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Positive Payment Shocks, Liquidity and Refinance Constraints and Default Risk of Home Equity Lines of Credit at End of Draw

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Abstract

Using a unique and comprehensive dataset of loan-level home equity lines of credit serviced by large US national banks, we confirm that default risk of home equity lines of credit increases at end of draw. More importantly, we quantify the increase in default risk with the size of positive payment shock at end of draw. Furthermore, we find the effects are more pronounced when borrowers are under greater liquidity or refinance constraints and less pronounced if banks manage the credit risk proactively by freezing the credit lines. Our findings are robust across various model specifications and risk segments, payment shock definitions, and after controlling for sample selection bias from HELOC payoffs. These results have important implications for evaluating and managing HELOC credit risk: (i) the need to capture payment shocks, liquidity and refinance constraints in credit risk models, (ii) the benefit of smoothing payment shocks in contract design as well as the workout process, and (iii) the need to consider proper timing for tightening HELOC lending standards.

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Notes

  1. Source: Moody’s Investors Service, June 2013.

  2. http://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-29.html.

  3. See, for example, http://www.marketwatch.com/story/the-bill-for-home-equity-lines-is-coming-due-2014-03-26.

  4. Some earlier originations exist but are below 100 observations per month. The number of HELOCs originated in a given month exceeds 100 observations from 1985 onwards.

  5. This includes observation time before origination time, EOD time before observation time, maturity time before origination time, and maturity time before EOD time.

  6. We tried longer and shorter observation windows and found the results are consistent.

  7. See, for example, http://www.occ.gov/publications/publications-by-type/other-publications-reports/ mortgage-metrics-2014/mortgage-metrics-q2–2014.pdf.

  8. We have checked other common default definitions for robustness and obtain similar results throughout. One of such alternative default definitions is the Basel definition, which differs from the above as it is based on a payment delinquency of 180 days or more and a payment delinquency of 60 days or more if the borrower is in bankruptcy.

  9. We have tested alternative payment shock definitions with consistent results: (i) the ratio of the difference in minimum payment of the current period and the minimum payment at origination and the house price, and (ii) the ratio of the difference of the minimum payment of the current period and the minimum payment of the previous period (i.e., one-month lag) and the latest available house price. Furthermore, “Alternative Payment Shock Definitions” section shows consistent results using alternative house price definitions: (i) house prices at origination, and (ii) house prices updated by changes in the house price index since the last evaluation. We have also related the raw payment shock to credit limit. We do not use the outstanding loan amount as it may result in outliers for PS.

  10. This assumes that minimum payment is not a constraint for borrowers prior to EOD when an unused liquidity facility is available to the borrower. We have tested the minimum payment provided by the lender prior to EOD with consistent results.

  11. Approximately 46% of the CLTVs are refreshed this way.

  12. We have tested other macro-economic variables such as the annual growth in real GDP, which were not included as the model fit did not improve.

  13. The unemployment rate was unavailable at the MSA level from January 2015 onwards and we used the December 2014 values for February 2015 and March 2015.

  14. Pairwise correlation is not reported due to space limitation and is available upon request.

  15. US bankruptcy and foreclosure laws allow for judicial and non-judicial foreclosures. In a judicial foreclosure, a court orders the foreclosure and supervises the whole foreclosure process. A deficiency judgment allows the recourse to other borrower assets if assets fall short of the outstanding loan amount. Statutory right of redemption gives the borrower a right to buy the house after a foreclosure adding uncertainty about ownership and providing for less efficient workout processes. The signs on these variables are generally mixed or insignificant and driven by inclusion/exclusion of other key factors.

  16. Deng et al. (2000) analyse mortgage termination with regard to payoff, default, missing information and end of observation period.

  17. Due to space limitation, details on the estimation of these models are included in an Internet Appendix available via www.ssrn.com.

  18. We have confirmed consistency in a simulation study.

  19. The one-year models are included in the Internet Appendix to show the robustness of our findings.

  20. The positive impact of HPA on default is counterintuitive, this is likely due to multicollinearity as HPA has fairly high correlation with other variables, such as CLTV, RS and UER.

  21. The parameter estimates for the payment shock categories (in brackets) are: −0.1579 (−0.0015), −0.1681 (−0.001), −0.4724 (−0.0005), −0.0587 (0), 0.6666 (0.0005), 0.8993 (0.001), 0.9453 (0.0015), 0.9665 (0.002), 0.9956 (0.0025), 1.1617 (0.003), 1.1367 (0.0035), 1.9245 (0.004). Category names specify the lower bound of a given category.

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Acknowledgements

The views expressed in this paper are those of the authors alone and do not necessarily reflect those of the Office of the Comptroller of the Currency or the US Department of the Treasury. The authors would like to thank Regina Villasmil, Maria Mejia and Erjan Kurbanov for assistance in data preparation, CJ Dua for help with parallel programming, Sebastian Batista for editorial assistance, and the seminar participants at the OCC for helpful comments. We thank the discussants and participants at the American Finance Association 2017 Annual Meeting, Interagency Risk Quantification Forum 2016, Financial Research Network Conference 2016 and various financial seminars for their feedback. Harald Scheule gratefully acknowledges support of the Centre for International Finance and Regulation (CIFR, project number E001, CIFR is funded by the Commonwealth and NSW Governments and supported by other Consortium members). The authors take responsibility for any errors.

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Authors and Affiliations

  1. Risk Analysis Division, Office of the Comptroller of the Currency, 400 7th St. SW, Washington, DC, 20219, USA

    Min Qi & Yan Zhang

  2. Finance Discipline Group, University of Technology Sydney, PO Box 123, Broadway, Sydney, NSW, 2007, Australia

    Harald Scheule

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  1. Min Qi
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  2. Harald Scheule
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  3. Yan Zhang
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Correspondence to Min Qi.

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Qi, M., Scheule, H. & Zhang, Y. Positive Payment Shocks, Liquidity and Refinance Constraints and Default Risk of Home Equity Lines of Credit at End of Draw. J Real Estate Finan Econ 62, 423–454 (2021). https://doi.org/10.1007/s11146-020-09752-x

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