The lowest interest rates in almost half a century have not only been a godsend for new-home buyers but for homeowners as well, many of whom have either refinanced their mortgages or used home equity loans to renovate or expand. Even in Canada, demand for home equity loans has been rising twice as fast as the conventional mortgage market, and in the United States it has been growing even faster. Banks have been more than happy to meet this demand, but as interest rates begin to rise they could find themselves between a rock and a hard place.
J.P. Morgan raised the issue in a recent research report on the U.S. bank and trust sector, under the title "Home equity boom leaves some banks highly exposed." In just the past three years, the brokerage firm says, home equity loans have doubled as a share of banks' loan portfolios, and the sector continues to expand at a rapid rate. In the first three months of this year, home equity lines of credit jumped by $104-billion (U.S.), a 15 per cent rise compared with the previous quarter and 40 per cent higher than the same quarter last year.
According to J.P. Morgan, U.S. banks and thrifts had about $377-billion of home equity loans outstanding as of March 31, with about 87 per cent of that figure held by commercial banks. The brokerage firm says the banks have increased their equity-backed loan portfolios by almost 40 per cent over the past year. The category only includes open-ended loans or lines of credit secured by real estate; traditional second or third mortgages, which have a fixed term and payment schedule, are not included.
The problem this poses for the banks is twofold: on the one hand, as interest rates rise — as they are expected to do in both Canada and the United States — demand for this kind of financing will likely fall, and writing such loans has been a source of growth for the financial industry over the past two years. At the same time, higher interest rates could push some borrowers over the edge, if they have leveraged their house a little too far. Higher rates could also help cause house prices to level off or even slide in some markets, and that would reduce the value of the equity that is being used as collateral for some loans.
The first of these effects — a decline in mortgage refinancing and other equity-backed lending — is already starting to occur. On Tuesday, Washington Mutual, the largest savings and loan company in the United States, scaled back its profit forecast dramatically, in part because of a decline in demand for mortgages. The company said it now expects profit to be as much as 30 per cent below earlier forecasts. Mortgages made up more than 30 per cent of the bank's business in 2003, and accounted for about 20 per cent of its overall profit.
J.P. Morgan says that the banking industry's exposure to open-ended home equity loans and undrawn lines of credit amounted to $779-billion at the end of March, which is equivalent to 14 per cent of all loans and leases, and 24 per cent of all real estate lending. More than one quarter of the increase in loans in the past year came from the growth in home equity lending, the firm says. And the amount of unused credit in those outstanding loans is about $400-billion, according to J.P. Morgan, having increased at an annualized rate of 90 per cent in the first quarter. That unused credit now amounts to more than 7 per cent of all outstanding loans and leases in the U.S. banking system.
While the default rate on home-equity loans is not that high, it is higher than on other types of asset-based lending, the brokerage firm says, and the risk is that as interest rates rise that could increase — particularly if personal incomes don't rise at the same rate. "Declines in housing prices could raise default rates and leave some institutions at risk," J.P. Morgan says. Some banks and trusts have significantly increased their exposure even in the past year: home-equity loans make up more than 25 per cent of Countrywide Financial's loan business, up from 6 per cent last year, and about 11 per cent of Washington Mutual's overall loan business, up from 5.7 per cent.
"Falling real estate prices can be expected to lead to higher delinquency and default rates on home equity loans," J.P. Morgan says. While some large and diversified financial institutions will be protected from the fallout of such an event, since house prices are unlikely to fall across the country in all markets, banks and trusts that are regionally focused may have a harder time of it, the brokerage firm says. Although no similar breakdown is available for Canadian banks in terms of home-equity exposure, the home-equity loan market has been growing at more than 20 per cent a year, about twice as fast as the mortgage market.
Just because interest rates start to rise doesn't mean that all those with home-equity loans will suddenly default, and the impact may be even smaller if incomes continue to rise. Areas where home prices remain stable or continue to climb should also be better off. But there are those homeowners who saw low interest rates and easy credit terms as a licence to get even further into debt, and they could get hit by either stagnant home prices or rising rates, or both.
© The Globe and Mail
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