Home equity lending has returned, and while we would not call it a boom, the industry is starting to heat up. The vanishing refinance market is causing many lenders to turn to home equity lending. Some are reporting volume increases greater than 100 percent from Q4 2012 to Q4 2013. Industry insiders report that the secondary market demand for second liens far exceeds the supply, with higher demand driving stronger pricing.
Increasing Demand for Home Equity Loans
Before the financial crisis, home equity lending was a robust market, both on a standalone basis and as a counter-cyclical product to the refinance market. Home equity lending took a back seat during the financial crisis as home values declined, equity weakened and credit standards became more restrictive. As a result, equity loans were almost non-existent until recently. Today, the environment is much different with several factors driving increased demand:
- More homes in a positive equity position;
- Rising interest rates driving down refinance demand; and
- A wave of existing, maturing home equity lines over the next three years.
Estimates are that more than 4 million homes returned to positive equity in 2013. The appreciating market has created more than $5 trillion in untapped equity and that number is growing. Increased equity has improved the risk profile for home equity loans and in response; credit standards have seen some easing. With both increasing equity and easing credit standards, more borrowers are eligible to borrow on a home equity loan or line of credit.
Interest rates also play a critical role and must be favorable for home equity lending. As rates increase, borrowers are prompted to leave the existing first mortgage in place to maintain the already low rate, making a home equity loan or line of credit a better loan product to provide access to equity than a first mortgage.
As a result of the interest rate increase that began in mid-2013, home equity lending has become a more attractive option compared to refinancing. More than 6 million homeowners refinanced in 2012. As rates creep up to the 5 percent range toward the latter half of 2014, forecasts predict that the refinance market will drop by 70 percent from the 2012 high, removing more than 4 million borrowers from the refinance market. The most cost effective option for tapping equity will be home equity lines of credit for the next several years.
The final factor driving demand is the wave of home equity lines of credit is the number of existing home equity lines of credit that will reach the repayment stage over the next few years, upwards of $176 billion. Home equity lines of credit written from 2004 through 2007 are reaching the end of their interest-only period and borrowers will soon begin repaying principal. Borrowers accustomed to low rate, interest-only payments are headed for big payment shock as these loans reach maturity. In fact, this “after-shock” of the financial crisis is a big concern for banks and the regulators providing lenders with guidance to develop plans for managing these loans. Modifying the terms is one option, but refinancing into another equity loan is also an option. As borrowers search for the most favorable option, additional opportunities for equity lending will naturally be created.
Differentiating in a Growing Market
As demand grows, the competition will increase. Lenders will need to differentiate by streamlining processes while remaining compliant as well as improving customer service. Technology and services investments will be required to save time and lower costs.
Perhaps the most significant challenge in a growing market is managing capacity. As the latest refinance wave has shown, staffing up in a cyclical business can be very painful in a downturn. Building capacity through business process outsourcing (BPO) should be a key focus, not just to increase capacity but to create a competitive advantage. BPO can include a single process or the entire process from origination through funding.
The need to build capacity will be coupled with pressure on margins. As the market improves, competition will increase. The temptation to reduce rates to edge out the competition will squeeze margins and the increasing cost to implement regulatory requirements will drive margins further down. It has become a mandate for lenders to look at ways to optimize cost. Many turn to BPO to help drive that improvement.
However, if you think BPO is simply about cost and capacity, think again. The BPO industry is more than 20 years old and the days of using outsourcing as a pure labor arbitrage are over. When BPO was first beginning, processes were shifted from the U.S. to low cost locations around the world. Most of the time, these processes were moved without change, so the result was the same process, good or bad, for less money. As the industry began to attain critical mass and the landscape became more competitive, BPO evolved and BPO providers began to differentiate through process improvements that drove incremental improvements in process and cost.
Today, these BPO providers still exist, but a new breed of “specialty” providers has emerged. The ability to execute a process is table stakes in the BPO industry. Successful BPO providers are defined by the value they deliver to their clients. These “specialty” providers have invested heavily in domain expertise and they differentiate through the transformation they deliver to create a competitive advantage for the client.
As the regulatory environment has reinforced, the mortgage industry is not for amateurs. The ability to transform a business model requires expertise and building expertise requires investment. In the case of mortgage, many times simply executing the process requires licensing. Specialty providers typically have both domestic and global presence because of the regulatory environment and the level of expertise required to manage the business. The domestic presence brings highly experienced U.S. based talent while the global presence provides a cost and time advantage.
Outsourcing with a specialty provider has become the “go to” strategy for both originators and servicers to cope with today’s market. Solutions are highly collaborative and focused on strategic business outcomes such as:
- Increasing customer retention;
- Improving cycle times;
- Expanding operational capacity;
- Optimizing working capital;
- Creating new business capabilities;
- Improving quality and compliance;
- Enhanced change management capabilities; and
- Transforming cost models.
Specialty providers use data and analytics across processes, including disparate processes, to develop recommendations and drive improvement. For example, in the effort to reduce lock to fund cycle times, the data gathered downstream can be used to make improvements at the time of origination to avoid cost and time consuming delays. Specialty providers use technology, often in the form of business process management (BPM) technology, to drive the process and to capture the data necessary to identify improvement areas.
The mortgage industry is not only dynamic, but complex with extensive oversight. While many lenders will (and already have) exited, others are adapting to the change and thriving. Home equity products are in demand and a great counter-cyclical product to the refinance market. The lessons that we have learned through the last refinance wave should drive the strategy to manage the growing demand for home equity loans. Outsourcing is a very effective strategy to manage not only the capacity needs and cost pressure, but to transform a business model to be more competitive.
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