loans in excess of the supervisory LTV limits should be identified in the institution's records. The aggregate of high LTV one- to four-family residential loans should not exceed 100 percent of the institution's total capital. Within that limit, high LTV loans for properties other than one- to four-family residential properties should not exceed 30 percent of capital."
Lending institutions that are over or close to the limit of allowable HLTV loans must stop making these types of loans.

For HELOCs, lenders are now advised to consider the borrowers ability to pay over the life of the loan. This is a key difference in lending standards; previously lenders only considers the current interest rate and the borrower's income. Here is the key passage:
"... underwriting standards for interest-only and variable rate HELOCs should include an assessment of the borrower's ability to amortize the fully drawn line over the loan term and to absorb potential increases in interest rates."
The agencies must be very concerned when they caution lending institutions as follows:
"... prudently underwritten home equity loans should include an evaluation of a borrower's capacity to adequately service the debt."
Altogether, this is a clear warning shot across the bow of the housing bubble.

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