More growth ahead.
The dominant theme in the home-equity loan (HEL) sector of the asset-backed securities (ABS) market throughout 1997 has been growth. With total new-issue volume approaching $60 billion, the sector is poised to post a 55 percent year-over-year increase.
As a result of this tremendous growth, HEL ABS issuance now commands a 34 percent share of the ABS market, up from only a 12 percent share in 1993. Reflecting the shift in consumer borrowing behavior, HEL ABS issuance has even surpassed credit cards, which have traditionally been the largest sector of the ABS market. [ILLUSTRATION FOR FIGURE 1 OMITTED]
The increase in volume is tied to several factors, including increased consumer demand for home-equity loans as an efficient tool to consolidate loans with interest that is generally tax-deductible and as loans that can offer liquidity for credit- and equity-impaired borrowers.
Also, volume is being fueled by excess capacity in the conforming/jumbo mortgage market and by the potential for higher returns, which has increased the number of lenders offering B&C products.
Further enhancing volume is the fact that a greater variety of underwriting standards is now accepted, making it easier for originators to differentiate their product and niche market. Other forces helping to pump up HEL ABS volume in recent time are improved technology and increased advertising, which have allowed originators to better prospect and ultimately process borrowers. Finally, securitization has provided an efficient funding source for many new market participants.
Not surprisingly, the growth has been accompanied by fierce competition among lenders, who have recognized the need to immediately respond to the opportunities presented to them. Although this competition is rapidly driving the industry to a consolidation phase, opportunities for growth remain, primarily because of the nonconforming nature of the market. For example, product variations such as hybrid ARMs and high LTV (loan-to-value) home loans will continue to emerge and will enable lenders to tap into even more consumers. Meanwhile, the legalization of HEL lending in Texas opens up a whole new borrower base with significant potential.
On the securitization side, Wall Street has responded to the market growth by introducing new structures tailored to the new products being offered to consumers. As a result, bond types that were familiar to CMO (collateralized mortgage obligation) investors, including PACs, TACs and Interest Only (IO) strips, have now become part of the HEL ABS landscape. This type of innovation and evolution can be expected to continue.
An important and increasingly controversial issue related to securitization is gain-on-sale accounting and the assumptions used to book the residual cash flows from securitizations. Investors from both the equity and fixed-income disciplines have recognized that they must more carefully scrutinize these assumptions as part of their investment analysis. This scrutiny will only escalate in the year ahead.
All participants in the HEL ABS market - lenders/issuers, investors and dealers - will need to be keenly aware of the very close relationship between growth and risk. Because growth has been accompanied by increases in both the complexity of the securities' structures and the diversity of the underlying assets, there are now simply more risk parameters to consider.
The continued success of the HEL ABS market will be determined by the degree to which all participants understand and manage the risks being taken. An essential part of this process will be complete and thorough disclosure by issuers of all relevant information regarding loan parameters and how they perceive and manage the associated risks.
Changing collateral composition
Historically, the defining characteristics of a home-equity loan were its second-lien status, its short term (10 to 15 years) and its use as a tax-advantaged debt consolidation tool. More recently, HELs have been defined by their nonconforming status, which may be the result of lien position, credit status of the borrower, documentation standard or loan characteristic. The result is that HELs currently encompass first and second liens; 15-year to 30-year terms; debt consolidation, rate refinancing and purchase-money loans; "limited" and "no" documentation loans; and, of course, A, B, C and D credit quality loans.
Aside from these loan characteristics, the mix of product types being securitized in the HEL ABS market has changed dramatically. As seen in Figure 2, at the inception of the HEL ABS market, home-equity lines of credit (HELOCs) were the primary source of supply. That has changed as closed-end collateral has constituted the bulk of the market in recent years. Even the mix within the closed-end HEL sector has changed as originators have introduced adjustable-rate and high LTV products to broaden the borrower base and increase loan originations.
One sector of the HEL market that has shown rapid growth is the high LTV/home-improvement loan (HIL) sector. Last year alone, 2.7 deals using these collateral types were issued totaling $6.3 billion. High LTV loans give borrowers with little or no equity in their homes the ability to borrow up to 125 percent (although some lenders have recently lent up to 150 percent) of the value of their home. This allows them to consolidate higher-rate consumer debt and/or to finance home improvements.
These loans lie somewhere between a pure unsecured loan - like a credit card - and a traditional second mort gage. Most issuers target high FICO (credit score) borrowers who have demonstrated the ability to use and manage credit, as little or no value is placed on the collateral. We believe this segment of the market will continue to grow as more of the mainstream HEL lenders cautiously move into this product.
Adjustable-rate mortgages (ARMs) have become a larger part of the HEL ABS market, growing from 9 percent of production in 1994 to more than 36 percent in 1997. These products have been used as a means to qualify more borrowers by lowering their respective debt-to-income ratios: underwriting ratios are based on either a teased rate or by extending the term of the loan. Consequently, the average terms and balances observed in the ARM HEL market are significantly higher than those in the fixed-rate HEL market.
Initially, lenders offered six-month LIBOR (London Inter Bank Offered Rate) or one-year CMT (Constant Maturity Treasury) products with an initial teased period of six months to one year. However, after the teaser-rate period ended and as borrowers saw their monthly payments increase, brokers aggressively refinanced these borrowers into another teaser-rate loan. This resulted in some lenders reporting prepayment speeds in the 50 percent to 60 percent CPR range.
In response to high prepayment rates, lenders began offering hybrid fixed/adjustable products such as 1/29, 2/28, 3/2.7, 4/26 and 5/25 loans. These loans accrue interest at a fixed rate for one, two, three, four or five years, respectively, then adjust every six months thereafter based on six-month LIBOR. The goal of these loans is to keep borrowers on the lender's books longer by offering a slightly higher initial rate in return for an extension of the time that the teaser rate applies.
In addition to offering hybrid fixed/adjustable-rate products to stem prepayments, lenders have also used prepayment penalties and performance-based loans to keep borrowers from prepaying their loans.
Prepayment penalties usually take the form of six months' interest on 80 percent of the loan; that is, borrowers are allowed to make a curtailment of up to 20 percent before they are penalized. The penalties are typically in effect for one to three years. In some recent securitized pools, 50 percent to 75 percent of the loans carry prepayment penalties. Going forward, we will see more issuers using prepayment penalties, because they are an effective means of at least delaying a borrower from prepaying.
Performance-based loans take a different approach: They reward borrowers for keeping their loans on the books rather than penalizing them for leaving. Under the terms of these loans, if the borrower makes a specified number of payments on time, the rate on the loan will be lowered. This type of loan is an attempt to mitigate the "credit-cure" effect, in essence giving the borrower a lower rate associated with a higher credit grade without having to refinance the loan. These types of loans offering incentives for borrowers to remain on the lender's books will become more prevalent soon.
Increased competition in HEL market
As the environment has grown more competitive over the past two years, lenders have looked for new ways to differentiate their product offerings and qualify new borrowers. As a result, the market has seen a shift in some of the basic collateral characteristics of securitized HEL pools. Most importantly, average loan balances, average loan terms and average LTVs have all been on the rise.
HEL market growth and competition also have led to an increasingly fragmented lending environment. In 1993, for example, 13 issuers made up the closed-end HEL ABS market. By 1997, the number of issuers had grown to 50. Table 1 shows the top-10 issuers in 1993 and 1997. In 1993, the top-10 issuers made up more than 95 percent of the HEL ABS market, while in 1997 their market share dropped to only 54 percent. Securitization has helped new entrants fuel their rapid growth and take market share from more established players.
A number of factors lead us to believe this competitive environment is unsustainable. Perhaps most important is that some lenders have been buying loans at lofty prices just to grow their servicing portfolios, book profits and post high growth rates in an effort to increase their stock price or come to the equity market with an initial public offering (IPO). The players without a servicing platform in place or the expertise to manage a rapidly growing portfolio may be forced to, at some point, scale back originations and possibly write down their balance sheet, especially if prepayments and/or losses exceed projections.
Entrance of Freddie Mac and Fannie Mae
A major question for the B&C lenders is whether Freddie Mac and Fannie Mae will enter the B&C market as large-scale purchasers and take advantage of their low cost of capital. To date, the agencies have not had a significant presence. Freddie Mac has surfaced primarily in a bond-insurer context, while Fannie Mae has occasionally purchased large tranches of HEL ABS where the loans were less than the conforming loan limit.
Going into 1998, the likelihood of greater participation at the loan-purchase level remains uncertain. Freddie Mac has announced it will become a major player in 1998, although it is still not clear exactly what is meant by that. The most obvious point of entry is to purchase loans at the high end of the credit spectrum, the so-called A-minus loans, because they are closest to the product Freddie Mac knows best. We look for them to achieve success in these efforts but do not expect them to make much headway in the lower credit-quality loans.
Meanwhile, Fannie Mae can be expected to play a larger role as an investor in HEL ABS, and we would look for Freddie Mac to assume a greater role in this capacity as well. Interestingly, contrary to the concerns of many HEL lenders, the agencies may end up having an overall positive impact on the industry through their purchases of HEL ABS and the associated result of driving spreads tighter.
Table 1 Top 10 HEL ABS Insurers 1993 ABS Market Seller Issuance Share Money Store $852 19.93% ADVANTA $656 15.33% EQCC (Old Stone) $601 14.05% UCFC $518 12.10% Alliance Funding $343 8.03% Long Island Savings Bank $304 7.11% Fleet $256 5.99% Corestates Bank $253 5.91% Zions First National Bank $159 3.73% First Alliance $141 3.30% Top 5 Issuers $2,970 69.45% Top 10 Issuers $4,083 95.49% Total HEL ABS $4,276 Issuance 1997 ABS Market Seller Issuance Share IMC $4,549 8.96% ContiMortgage $4,025 7.93% Money Store $3,795 7.47% FirstPlus Financial $2,960 5.83% EQCC $2,307 4.54% Amresco $2,291 4.51% ADVANTA $2,150 4.23% Green Tree Financial $1,899 3.74% UCFC $1,850 3.64% Aames Financial $1,629 3.21% Top 5 Issuers $17,636 34.74% Top 10 Issuers $27,455 54.08% Total HEL ABS $50,772 Issuance SOURCE: MERRILL LYNCH ABS RESEARCH
Gain-on-sale accounting and residual valuation
Gain-on-sale accounting has been an essential ingredient in the growth of the subprime home-equity loan market. When a company does a securitization, it immediately books a gain on the sale of its loans on its income statement, even though this "revenue" is really just an estimation of future residual cash flows from the securitizations. These estimates are based on prepayment, loss and discount-rate assumptions. In effect, this accounting treatment has enabled issuers to post impressive net income and earnings per share results based on future cash flows that they may or may not receive. Equity investors, seeing the rapid growth, drove up the share price of many gain-on-sale companies throughout 1996 and provided these companies with a valuable source of capital. Now, in light of recent writedowns of these residual cash flows, which resulted from deviations in prepayment and loss from initial assumptions, the estimates used to book these gains have become more closely scrutinized.
Sensitivity analysis of residual values to the underlying assumptions shows that they are most strongly dependent on the loss assumption (see Table 2). If a loan prepays earlier than anticipated, the excess servicing stream that was expected over the life of the loan will not be realized, making the residual, which is just the net present value (NPV) of these cash flows, worth less. However, when a loan defaults and a loss is recognized, not only are future cash flows lost but also current cash flow, which further erodes residual value. As a result, defaults and loss severity have a much greater impact on the residual value than prepayments.
The recent write-downs by Cityscape, Aames Financial and Green Tree Financial resulted in both downgrades of the companies' unsecured debt and a contagion effect in the market resulting in spread widening throughout the HEL ABS sector. The write-downs, particularly that of a high quality ABS issuer such as Green Tree Financial, alerted the ABS market to the possibility that there may be "headline risk" associated with their bonds, no matter how structurally sound the bonds are.
To reduce such risk, ABS investors will increasingly focus on the quality of the gain-on-sale assumptions, recognizing that conservative valuations will minimize the risk of future write-downs and the consequent tainting of the issuer name. In effect, the ABS investor will increasingly wear the hat of an equity investor, and vice versa, when making investment decisions. In this context, issuers who take the initiative in terms of aggressively disclosing and explaining their gain-on-sale assumptions will likely be rewarded with better execution (i.e., tighter spreads) when they bring issues to market.
Last year saw significant volatility in HEL ABS yield spreads. In the first half of the year, spreads moved sharply tighter as ABS investors became comfortable with the prepayment story for HEL ABS (minimal interest rate sensitivity). That tightening was reversed in the second half of the year as heavy supply, increased prepayment and credit uncertainty, residual write-downs and international market turmoil combined to result in a widespread repricing of the sector. As is typical, spreads overshot the fair value point during both phases, as the market became too rich during the first half of the year and is currently too cheap.
Going forward, spreads should be more stable for the market as a whole, although weaker issuers that do not respond to market pressure for disclosure of residual pricing assumptions will be subject to spread-widening pressures. As a result, the major spread theme for 1998 will be tiering between high-quality and low-quality issuers.
In spite of a still-healthy economy, there are several areas of concern in B&C lending. The dramatic decline in consumer credit quality evidenced by rising delinquencies, bankruptcies and losses in the credit card and auto sectors is sure to spill over into HELs. However, the relatively long credit-aging period on mortgage-related products means that the impact may not be felt for several years.
More importantly, extensive competition has compressed lending margins and eased underwriting standards, which have already shown up in the weaker delinquency performance exhibited in the 1995 and 1996 vintages [ILLUSTRATION FOR FIGURE 3 OMITTED]. Although healthy excess-spread levels suggest these pools should perform well under current economic conditions, loss volatility for these products in a stressed economic environment remains largely unknown. While there is little potential for investment-grade HEL ABS to suffer any principal loss, the risks that remain - and which will affect bond prices - include headline risk, downgrade risk and servicing transfer risk. Once again, the presence of these risks means that ABS investors will need to scrutinize the quality of the issuer.
[TABULAR DATA FOR TABLE 2 OMITTED]
One of the hallmarks of the ABS market has been the relative prepayment stability of the collateral. However, prepayment speeds across all sectors have been increasing, with ARM HELs exhibiting the most dramatic rise. These increases are due primarily to the competitive lending environment and not to an increased sensitivity to interest rates. This situation is similar to the changes that took place in the conforming mortgage market during the 1992 to 1993 refinancing boom when competition and improved technology resulted in a dramatic change in the prepayment dynamic.
Because industry consolidation is expected to ultimately reduce competitive pressures, the high prepayment rates currently being observed are not likely to be sustained. Figure 4 shows a schematic representation of how the baseline prepayment function has been altered by the competition effect, where the decline from peak speeds after year three is due to expected industry consolidation and to collateral burnout after the very high prepayment phase.
This anticipated experience is most relevant to adjustable-rate HEL collateral, where some pools have been paying in excess of 5 [degrees] percent CPR. Adjustable-rate HELs tend to prepay relatively fast due to the interaction between "credit curing" - the primary HEL prepayment determinant - and the use of teaser rates. As borrowers come to the end of the teaser-rate period and the rate adjusts upward, they have an added incentive to refinance their loans. The competitive environment has only exacerbated this effect and led to greater prepayment uncertainty on the part of ABS investors.
The prepayment uncertainty due to competition is further compounded when it is considered in the context of the 2/28 and 3/27 hybrid products, which have relatively little prepayment history. Nonetheless, the available data confirms intuition by showing that the shorter-teaser-period loans ramp up more quickly to their peak prepayment rate [ILLUSTRATION FOR FIGURE 5 OMITTED]. In addition, lenders are employing enforceable penalties tailored to the teaser period to offset prepayment uncertainty associated with the hybrid loan products because the early data shows that penalties contain prepayments [ILLUSTRATION FOR FIGURE 6 OMITTED].
Wall Street has responded to increased prepayment uncertainty by employing CMO technology in the bond structures. Nonaccelerating seniors (NAS) bonds, where principal is allocated to the bond according to fixed percentages, were introduced first and have since become a staple in the HEL ABS market. Expanding on the NAS structure, more recent deals have been structured to further insulate investors from prepayment risk by creating even more stable average-life planned amortization class (PAC) bonds. On the credit side, a significant trend has been the emergence of senior subordinate structures as the most efficient form of execution for many issuers (ironically, just as the credit quality of the collateral is being pushed to the limits of their credit grades).
Over the past year, issuance of senior/subordinate HEL structures increased as many investors pursued a down-in-credit strategy to enhance their returns. Heightened demand from yield-hungry investors and exposure limits to monoline insurers caused the senior/subordinate structure to become the most efficient form of execution for many home-equity issuers. The use of the senior/subordinate structure rose from roughly 10 percent of all home-equity structures in 1996 to more than 50 percent in 1997. HEL ABS issuers will continue to tap the subordinate market as "deal economics" dictate. However, as credit becomes more of a concern in light of problems such as Cityscape and investors demand a larger spread concession for weaker issuers, deal economics will be accordingly affected and the advantages of a senior/subordinate execution will be less apparent. Also, because the bond insurers have become more competitive in an attempt to retain market share, the gap in economics between the senior/subordinate and wrap structures should continue to narrow, resulting in more bond-insured deals.
Growth and risk in markets are often closely related because it is only by taking risk that growth can be achieved. Over the past few years, home-equity loans have gone from being a relatively small sector of the asset-backed securities market to become the dominant sector in terms of new issuance. This extraordinary record of growth has been achieved through the willingness of all market participants to assume risks under conditions of increasing uncertainty. That uncertainty flows from the emergence of a greater array of collateral product types and security structures, in the context of an increasingly competitive environment.
To sustain the growth, the associated risks must be manageable. This, in turn, places a premium on the flow of information regarding the risk parameters. Issuers of HEL ABS can help sustain the market that has proven so beneficial to them by being vigilant about disseminating all pertinent information. Meanwhile, investors will serve themselves well by understanding fully what the important risk parameters are and continuing to push dealers and issuers to get that information to them in digestible form. Issuers that rise to this challenge will likely be the industry survivors, while those unable to do so will fall by the wayside in the coming consolidation.
Chris Flanagan is director, Ralph DiSerio is first vice president and Ryan Asato is vice president with Merrill Lynch Real Estate ABS Research in New York City.
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|Title Annotation:||Cover Report: Business Outlook; home-equity loan securities market|
|Author:||Flanagan, Chris; DiSerio, Ralph; Asato, Ryan|
|Date:||Jan 1, 1998|
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