Equity Borrowing Erodes Credit-Positive Effects of Rising Home Prices

Homeowners are increasingly borrowing against the equity in their properties and this is eroding the credit-positive effects of rising home prices on U.S. residential mortgage-backed securities (RMBS). The borrowing is through both cash-out first-lien refinancing and second-lien equity borrowing, according to a new report from Moody’s Investors Service. If home prices continue to rise, the negative effects may be offset with current underwriting practices, but risks remain if the loan products used for equity extraction gain popularity.

“Rising home prices generally help lower default risk and loss severities, and therefore are credit positive for RMBS transactions,” said Moody’s analyst Peter McNally. “Rising prices, however, can also entice borrowers to extract equity from their homes and increase their debt loan, adding risk to RMBS deals.”

More risk resides in cash-out refinancing in RMBS tied to newly originated loans, because they are more likely to default than rate-term refinancing and purchase loans. “However, whether cash-out refinancing will boost risks in individual RMBS deals depends on the loans’ other characteristics,” McNally said.

The performance of loans in outstanding RMBS can be weakened by the increasing use of second-lien home-equity products. “Borrowers’ addition of debt secured by their homes can reduce their incentive and ability to remain current by lowering their equity stake in a property and reducing their available income after mortgage payments, which would be particularly concerning if home prices were to fall,” said Moody’s analyst Jody Shenn.

The Moody’ analysts noted, however, that today’s underwriting standards and operational practices are stronger than those before the financial crises that began in 2008.

– Adam Fusco, editorial associate

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