Housing Doom

How Vulnerable is the FDIC (and the US Taxpayer) Today? [Originally posted July 5, 2006]

In a fascinating report "Focus This Quarter" for Winter 2004, the FDIC looked in their crystal ball and saw 2006.  It would have been comforting to see the FDIC accurately assess the difficulties, had they not appeared to encourage risky loan practices. The report specifically delt with HELOC concerns (Home Equity Line of Credit), but adressed concerns with the mortgage industry in general as well.  They began the report with:

As a component of the mortgage lending business, home equity lending has traditionally been characterized by low credit losses. However, recent trends reveal a rapidly changing landscape in the way that home equity lines of credit (HELOCs) are used by household borrowers and structured by mortgage lenders. Home equity debt is rapidly growing as a percentage of total household indebtedness, in part as a result of new loan programs that make HELOCs more accessible to borrowers, including groups of people who previously would not have had access to this product.

Amid these longer term changes in the marketplace, the current environment offers the additional challenges of rising short-term interest rates and the likelihood that home price gains will eventually level off in some of the nation’s pricier home markets.  As a result of these trends, it is increasingly uncertain whether the traditionally low credit losses associated with home equity lending will remain a permanent attribute of this line of business. In any event, the changes being wrought by the marketplace are requiring both lenders and borrowers to think about home equity products in new ways.

The article discussed potential problems with loosened lending standards:

Because of the tremendous growth of HELOC lending in recent years, concern has arisen that home equity underwriting practices have eased. Indeed, home equity products exhibited the greatest increase in risk, according to the 2003 Survey of Credit Underwriting Practices conducted by the Office of the Comptroller of the Currency (OCC). Although the performance of home equity loans remains strong, as demonstrated by low delinquency rates, the survey noted that ‘banks need to be alert to the risks that are introduced when high growth is coupled with liberalized underwriting.

They also discussed the potential problems with rising interest rates and eroding home values:

Lenders should be especially cognizant of underwriting practices during a period of change in the macroeconomic environment. The two biggest issues here that bring up questions are interest rates and home prices. Specifically, how fast and how far will interest rates rise during the present period of tightening monetary policy? Also, when will home prices ultimately level off, and could they actually decline in certain high-priced metropolitan areas? Because HELOC interest rates are typically tied to benchmark short-term interest rates, rising rates make it more expensive for borrowers to service their debt. Higher rates could also dampen demand on the part of new homebuyers, thereby slowing the rate of home price increases. Should home prices stagnate or fall, the most important effect for lenders could well be an erosion in the equity position of some homeowners that will marginally reduce their incentive to repay the HELOC.

The article also addresses the difficulties attendant with the riskiness of new loans, subprimes, etc.- all the things I would hope the FDIC would be concerned with- but there were some other themes in this FDIC report that concerned me:

One concern was the comment, "…many homeowners are converting the equity in their home into cash through home equity borrowing and making this kind of transaction an increasingly important part of their household finances."

It is bad enough to hear this kind of fundamentally flawed thinking from lenders, but from the FDIC?  The only way to convert the equity in your home into cash is to SELL IT- HELOCS are secured LOANS.

The other frightening thing about the article is how, in spite of enumerating the risks, the article, rather than decrying these risky practices, emphasized the upside for lenders:

The challenge for lenders in this post-refinance period is not only to lift production of new HELOCs but also to get customers to draw more against existing lines. Although HELOC outstandings totaled $415.8 billion in second quarter 2004, this represented only half of the total approved borrowing limits, or commitments, on those lines. The utilization rate for HELOCs was almost 49 percent as of second quarter 2004, leaving $435 billion sitting untapped in committed home equity lines extended by banks.  This untapped amount represents a substantial source of potential fee income for lenders and available cash for consumers.

The report goes on at length describing the efforts lenders have been making to make sure that homeowners are completely tapped out, with very little indication of concern.  It ends with the anemic recommendation, "Given these uncertainties, lenders and borrowers should not automatically assume that their historical loss experience is an accurate guide to future repayment ability. To the extent possible, it makes sense in this environment to estimate how loss projections might change under a less advantageous set of market conditions."

Personally, I prefer a more conservative message from the FDIC.  This report made me wonder exactly how the FDIC fared during the crisis of the 1990s, and if they were better prepared to deal with a potential housing downturn today. 

At the FDIC website, is a "Brief History of the FDIC." In this 76 page document (I guess that’s brief for a government document) they describe the banking crisis of the 1980s and 1990s, including the causes and how it changed the FDIC. This was a period when insured bank failures and insurance losses caused the BIF (Bank Insurance Fund) to bececom technically insolvent by 7$ Billion.

In describing some of the conditions that set up the S&L crisis, some of the factors can be identified today.  The FDIC history describes volatile interest rates, commodity rates, and riskier banking practices as some of the significant contributing factors.

In describing what caused so many banks to fail during that period, the FDIC states, "Banks that failed generally assumed greater risks, on average, than those that survived, as measured by the ratio of total loans and commercial real-estate loans to total assets.  Banks that failed generally had not been in a weakened condition, as measured by equity-to-assets ratios, in the years preceeding the regional recessions."

So if equity-to-asset ratio is the best indicator for whether or not a bank would fail, why in the world is an FDIC report touting the potential opportunities for banks who lend as much as possible against assets, instead of encouraging a more conservative approach?

In spite of changes brought about by the enactment of the Financial Institution Reform, Recovery and Enforcement Act (FIRREA) it appears that given the low rate of equity many Americans have in their homes, banks could once again find themselves vulnerable.  As the FDIC also points out, the large number of bank mergers since that time has added to the risk.  This has reduced the amount of diversification in the industry, allowing for greater loss, should a bank fail.

While nationally real estate did not crash during the S&L crisis, it did in regional markets. The damage affected banking, and ultimately the tax payer.  There is no guarantee that it couldn’t happen again.