Rising tide of home equity cash-outs brings risk

The Scotsman Guide - Victor Whitman - 07 March 2017

Home equity lines, second mortgages and cash-out refinances are on the rise again, says Moody’s Investors Service.  

While this suggests that the housing market is improving and homeowners are feeling better about the economy, it adds to the risk of the securities underpinned by the mortgages, the rating agency said. 

In the first nine months of 2016, borrowers extracted $70.8 billion through cash-out refinances, Moody’s reported, the most over the same period since 2009.

Citing Equifax data, Moody’s also reported that new home equity lines of credit (HELOCs) and closed-end home equity loans totaled almost 2.3 million in 2016, up 21 percent from two years earlier and the most since 2008.

Borrowers are not taking out home equity lines and cash-out refinances anywhere near the levels of decade ago before the housing crash, Moody’s said. However, home prices are continuing to put more people in a position to draw out money.

“As the housing slump recedes further into the past, homeowners' available equity is increasing, along with their (and lenders') comfort with loan products that enable equity extraction,” Moody’s said.

Although the increased levels of borrowing suggest an improving housing market and that consumers are feeling better about their jobs and the economy, it isn’t necessarily good news for the credit quality of the mortgage-backed securities underpinned by the pools of mortgages, Moody’s said.

The company noted that more cash-out refinances are showing up in mortgage-backed securities. Cash-out refinances have higher default rates than rate-term refinances and purchase loans, thus weakening the credit quality of a pool.

Moody’s expects that the share of cash-out refinances to increase as rate-term refinances diminish with the rise in rates.

Meanwhile, second mortgages and HELOCs have a “credit negative” effect on the first-lien mortgages in a pool, Moody’s said.

“Increasing levels of home equity borrowing mean that homeowners are more likely to end up with little or even negative equity if home prices subsequently decline,” the report said. “Low levels of equity can reduce a borrower’s willingness to keep paying on their loan.”

Moody’s said the risk should be offset somewhat by improved underwriting standards and the more conservative approach to appraisals.