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Bank Stress Tests: Vigorous or Sham? Let’s Review HELOC Losses

Posted by Larry Doyle on May 20, 2009 9:26 AM |

If you want to know just how inaccurate government loss assumptions were in the recently released Bank Stress Tests, let’s enter the world of HELOCs (Home Equity Lines of Credit).

Before we address loss statistics on HELOCs, let’s go to the Federal Reserve for a clearcut definition of the product. What is a Home Equity Line of Credit?

A home equity line of credit is a form of revolving credit in which your home serves as collateral. Because a home often is a consumer’s most valuable asset, many homeowners use home equity credit lines only for major items, such as education, home improvements, or medical bills, and choose not to use them for day-to-day expenses.

With a home equity line, you will be approved for a specific amount of credit. Many lenders set the credit limit on a home equity line by taking a percentage (say, 75%) of the home’s appraised value and subtracting from that the balance owed on the existing mortgage.

This mortgage product, often a second mortgage, developed as an enormously popular vehicle for homeowners to tap the equity in their home, especially during the period of significant home price appreciation earlier this decade. Make no mistake, though, it is just another form of leverage.

Even still, as other means of sourcing liquidity dry up – if not totally evaporate – homeowners continue to take out HELOCs. In fact, the U.S. Treasury just last week released updated info on the pace of recent HELOC originations:

In addition, home equity lines of credit (HELOC) increased in volume, due in part to seasonal factors as most borrowers seek bank credit in the spring and summer to remodel homes or for other home-related projects. The median change in HELOC originations was an increase of 17 percent from February to March. The increase was also partially driven by low interest rates. Demand was down slightly from normal levels, as some borrowers who would traditionally seek HELOCs may have applied for reverse mortgages given the low rates available in the month of March.

What about losses on HELOCs given the popularity of this product? For a more in-depth review of loss data, let’s go to our friends at 12th Street Capital who recently released analysis on HELOC losses for a number of 2006-2007 originated HELOC deals.

For those not aware, Turbo-Tim Geithner’s Bank Stress Test utilized an assumed cumulative loss on this product of 6-8% in the base case. The most adverse scenario assumed cumulative losses on HELOCs of 8-11%.

What did our 12th Street Capital friends learn in their analysis? KD writes:

What I find very interesting here is comparing the Cumulative Loss numbers on these deals versus the Government’s assumption of losses in the stress test. As a reminder, our friends in D.C. assumed in a More Adverse Scenario that Helocs on bank balance sheets would generate losses of 8% to 11%. Now I know their numbers represent the projections going forward for the next two years, but when you take a look at numerous ’06 and ’07 deals already ringing up losses north of 20% I find it hard to reconcile. I think the Treasury has a very rosy picture of the loss curve going forward.

Well, perhaps the Treasury does have an excessively rosy picture of the loss curve going forward or just maybe they already had the needed results and worked backwards.

Do they think people don’t look at these reports? Thank you KD and 12th Street for “keeping them honest.”


  • bonddadddy

    yup ……. give them cover to issue a gazillion in new shares and raise capital before the commercial mortgage and HELOC losses can no longer be ignored

  • kbdabear

    I’m rather illiterate financially, thank you for making the obscure understandable to those of us not in the business. A farmer in Kansas may not understand the finer points of meteorology, but he looks at the sky and knows a tornado may be coming.

    I used to work for one of the megabanks in the commercial mortgage organization. One issue I don’t see discussed much if at all is the T in the PITA composition of commercial and residential mortgages. Even with interest rates artificially low at this time, property taxes are going up all over America and I know of a few people who say they will be hard pressed to pay those increases.

  • Great point!! Tax revenues at the local, state, and federal level will be significantly lower given this recession. What will happen and is already happening? Cuts in services and tax increases across the board.

    No place to hide.

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