The banking industry has a great Home Equity strategic opportunity. The Home Equity loan product nearly evaporated between 2007 and early 2022. Fast forwarding to today, the Home Equity tailwinds include:
an attractive rate environment,
little mortgage product substitution,
ample banking system funding deposits, and
record-breaking customer home equity borrowing capacity.
But some banks seem to have forgotten the unique characteristics that drive Home Equity product success! I provide the results of a Home Equity origination test. I conclude with our “Top 10” strategic suggestions to both build organizational resilience and capture the great Home Equity opportunity.
This article has the following sections:
Introduction
Home Equity - A 15-year Absence
The Home Equity Advantage
A Home Equity Origination Test
The Home Equity Growth Opportunity
Notes
1. Introduction
My generation of bankers has been around the block a few times. This banking class started during the S&L Crisis in the 1980s. I know - every generation feels like they had it worse. Granted, we did not live through the Great Depression or world wars. Indeed, every generation encounters unique challenges. But my banking contemporaries and I have had a go of it. After finishing the S&L crisis, we endured the Russian debt crisis, including the Long Term Capital Management meltdown. Do you remember LTCM? They started as a Nobel prize-winning and securities price arbitrage-based hedge fund. [i] They ended with a colossal financial collapse. From there, it went to the "dot com" bubble burst, to the Financial Crisis and Great Recession, and rounding out with the Pandemic. What's next?! Much gray hair was produced by the turbulence and uncertainty of this era. Plus, much learning about how people, both clients and our banking associates, respond to volatile, uncertain credit environments.
By the way, this old Money Store advertisement takes me back to the Russian debt crisis. First Union (a legacy Wells Fargo acquisition) bought The Money Store just before the debt crisis wiped out the high yield bond market funding The Money Store. First Union ended up paying multiples on its original acquisition price to protect the First Union bond rating…. and promptly shut down the operation. What a value-destroying disaster! But not nearly as bad as their ill-considered purchase of Golden West, the toxic mortgage poster child. I will save that story for another article…. [ii]
I have enjoyed a financial services career as a behavioral economist and data scientist, led a Mortgage and Home Equity division, been a Chief Consumer Credit Officer, led Mortgage and Consumer Lending advisory practices, and currently lead a Financial Services segment for a decision sciences software and services company. I have worked with some amazing people.
In this article, I will explore Home Equity lending with the help of experienced and talented executives and supporting research. I start with exploring where Home Equity lending has been. Building on a current state lens, I then project where Home Equity is going and advise a path to help banks get there.
2. Home Equity - A 15-year Absence
For the past 15 years, home equity originations dried up and home equity assets almost disappeared from bank balance sheets. Why did this happen? There were a few big drivers. In 2007 and 2008, the mortgage market and residential home prices collapsed during the Financial Crisis and Great Recession. It took almost a decade for home values to fully recover. Think of a home equity loan as a substitute for a high loan to value ("LTV") Mortgage Insurance policy. [iii] While the mortgage industry was rocked by the crisis, the attendant super high LTV credit risk caused home equity lending to nearly evaporate. As a result of the Dodd-Frank Act and other financial crisis regulations, the cost of compliance for home equity lending increased significantly. [iv] Then, following the financial crisis, mortgage rates generally dropped. The pandemic caused mortgage rates to drop even more. When rates are low, mortgage refinancing displaces home equity lending. Home Equity lending generally does not make sense in a lower and declining rate environment. So, the Home Equity product headwinds were plentiful over this 15-year period.
That was before 2022. That was before the great inflation. The cause of this impactful inflation situation may be understood by answering a related question…. “What do you get when you fill a balloon faster than you empty the same balloon .... and persistently for 3 years?” As you would expect, whether filling the balloon with air or money, you will experience great INFLATION. [v] Thanks to both monetary and fiscal policy oversteering during the pandemic, we now have high inflation - pumped further by the ongoing economic repercussions from Russia's invasion of Ukraine. I cannot blame U.S. government policymakers too much. There was likely more downside risk to monetary and fiscal policy understeering than upside risk for policy oversteering. Be that as it may, we are living in one of the highest inflation environments in the last 50 years. Now, we have mortgage rates over 5% for the first time in a generation. With so many people refinancing over the last 3 years, you had to be asleep or a new homeowner not to have a mortgage loan rate below 5%. Thus, mortgage refinancing has ground to an almost complete halt. Bill Knudson is an economist and a former home equity pricing and market research executive. Mr. Knudson said:
"Market rates tend to feather down and rocket up. In the case of mortgage rates, clearly, the rocket has launched. This rocket appears to have significant fuel."
Given the premise that rates "Feather down and rocket up" it is possible the Home Equity product will be in vogue for some time. Another perspective is to consider the length of time since rates were this high. The idea is that the size of the "Mortgage Refi Rate Desert" matters and is directly related to the staying power of this Home Equity cycle. In the next chart, we present our perspective on the refi rate desert over time. At the present time, the refi rate desert is quite wide. In fact, it is the widest it has been in over 20 years, covering three recessions and including the great financial crisis. The current refi rate desert at the top of the chart is almost 15 years wide. This means the group of people that opened a mortgage between 2008 and 2022, have lower rates than the current mortgage rate. As such, with the exception of moving from their home, the people that opened mortgages in the last 15 years will likely not be economically motivated to refinance. Home Equity is an attractive product for those in this well-populated Mortgage Refi Rate Desert. [vi]
Please note: The way to think about this graphic is…. Imagine you are climbing a mountain and looking toward the valley. When you look directly across the horizon, the width of the bar tells you how far away is the closest mountain. In the case of this rate mountain, instead of measuring the distance in miles, we are measuring it in time. Also, the vertical thickness of the bar represents the steepness of the mountain. At the current time, the distance to the nearest mountain is far and you are hiking a very steep mountain!
Thanks to The Curiosity Vine team for completing this analysis. It required a significant Python coding exercise to perform the look back over several thousand weeks.
3. The Home Equity Advantage
Thus, almost overnight, the stars realigned to make Home Equity lending the darling bank product again. Banks have been swarming back into the business. Here is a recent comment from American Banker [vii]:
"JPMorgan Chase is considering offering more home equity lines of credit, a top executive said Monday, roughly two years after the megabank restricted the sometimes risky product."
Beyond a rate environment that has become far more conducive to home equity loan origination growth, the collateral value of U.S. homes has rocketed to historic levels.
Value of homeowner equity in real estate in the United States from 1960 to 2020 [viii]
(in trillion U.S. dollars)
Here is another important but underappreciated reason banks love home equity. In two words: "Match Funding." Home Equity loans, especially Home Equity Lines of Credit are short-duration. This means banks typically have access to the short-duration deposits available to match fund Home Equity loans. Compounding this, because of the pandemic, aggregate deposit balances in the United States have increased by over 35% in the last 3 years. [ix] This massive ramp-up in deposits has fed a hearty bank appetite for assets to fund. Also, with Wells Fargo's asset cap, a large $3 Trillion bank has no place to put their deposits! For all the other banks, Home Equity lending is likely a great funding play. In comparing the home equity and deposit charts, I find it very interesting that the banking system's $18 Trillion in deposits is almost enough to fund every $ of available home equity. It is helpful when both aggregate supply and aggregate demand capacity are aligned. Certainly, not all homeowners need a home equity loan. Just like not every deposit is available to fund a home equity loan. However, should deposit funding wane, asset-based securitization (ABS) or other structured finance-based funding is a likely alternative. Nate Gabig is a KPMG, LLP partner and helps lead their securitization practice. Mr. Gabig said:
“KPMG provides securitization services for traditional lending products as well as newer climate-focused products like solar. As funding is needed for Home Equity loan portfolios, we believe banks should consider securitization as one of their potential alternatives.”
Also, another home equity-based product is the “Home Equity Agreement” or “HEA.” [x] This provides homeowners an opportunity to access their equity by sharing in the home’s appreciation with a non-bank investor. The HEA is appropriate for long-money investors that desire exposure to the equivalent of a zero-coupon bond structure.
The last decade also has seen a significant rise in blockchain, machine learning, and other FinTech-related technology. As such, the capacity to drive customer efficiency, a lower cost of compliance, a more precise credit risk understanding, and customer delight are greater than ever.
Board member, start-up advisor, and former Fannie Mae Executive David Coleman said:
The Home Equity product has a great opportunity to realize a jump-start benefit. This occurs from the mortgage and consumer lending-based Machine Learning capabilities fine-tuned over the last decade. Banks that implement ML / AI will have the advantage.
With all this tailwind, you may think...
ALL IS GOOD IN HOME EQUITY LENDING! Let's Go!
4. A Home Equity Origination Test
I decided to test this "All is good in Home Equity" hypothesis. I very recently opened a Home Equity Line of Credit with a large, regional U.S. bank. Think of me as "The Man Who Knew Too Much." Given I have led home equity lending 1st line operations, 2nd line credit risk management, and provided related consulting services, I do have a unique perspective. Based on my Home Equity origination experience, my summary finding is:
Not ALL is good in Home Equity land.
The next part of this article provides a well-informed (and constructive, I hope) critique of my recent Home Equity loan origination experience. I acknowledge the limitations of a "focus group of one," yet I suspect that my experience would have been similar had I submitted my application to any number of other banks active in the home equity space. This test bank has been around for over a century. It has a brand associated with high quality. In a recent discussion with the bank’s Home Equity sales leader, they mentioned their backlog volume was well into the $ billions with greatly extended loan processing time frames. Based on my loan originations experience, nothing good happens in an extended time to close loan pipeline. Thus, risks such as credit, fraud, financial, operations, legal, and customer satisfaction only increase as the time to originate increases.
Borrower Profile: First off, I'm an easy credit decision. I've been on the credit bureau file for over 30 years. We have plenty of strength on the "5 C's of Credit" front that makes my wife and me very bankable. But we are far from unique. The majority of Americans are considered prime credit.
Training & Experience: The trouble started at the beginning. I began the origination process with a Mortgage Loan Officer. It became clear very quickly this bank was attempting to repurpose the employees of its declining demand Mortgage organization in the increasing demand Home Equity organization. I get it. That would cross my mind too. Especially given the great resignation. That is until I realized most of these mortgage operations people were still in grade school the last time Home Equity lending was widespread! Sure, repurpose people, but you have to train them and surround them with experienced leaders. It was clear my LO did not have much experience with home equity, other than some fundamental training.
Supporting Technology: Also, this particular bank is a Black Knight client. Black Knight is a big player in the mortgage industry and provides a leading mortgage origination software platform called "Empower." [xi] Empower is a time-tested Mortgage (LOS) solution. Black Knight also allows its clients to extend the mortgage platform to the Home Equity business. This may appear to be a great idea! Mortgage and Home Equity are both residential real estate collateral based. Also, the products have some legal consumer protection similarities. This bank decided to license Black Knight's Mortgage system for Home Equity as well.
It turns out that an important difference between these two loan products is secondary market execution. Mortgages and the related credit risk are usually sold on the secondary market. Home Equity and the related credit risk are generally retained in a bank’s portfolio.
Mortgage loans need structure. This is needed to comply with secondary market requirements. This enables the bank to offload credit risk and earn a loan sale fee.
Home Equity loans need credit risk adaptability. This is needed to adjust to the unique credit signals from the borrower's profile. This enables the bank to keep the credit risk and earn a net interest margin. [xii]
It turns out the standard mortgage LOS is not a natural match for the Home Equity product. By definition, the ability of a secondary market-focused Mortgage LOS to adapt to the portfolio credit signal-focused Home Equity product is a significant challenge. Gary Walton is the Chief Credit Officer for Retail Lending at MUFG Union Bank. Gary formerly held senior credit roles at SunTrust Bank, now Truist Bank. Mr. Walton said:
"Home Equity is a credit and operations game. Deep credit insight, credit policy clarity, and operational excellence is the key to good outcomes."
Customer Demand & Scalability: A compounding problem was the explosion in Home Equity demand when I submitted my application. My young and "try-hard" loan processor has this notice below her email signature line.
"Our applications are taking longer than normal to get through the approval process."
It was clear that this bank's home equity operations were overwhelmed. From the time I contacted the LO to closing the loan, the whole process took more than 90 days. Pretty shocking. In my day, we closed "prime" Home Equity loans in 20 days. The customer-facing digital workflow either did not exist or was not being used to collect documents. I would generally just email pdfs. Given my underwriting and audit experience, I did my best to package and annotate my underwriting evidence in a way that made it easy to process and clear the loan requirements. My processor was appreciative. I felt bad for her. I could tell the loan volume was overwhelming.
Credit Requirements Rationale: This bank ordered a full appraisal. This begged two operative questions:
Why spend about $1,000 (and at the same time, why create avoidable COVID-19 risk for the homeowner and appraiser)?
Why take the regulatory risk on an appraisal system already under significant Fair Lending pressure? [xiii]
My home is in an area with deep and homogenous comparable properties. Clearly, a credit risk and analyst-informed desktop, broker price opinion ("BPO"), or automated valuation model ("AVM") would do. Not at all surprising is that the Zillow value on my home was almost identical to this costly appraisal value estimate. This relates back to the question about secondary market requirements vs. the value of the credit signal. In this case, more efficient credit signals are available for portfolio loans. Terry Loebs is the founder of Pulsenomics and is the former executive of the company that created the S&P CoreLogic Case-Shiller Home Price Indices and one of the first AVM systems for loan origination and risk management purposes. Mr. Loebs said:
“Deep and homogenous explanatory data enable high-quality AVMs to instantly calculate home values that lenders can safely bank on at a negligible cost."
What about the promise of FinTech and blockchain? Clearly, this bank was not using it at all or not leveraging it to achieve customer delight.
5. The Home Equity Growth Opportunity
Experience can be a great teacher. Often, experience’s wisdom helps us learn what NOT to do, even more so than what to do. My experience teaches me that the banking industry has a great Home Equity strategic opportunity. It also teaches me that the opportunity value will only be realized by those that make the appropriate early-stage investments. Truist's Mortgage Servicing is led by Mike Zarro. Mike's comments remind us that loan servicing experience has an important place in the growth of Home Equity originations. Mr. Zarro said:
"Another consideration for Mortgage divisions when servicing HELOCs is that fraud is a whole new ball game for them – checks, account takeovers, cards, etc."
Transactional product fraud risk has certainly evolved since the last time HELOCs were big.
Next, are the “Top 10” strategic suggestions to grow a resilient Home Equity organization. To help inform this Top 10 list, I appreciate the contributions from many experienced leaders, the research sources, and the very real experience provided by the test bank.
Home Equity growth and resilience "Top 10" strategic suggestions
Separate the Home Equity and Mortgage production operations. Recognize they are different cultures and different products. The credit risk "offload" vs. "keep" dichotomy should be top of mind.
Train, Train, Train! Hire leaders with PROVEN Home Equity product knowledge.
Implement credit-focused underwriting requirements. Rid yourself of the "because we have always done it this way" secondary market habits. Home equity is a unique portfolio product!
Focus on your centralized (virtual or in-person) call center channel. Right size your more expensive and decentralized retail LO sales channel.
Create a business-leading "Marketing and Analysis" team. These are often data scientists and business analysts driving a "test and learn" evolutionary culture. They will be your best friends for uncovering hidden value and watching your credit back.
Simplify the Home Equity product to enable call center scaling. Home Equity works better in a "factory" environment.
Implement a scalable, compliant, data-rich Home Equity LOS and related technology. The LOS should anticipate the requirements for ABS or related investor funding. Repurposing inflexible mortgage tech is like pushing a boulder uphill.
In the new home equity world, fraud is a whole new ball game. Make sure your servicing system is capable of handling both property AND transaction-based fraud challenges.
Ramp up digital marketing and your client journey focus. Home Equity should be integrated into your broader product portfolio and direct-to-consumer client journey.
Focus on blockchain, machine learning, and FinTech-based technology. Now is a great opportunity to reimagine your Home Equity business by implementing next-generation technology. This is especially helpful for increasing customer delight, reducing your cost of compliance, and increasing the precision of your credit risk understanding.
6. Notes
[i] Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2001
[ii] Your intrepid author, Jeff Hulett, was a new employee of First Union when The Money Store ("TMS") purchase was made. I was on the team that helped integrate TMS into First Union. I had come to First Union via an earlier acquisition of Signet Bank. I left First Union, not long after the Wachovia merger but before the Wells Fargo acquisition. As an interesting and ironic side note, I was at the "Big 4" audit, tax, and advisory firm KPMG, LLP at the time of the Wells Fargo acquisition of Wachovia. I led the team that helped the KPMG audit team validate the mark-to-market "mark" placed on the Golden West mortgage book as it was first entered on the Wells Fargo balance sheet. Without seeing the loan performance data with my own eyes, I would have never believed mortgage loans could perform so poorly and be worth so little. By the way, the Golden West loan valuation impact is public information as found in the 10k after the Wells Fargo acquisition of Wachovia.
[iii] Granted, not all LTVs are the same when it comes to understanding the credit risk associated with Home Equity loans. My experience suggests that the likelihood of defaulting (aka, frequency risk) interacts with severity risk. The borrower associates an investment value with their home. There comes a tipping point where the borrower realizes the remaining home equity after all loans are so low that they become more willing to default. Also, the home equity loan severity risk is nuanced beyond the LTV measure. See this article for a deeper dive:
Hulett, Not All Loan To Values Were Created Equal, The Curiosity Vine, 2022 and 2008
[iv] Hu, Huntington, Mi, Frey, Bergman, Hirsh, Weiss, Summary of Dodd-Frank Financial Regulation Legislation, Harvard Law School Forum on Corporate Governance, 2010
[v] For a deeper dive into the pandemic-related mechanics of inflation, monetary policy, and fiscal policy, please see the article:
Hulett, Pandemic reflationary policy and our social justice opportunity, The Curiosity Vine, 2021
[vi] The core data for the "Mortgage Refi Rate Desert" is the Weekly Freddie Mac Primary Mortgage Market Survey as of 9/29/22. We performed a look back at every week's 30-year FRM rates to answer a simple question. "How motivated are people to refinance their mortgage?" We want to answer this question by measuring the mortgage refi rate desert in terms of time. That is, how long has it been since the current mortgage rate was at or above the past mortgage rates that would have been available to refinance? The idea is, the longer the current rate is above past rates, the lower the aggregate motivation is to refinance a current mortgage across the population of U.S. mortgage borrowers. The shorter the time that the current mortgage rate is above past rates, or is lower than past rates, the higher the motivation is to refi across populations. The premise is that people are motivated by their economic self-interest:
Mortgage Refi motive - To refinance their mortgage when current rates are lower than their mortgage loan rate. (That is in lower (or negative) mortgage rate deserts) and
Home Equity motive - To maintain their current mortgage and use home equity loans to fund incremental needs when current rates are higher than their mortgage loan rate. (That is in higher mortgage rate deserts.)
To clarify a technical point, in order to smooth the data, we used a three-month moving average to compare rates in the lookback. The idea is that people will not be motivated to refi as soon as their existing mortgage rate is above the current rate. The timing of refinancing decisions may be impacted by a number of effects that create refi decision inertia, such as:
Fear Of Missing Out ("FOMO") - or wanting to get an even lower rate in the future if the borrower believes rates are dropping,
Time to shop,
Time to underwrite,
Incremental cash needs,
Life distractions, and
Many other reasons.
The idea is not to predict the exact timing of an individual refinance event. Our focus is to indicate when the current rate would provide a rational economic environment for motivating a mortgage refinance or a home equity loan. In other words, our hunt is to identify the medium, not the catalyst.
[vii] Prior, Two years after HELOC pullback, JPMorgan again eyes the business, American Banker, 2022
[viii] Statista research department editors, Value of homeowner equity in real estate in the United States from 1960 to 2020, Statista, 2022
[ix] Editors, Statistics at a Glance - Latest Industry Trends - 1st Quarter 2022, Federal Deposit Insurance Corporation (FDIC), 2022
[x] Cook, Equity Sharing Lets Homeowners Sell ‘a Slice’ of Their House. Should They?, Money, 2022
[xi] Editors, EMPOWER® LOAN ORIGINATION SYSTEM, Black Knight, 2022
[xii] I make reference to bank profitability and revenue measures, such as mortgage loan sale fee (also known as a "Servicing Release Premium" and a Net Interest Margin. There are accounting nuances, but the mortgage fee is usually a one-time fee paid at the time of the loan sale. A Net Interest Margin is the ongoing revenue, net of loan costs, received when a customer makes their loan payment over the life of the loan.
[xiii] Editors, ldentifying Bias and Barriers, Promoting Equity: An Analysis of the USPAP standards and Appraiser Qualifications Criteria, National Fair Housing Alliance, Dane Law LLC, Christensen Law Firm, 2022