You have probably already started to feel it in your local markets. Six months ago, homes were being swept up within hours, or days of being listed, if they hit the market at all.
Today, home values remain strong on paper, but they are being scooped up more slowly, indicative of a disconnect between what sellers want to sell their homes for and what buyers are willing and able to pay. In fact, Redfin is reporting widespread reductions in sales price for many metropolitan areas as sellers struggle to find buyers. There is seemingly a shift coming from a seller’s market to a buyer’s market.
The largest factor in the cooling of the housing market is the increase in interest rates. According to the Federal Reserve Economic Data (FRED), 30-year fixed rate mortgages in the United States have risen from under 3% in November of 2021 to just below 6% in June 2022. The impact of increasing interest rates is broken down in detail in our previous article, Breaking Down the Drivers of Home Affordability.
We are seeing more and more data that suggests a cooling down of the housing market is likely. If we do see changes in home values in our future, you should consider the ways that impacts you as a Credit Union and how you can plan to absorb those impacts.
Pressure on Borrower Cash Flows
The impacts of inflation and subsequently increasing interest rates are not felt overnight. Inflation means that, all else equal, things cost more. That reduces available cash for Americans in all walks of life. Increasing interest rates to combat inflation means that, all else equal, new borrowers are squeezed tighter than they would have been previously. With a number of consumers living paycheck to paycheck, even a small shock in the cost of consumer goods or costs of borrowing can have folks scrambling to make their monthly payments.
Credit risk has been strong for so long, that many have put reviewing and updating credit quality on the back burner. As we move further into 2022, Credit Unions should take this time to consider more robust practices for evaluating and mitigating portfolio risks.
Increasing Collateral Risk on New Home Equity Originations
In the article on home affordability linked above, we determined that for affordability to maintain consistent with these changes in interest rates, home values would need to fall 27.9%. However, your historical originations should be well positioned to absorb this shock. Let’s consider an example:
According to Corelogic, home prices nationwide, including distressed sales, increased year over year by 18.3% in June 2022. In general terms, a first mortgage originated in June 2021 at 80% LTV would have a 67.6% LTV as of June 2022, even if they didn’t make any principal payments. If we saw an immediate 27.9% drop in home values, the LTV would increase to 93.8%, still above water.
If that home originated at 80% in June 2022, it would have a 111.0% LTV. Not great for a first mortgage, but also wouldn’t break the bank on foreclosure. A second mortgage, however, could be a total loss under those same order of events.
Where real estate has been considered a little-to-no risk portfolio segment for the past 8-10 years, you should start to get a handle on how your credit and collateral quality is balanced within your mortgage portfolio and consider your concentrations within these portfolio segments.
Increasing Reserves for Current Expected Credit Losses (CECL)
January 1, 2023 marks the implementation date of the new accounting standard for Credit Losses (ASC 326), commonly known as CECL. The standard requires you to reserve for losses over the life of your loans as opposed to a reserve covering probable losses (one year of losses, generally).
A popular methodology for reserving for CECL is to multiple the probability of default (PD) by the loss given default (LGD). In today’s real estate market, LGD on most homes is $0, meaning you’ll recover the full principal amount in the event of foreclosure. Anything multiplied by 0 is 0! A weakening collateral market can significantly increase your forward-looking reserve requirement.
A potential for increasing reserve requirements can result in a double whammy for your capital position. Increasing reserve requirements are taken out of capital. If those forecasts prove to be true, the losses will flow through out of the allowance for credit losses and you’ll have to restore your reserves through additional provision expense. Credit Unions have historically been conservative in their reserves, and the uncertainty in the market conditions make continuing that conservatism prudent.
The combination of economic and regulatory hurdles on the horizon point to challenges for both borrowers and financial institutions. By taking a proactive approach to clearing these hurdles, you’ll position your credit union favorably to continue providing affordable financial products to members in both times of economic prosperity and hardship.
Dan Price, CPA, CFA