By David Glehan, director, and Amanda Hopkins, rating specialist, Standard & Poor's
The closed-end second (CES) lien securitization market continues to grow dramatically, offsetting the trend of borrowers retreating from HELOCs, which do not provide the same interest rate or payment certainty as CES loans. To alleviate short-term interest rate concerns, some lenders are now originating HELOCs with the interest rate fixed for the first year rather than adjusting based on the prime rate. Further, some HELOC lenders are giving borrowers the option to convert all or a portion of the drawn amount to a fixed rate rather than adjust based on the prime rate.
To maximize originations for HELOC and CES loans, originators have reduced underwriting requirements such as income documentation and FICO score qualifications.
Additionally, HELOC lenders have expanded the ability of their borrowers to draw on their loans; they now offer credit cards that draw on the borrowers' HELOCs, enabling borrowers to access their credit lines on the Internet.
Issuance and performance overview
Key highlights of the HELOC and CES residential mortgage-backed securities (RMBS) market through third-quarter 2006 are:
*CES issuance volume in the third quarter increased approximately 25% (23 deals, worth more than $10.672 billion) over the second quarter (18 deals, worth $8.50 billion). Third-quarter 2006 issuance volume also increased approximately 98% compared with third-quarter 2005, with that quarter's CES volume at $5.386 billion, comprising 19 CES transactions rated by Standard & Poor's Ratings Services
*Rising prime rates helped the U.S. CES securitization market grow dramatically in third-quarter 2006, while HELOC securitizations decreased. Certainty with fixed-rate products has led borrowers to choose a CES loan rather than a HELOC.
*Total third-quarter HELOC securitization issuance was 42% less than it was in the same time period in 2005. Third-quarter 2006 securitization volume was at $8.041 billion, as compared with third-quarter 2005 HELOC securitization volume of $14.103 billion.
*CES pool characteristics have changed modestly. Concurrent with the increase in volume, average loan balances have dropped while the average combined loan-to-value ratios (CLTVs), average FICO scores, and use of 24-month documentation have all increased.
*The average FICO score for HELOC securitizations decreased to 705 during the third quarter, continuing a trend of reduced underwriting requirements. FICO scores have been declining since second-quarter 2005, but the most recent quarter's decline is more substantial than in previous quarters .
*Average FICO scores for CES remained fairly consistent. The third-quarter 2006 score of approximately 685 was down only about 0.5% from the previous quarter's 689. Average FICO scores increased approximately 2.8% from third-quarter 2005.
Market dispatches
What's on the mind of the HELOC and CES markets?
*Standard & Poor's released the CES Beta model (which was developed for CES loans with CLTVs no greater than 100%) in early December 2006. The model will be used on deals with first payment dates in February 2007 or later.
*In an effort to strengthen customer relationships and encourage HELOC origination volume, lenders are allowing borrowers to link their credit cards to their home mortgages in two ways: by offering rewards for each purchase the cardholder makes and then using these rewards to pay any remaining loan principal directly; and by allowing borrowers to access their second-mortgage funds by drawing on their credit cards.
*Programs that allow borrowers to draw on a line of credit at a fixed rate are becoming more popular. Among the largest lenders, 84% now offer the feature.
*The increase in the prime rate has caused many more HELOC originators to offer a "loan-in-line" feature, which allows borrowers to draw on portions of a HELOC at a fixed rate. Roughly 51% of respondents to the Consumer Banker's Association survey were offering borrowers the ability to convert portions of their drawn balances to fixed rates, up from 36% one year earlier.*
Trends and projections in collateral performance
Here's what our analysts are keeping an eye on:
*The percentages of lower-documentation loans in the HELOC market have increased steadily over the past few quarters, helping speed up the underwriting process for second-lien originations. Nearly 80% of second-quarter 2006 HELOC issuance volume comprised low-documentation loans.
*Origination documentation for CES loans of 24 months or more fell by almost 33% during third-quarter 2006 from the previous quarter, whereas verbal verification of employment rose by approximately 11%. Verbal verification of employment was up by roughly 123% compared with third-quarter 2005. Further, no-documentation loans represented approximately 4.8% of total volume in the most recent quarter. The combination of no documentation, less-than-12-months' income verification, and verbal verification of employment totaled approximately 63.6% of securitizations, while the same combination totaled approximately 45.81% during third-quarter 2005.
*HELOC CLTVs increased to the mid-to-high 80s in 2006 from the low 80s in 2004. These higher CLTV ratios reflect the relatively high volume of purchase loan originations. The average CLTV has remained fairly constant throughout 2006.
*The average CLTV for HELOC securitizations during third-quarter 2006 remained at 86% for the second consecutive quarter. The average CES CLTV also remained relatively steady at 94.01% during third-quarter 2006, as compared with 94.09% in the previous quarter. However, the average CLTV fell roughly 3.8% from third-quarter 2005.
*A decline in credit quality, an increase in low-documentation loans, and higher average balances demonstrate that HELOC originators may be reaching farther down the credit spectrum to offset declining origination volumes. More than 70% of third-quarter loans have a FICO score greater than 676.
*CES average balances and average FICO scores have remained consistent over the past few quarters; however, CES loans have also seen the increasing trend of reduced-documentation loans.
Hot buttons
Potential hot buttons that may affect the market include:
*Many HELOCs and CES loans have been originated over hybrid adjustable-rate mortgages (ARMs) as well as option ARM senior-lien loans. As these loans adjust, borrowers have begun to see their rates adjusting upward. The initial and subsequent adjustments may cause an increase in delinquencies on the senior loans, which may affect many junior-lien loans. After seeing an increase in delinquencies for 2006 CES transactions, we reviewed these transactions and determined that many of the loans were originated as purchase money loans with reduced documentation requirements.
*Many borrowers have chosen a payment option ARM loan as their first lien and have subsequently obtained either a HELOC or CES loan that is junior to their first lien. This may have an adverse impact on the junior lien as the first lien negatively amortizes and, correspondingly, increases the CLTV. The increase in the CLTV will ultimately affect the foreclosure frequency of the junior lien loan.
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