At the same time that some financial institutions have embraced high loan-to-value mortgage loans as a safe and profitable avenue to a new revenue stream, others have kept HLTV at arm’s length. Meanwhile, the accelerated growth of HLTV lending in the consumer market and HLTV’s defining characteristic of high mortgage debt relative to value of the home are causing the product to be viewed under a harsher light both by those inside and outside the financial services industry. A recently completed study, “High Loan-to-Value Mortgage Lending: Problem or Cure?” explored HLTV--its evolution, the picture today, a comparison with subprime lending, customers and marketing, the role of securitization, and risks, social costs, and benefits.

Some critics fear that HLTV loans pose new higher risks for lenders. That concern has grown recently as the group of potential lenders has expanded from uninsured finance companies to include federally insured banks and thrifts. Others worry. that consumers (who are attracted to the new loans because of the low interest rates they offer) are somehow being tricked into borrowing too much. This study looked at the demand side of the HLTV market (the types of customers who borrow HLTV loans) and at the supply side (the way funding is provided to loan originators). The study concludes that, rather than a cause for concern, HLTV lending is cause for celebration. HLTV loans efficiently provide low-risk consumers with low-cost loans, and do so in a way that reduces risk for both consumers and lenders.

Demand and Supply

On the demand side, the consumers attracted to this market are typically high-quality borrowers pursuing the legitimate goal of reducing their debt service costs by converting unsecured (often credit card) debt to consumer credit tied to their homes. On the supply side, the financing of this product entails sophisticated methods of measuring individual consumers’ credit risks, and using those measures to develop ratings for portfolios of loans financed through market securitizations. Objective, reliable criteria for rating credit quality (Fair Isaac Co., or FICO, scores) are employed, and ratings agencies and sophisticated institutional investors are placing their reputations and their money on the line when expressing their confidence in the low risks of HLTV lending.

FICO scoring. The first fact to note about HLTV loans is their low risk. Despite the high leverage of these loans relative to the value of the borrower’s home they are, in fact, not very. risky loans. The vast majority of HLTV borrowers have “prime” FICO credit scores. Thus, unlike subprime lending, which is often confused with HLTV lending, typically these are prime quality loans. That is not to say that subprime lending (or the small portion of HLTV loans that are subprime) is a problem to be avoided. As long as subprime borrowers have legitimate needs for credit, and as long as underwriting standards properly price and control risk, subprime lending also serves consumers’ interests. Nevertheless, as a matter of fact, HLTV lending is not subprime lending.

Not only are FICO scores at origination very, high on HLTV loan portfolios (typically averaging between 660 and 700), that high quality is also reflected in superior default experience. Compared with other home equity products--those with low loan-to-value ratios--HLTV loans have a much lower incidence of delinquency. To date, only 0.6% of HLTV loans have become severely delinquent (more than 90 days past due), compared with 3.0% of low-loan-to-value home equity loans. The delinquency rates for credit cards have been higher still. The high quality of HLTV borrowers reflects the selectivity of lenders, who use FICO scores and other information to carefully screen borrowers, and to control the amount lent to them.

The connection to the borrower’s home helps to reduce default risk (because consumers are more likely to repay mortgage debt than unsecured consumer debt) but the primary underwriting criterion used for screening HLTV borrowers is their overall creditworthiness, not the value of their home.

Most mortgage professionals agree that the credit ratings used by the HLTV industry provide a clear picture of a consumer’s credit standing to be used in conjunction with the loan-to-value ratio in judging the likely loan performance of the customer. For a given FICO score, loan performance will be poorest for unsecured loans, better for second-trust loans (including HLTV loans), and best for low loan-to-value mortgage loans. Thus, a portfolio of HLTV loans of a given FICO quality will have lower default risk than a credit-card receivable portfolio of a comparable FICO quality but higher default risk than a traditional mortgage portfolio with the same FICO score profile.

How will HLTV loans behave during a severe economic downturn? Like all loans, default rates on HLTV loans will rise during recessions. However, secured creditors, including HLTV creditors, fare better during downturns than do unsecured creditors. In fact, part of the initial appeal of HLTV lending came from observing the superior performance of Title 1 loans--a government-sponsored HLTV product that has been in existence since 1934--during economic downturns.

Commitment to Repay

High-quality borrowers capture much of the gain from transferring credit card debt balances to HLTV loans. On a pretax basis, a conservative estimate of annual cost savings for many consumers (including interest and points) would be 3.3% (that is, an all-in cost of 14.7% on an HLTV loan compared with 18% on a credit card loan). On an after-tax basis, cost savings can be significantly greater to the extent that interest costs are deductible (deductibility is limited to mortgages up to 100% of home value).

What is behind the reduced pretax debt service costs consumers enjoy from HLTV lending? In a word, commitment. By offering their homes as security for consumer borrowing, consumers credibly promise not to abuse the protection of Chapter 7 of the Bankruptcy Code. Linking credit to the borrower’s home prevents default by many consumers who can easily repay their debts but may choose not to do so.

How does Chapter 7 permit this abuse, and how does HLTV lending provide a solution to that problem? As Professor Michelle White has shown in her recent study of the abuse of debtor protection (“Why It Pays to File for Bankruptcy . . . ,” University of Chicago Law Review, forthcoming), current law permits consumers to discharge debt under Chapter 7 without any loss of future wage income (a 100% future wage “exemption”) and, typically, without losing their home or any of their home equity. She estimates that roughly one quarter of American households would benefit financially from filing for bankruptcy under current law, and that many are doing so. Professor White also finds that a very small change in the wage exemption--lowering it from 100% to 90%, and thus placing only 10% of future wages at risk of loss to existing creditors--would drastically reduce bankruptcy filings and virtually eliminate the abuse of the system. In other words, many consumers who file for bankruptcy are choosing to default to take advantage of legal exemptions, even though they could easily repay their debts using future income.

Professor White’s findings provide the key to understanding the attraction of HLTV lending. When consumers exchange credit card debt for home equity debt, they give the creditor a form of protection against voluntary default by the consumer by raising the cost to the consumer of defaulting on the loan. Borrowers who default on secured loans risk losing their homes, which (apart from the equity loss) is a major inconvenience. Perhaps more importantly since high costs of foreclosure sometimes discourage HLTV lenders from foreclosing to recover scant equity from their second trusts secured lenders retain a lien against the defaulting borrower’s home that is not extinguished by filing for bankruptcy protection. That lien can be a nuisance for consumers another cost that encourages borrowers to repay secured debt.

The fact that HLTV loans are geared toward consumers who are likely to be able to repay their debt is consistent with their role of preventing those who are able to repay from avoiding repayment. The fact that interest rates are lower on HLTV loans shows that in today’s competitive markets consumers are able to capture the gains of efficient financial innovations (like HLTV loans) that help to prevent avoidable abuses.

Assessing the Concerns of Critics

The study also addresses some common concerns about HLTV lending, in particular, the claims that HLTV borrowers irrationally “reload” their credit card debt after their initial HLTV debt consolidation and accusations that consumers use an initial HLTV debt consolidation to fraudulently obtain a second loan (churning) by appearing to have no credit card debt outstanding.

Some reloading is probably beneficial to consumers, is anticipated by lenders, and is not problematic or irrational. Recent survey findings show that 70% of HLTV borrowers reload, but apparently the amount of reloading is small. That is precisely what one would expect. HLTV borrowing only makes sense if the borrower wants to borrow for several years because HLTV lenders limit prepayment risk on their portfolios by frontloading costs through high point charges. Thus when a small amount of additional short-term borrowing is desired, consumers rightly choose to finance it through short-term credit card debt.

With respect to churning, consumer fraud of this type is effectively prevented by a variety of means, including due diligence by lenders who investigate recent paydowns of credit card balances (a potential sign of churning) when screening HLTV loan applicants.

Some of the concern about reloading and churning seems to have been prompted by the simultaneous growth in bankruptcy filings and HLTV lending over the past four years, which has led some to wonder whether HLTV lending could be causing greater bankruptcies. That view is implausible and confuses the direction of causation for two masons:

Bank and thrift regulators are beginning to become concerned about HLTV lending now that banks and thrifts are considering entering this profitable new area. A legitimate concern of regulators about all types of lending is whether financial institutions might abuse deposit insurance protection by undertaking higher portfolio risk. Regulators have been concerned in the past, for example, about credit card securitizations. This type of off-balance sheet lending reduces required capital ratios of banks, but leaves banks with almost all of the risk of the securitized portfolio because banks retain a junior stake in the trust that issues the securitized debt.

When considering whether such concerns warrant special treatment of HLTV loans or securitizations by banks and thrifts, regulators should bear in mind that HLTV portfolios have lower default risk than credit card portfolios because of the high credit scores of HLTV borrowers and because HLTV loans are secured debts. In other words, banks and thrifts that replace credit card debt with HLTV debt will actually be reducing the riskiness of their consumer lending. Thus, regulators should encourage entry by banks into HLTV lending, if it replaces credit card lending.

The Dark Side

Is it possible that there is a “dark side” to securitization? Might securitization expose consumer financing costs to a new risk--the possibility that funding might be withdrawn suddenly from the market? The possibility of a significant interruption is remote. Securitized debt is held by diverse and sophisticated market participants, and the structures of these securitization conduits are customized to cater to the preferences and concerns of those securities holders. Multiple safeguards are built into the structure of securitized debt to protect debtholders and, thus, limit their incentive to flee in response to heightened risk. Experienced investors are sophisticated enough to understand how to measure and manage the risks of HLTV. Ratings agencies provide information to investors on the details of securitizations and require detailed disclosure about asset quality, collateral, and other provisions that protect investors.

Cram-Down

Finally, the study considered recent proposals to impose “cramdown” on HLTV loans. Doing so would effectively eliminate the special rights of HLTV lenders in the event of default. Consider the case of a borrower who files under Chapter 13, avoiding foreclosure on his or her home. With a cramdown provision in the law, the amount of the HLTV loan that is above and beyond the value of the home would essentially be considered the same as any other uncollateralized consumer debt. This could have a profound impact on the HLTV industry, as the HLTV lender is already second in line to the primary mortgage lender in terms of claims on the borrower’s assets.

Weakening the rights of secured lenders would prevent consumers from using HLTV loans to commit not to default voluntarily. Thus, cram-down would virtually eliminate the gains consumers now receive from HLTV lending. Cram-down provisions under Chapter 12 of the bankruptcy code have produced a collapse in the supply of agricultural credit to small and medium-size farmers, who have borne the enormous costs of the misguided “protection” afforded them by cramdown.

Despite confidence in the benefits of HLTV lending, the study notes that the past year has seen substantial losses for several HLTV lenders, including Cityscape, Greentree, Master Financial, Preferred Mortgage, and Mego. The problems these firms experienced typically reflected unrealistically optimistic assumptions about prepayment risk (combined with a declining interest rate environment), poor underwriting standards, and poor (or illegal) managerial practices. In the latter category, Mego, which is viewed by some as a victim of churning by its brokers, suffered in part because of its practice of rewarding brokers according to the number of originations produced.

The story of HLTV lending is at once encouraging and discouraging. The growth and success of HLTV lending shows how a sophisticated financial system and self-interested consumers can effectively work around unwise and counterproductive laws. But the aggressive, uninformed attack on HLTV lending by some in Congress, in the press, and in regulatory agencies also shows that the gains from market creativity can be threatened by the illogic and ignorance that sometimes underlies financial regulation.

Notes

1. HLTV lending, which currently amounts to less than 2% of credit card debt, is simply too small a component of consumer credit to have any discernible effect on aggregate trends in bankruptcy.

2. The causal link between bankruptcies and HLTV lending is actually the opposite of that suggested by critics. The increased abuse of the bankruptcy code has been an important contributing cause to the growth of HLTV lending, which explains the correlation between the growth in filings and HLTV lending over the past five years.