Does anybody remember the old EF Hutton financial services commercials? The commercial stated: “When EF Hutton talks, people listen.” As a fan of good advertising, I loved these commercials. Fed governors are the banking equivalent of EF Hutton; when they talk, people listen. Today, Fed Governor Bies made a speech about the real estate market, and we should listen.
“The recent growth in HELOCs has been remarkable; at the end of 2004, outstanding drawn HELOCs at all insured commercial banks totaled $398 billion, a 40 percent increase over 2003. Meanwhile, the agencies have observed some easing of underwriting standards, with lenders competing to attract home equity lending business. Lenders are sometimes offering interest-only loans and are sometimes requiring very small down payments and limited documentation of a borrower’s assets and income. They are also relying more on automated-valuation models and entering into more transactions with loan brokers and other third parties. Given this easing of standards, there is concern that portions of banks’ home equity loan portfolios may be vulnerable to a rise in interest rates and a decline in home values. In other words, there is concern that not all banks fully recognize the embedded risks in some of their portfolios. But supervisors believe that, like most other lending activity, home equity lending can be conducted in a safe and sound manner with appropriate risk-management systems.”
From a banking perspective, tighter credit standards increase the price of loans. For example, a more in-depth financial analysis for a perspective borrower increases the bank’s costs in preparing the loan. In addition, from a consumer perspective, banks are nearly identical – there is little difference between bank 1 and bank 2. Therefore, a bank’s best sales pitch is price. Also note the huge increase (40%) in home equity lending over the last year. This increase indicates home equity loans are cash centers for the financial industry. And the banks – being for profit institutions – want to milk this cow for all it’s worth.
Finally, a slipping of credit standards is a sign that the real estate market may be topping. An increase in the level of risk market participants are willing to take is usually a sign they are stretching their abilities to make as much money from an economic cycle as possible.