United States General Accounting Office

GAO Report to the Chairman, Subcommittee

on Financial Institutions and Regulatory

Relief, Committee on Banking, Housing,

and Urban Affairs, U.S. Senate

August 1998 HIGH-LOAN-TOVALUE LENDING

Information on Loans

Exceeding Home Value

GAO/GGD-98-169

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-279255 

August 13, 1998

The Honorable Lauch Faircloth

Chairman, Subcommittee on Financial

 Institutions and Regulatory Relief

Committee on Banking, Housing, and Urban Affairs

United States Senate

Dear Mr. Chairman:

This report responds to your request that we provide information on

high-loan-to-value (HLTV) loans. Since 1995, a segment of the financial

services industry has offered loans that are tied to the value of a

borrower’s house but that, in combination with preexisting first

mortgages, exceed this value. The loans, referred to as HLTV loans, provide

for a combined loan-to-value ratio that could reach 125 percent or even

more of a home’s value.

As agreed with your office, this report provides information regarding

(1) the characteristics of HLTV loans; (2) the major organizations that

provided HLTV lending; (3) the volume of HLTV lending in 1995, 1996, and

1997, and the expected volume in 1998; and (4) the benefits and risks of

HLTV lending for borrowers, lenders,1 investors, and regulated depository

institutions.

To compile this information, we interviewed officials representing federal

regulatory agencies, lending institutions, industry associations, a rating

agency, investment banks, and a consumer advocacy group. We also

reviewed publicly available information, including published reports,

prospectuses associated with the selling of HLTV-related securities, and

academic studies. Comprehensive industry data on HLTV loans were not

maintained by any single entity. Therefore, in addition to interviews with

officials, we relied on the limited industry data that were available at

various institutions. Although we did not independently verify these data,

we corroborated evidence with other independent sources whenever

possible. To ensure that its contents were factually accurate, we provided

draft copies of this report to public sector and private sector officials. We

incorporated their technical comments where appropriate. We conducted

our work between January and June 1998 in accordance with generally

accepted government auditing standards. For more detailed information

concerning our scope and methodology, see appendix I.

1

We use the term lender in this report to cover all businesses that either originate these loans

themselves or acquire these loans from correspondents or other financial institutions.

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Results in Brief HLTV loans are considered “hybrid” loans because they have characteristics

of both mortgage loans and unsecured consumer loans. Like mortgages,

HLTV loans are secured by a lien2 on a house. However, the lien itself may

have less financial value than the amount of the loan in the event of a

borrower’s defaulting, because the value of the HLTV loan and the original

mortgage (which would have first claim on the value of the house in the

event of a default) may exceed the value of the house. Thus, as with

unsecured consumer loans, HLTV lenders rely more heavily on borrowers’

creditworthiness—that is, the borrowers’ likelihood of making timely and

complete payments—in making loans. According to industry officials,

most borrowers use HLTV loans primarily to consolidate credit card debt. In

addition, some borrowers used HLTV loans to make home improvements.

While comprehensive industry data were not available, data provided by a

lender responsible for about one-third of HLTV lending showed that, in

1997, HLTV loans averaged about $30,000. The data also showed that the

average contract interest rate was between 13 and 14 percent, with an

average loan term of 25 years.3

 The average combined indebtedness of the

first mortgage and the HLTV loan represented about 110 percent of the

borrower’s property value, although in some cases the combined loans

reached or exceeded 125 percent of value.

According to industry officials and our review of the limited available

industry data, from 1995 to 1997, HLTV loans were made or managed

primarily by 10 institutions. Often, these 10 institutions obtained loans

originally made by correspondents—that is, institutions that dealt directly

with the borrower and then transferred the loans to one of the 10

institutions. According to public and private sector officials, regulated

depository institutions were not heavily involved in originating HLTV loans.

The involvement of these institutions would be important to any

assessment of the potential exposure of federal deposit insurance funds to

defaults of HLTV loans. One nondepository institution—FirstPlus Financial

Group, Incorporated (FirstPlus), of Dallas, Texas—has had about

one-third of the market since 1995.

Available data indicate that HLTV lending has grown since its introduction

in 1995 but that it remains small relative to other consumer lending. Data

on the volume of HLTV loans were limited to those loans that were

2

A lien is a legal claim in the event of default on a loan that gives the lender claim to the value of a

property used as security for the loan.

3

We use the term contract interest rate to refer to the interest rate stated in the loan agreement. If

origination fees or points were charged on the loan, its effective interest rate would exceed the

contract interest rate.

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subsequently packaged into loan pools used to back securities sold to

investors. Lenders and securities firms involved in this process of

securitization said that about 95 percent of HLTV loans were sold as

securities to investors. The volume of securitized HLTV lending has more

than doubled from year to year from 1995, the year it was introduced,

through 1997. According to industry representatives, about $1 billion

worth of these loans were made in 1995; $3 billion in 1996; and $8 billion in

1997. Industry and securities firm representatives expected HLTV lending to

increase again in 1998 to $12 billion or higher. Although this has been a

growing market, total HLTV lending was small compared with other types of

consumer lending. For example, even if no HLTV loans had been repaid, the

total amount of outstanding HLTV loans would only have been about

$12 billion at the end of 1997. In contrast, total outstanding residential

mortgage debt reached $3.8 trillion in 1997, and total outstanding

consumer debt (other than mortgages) reached $1.3 trillion in the same

year.

While only limited data were available for documenting the performance

of HLTV loans, public and private sector officials pointed to several benefits

and risks associated with HLTV lending to the borrower, lender, and

investors. For example, while some of these officials said that HLTV lending

provided borrowers with a quick way to consolidate credit card debt and

lessen their monthly debt payments, others noted that HLTV loans could

make it more difficult for homeowners to sell or refinance their houses.

Also, while lenders and investors have benefited from the high rate of

return on these loans, it is uncertain how these loans would perform

during any future economic downturn. If defaults were to increase, the

rate of return would decrease. In addition, officials representing the two

largest government-sponsored enterprises in the secondary market for

residential mortgages4

 did not believe that HLTV lending, at its current level,

posed substantially greater risks to their portfolios than did the existing

credit card lending that the HLTV lending generally refinances. The risks to

the portfolios exist because a high total debt burden could increase the

risk of default on the mortgages that comprise the portfolios of these

government-sponsored enterprises.

Background According to industry officials, HLTV lenders used credit scoring models as

the primary basis for identifying creditworthy borrowers and thus for

4

Government-sponsored enterprises are federally chartered, privately owned corporations designed to

provide a continuing source of credit nationwide to specific economic sectors. The nation’s two largest

government sponsored enterprises are the Federal National Mortgage Association (Fannie Mae) and

the Federal Home Loan Mortgage Corporation (Freddie Mac).

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approving HLTV loans. Generally speaking, lenders used credit scoring

models to evaluate credit risk—the possibility that borrowers would be

(1) delinquent (i.e., make late loan payments) or (2) in default (i.e., cease

to make loan payments). In general, credit scores have been developed by

assessing various types of information from a large pool of borrowers,

including borrowers with good payment histories and others with poor

payment histories. Statistical analyses identifying the characteristics of

borrowers who were most likely to make loan payments have been used to

create a weight or score associated with each of the characteristics. For

instance, borrowers who did not have a history of delinquent payments

receive a higher credit score than borrowers who had many delinquent

payments. Most widely used credit scoring systems have a range of scores

from 350 to 900. Borrowers with higher scores are usually considered

more creditworthy because they would be more likely to pay the loan on

time, and in full, than would borrowers with lower scores.5

According to an official familiar with these proprietary models, a key

variable associated with higher credit scores is home ownership.

Homeowners tend to have better payment histories than borrowers with

otherwise similar characteristics. Industry officials told us that

homeowners acted as if they had a vested interest or “psychological drive”

to make prompt loan payments in an effort to keep the homes in which

they lived.

In general, in making HLTV loans, lenders sought to assemble the HLTV loans

into pools of loans, which then were used to back securities sold to

investors. According to securities firm officials, about 95 percent of HLTV

loans were combined into pools and securitized. In general, securitization

involves a lender’s packaging financial assets—typically loans—into pools,

the creation of securities based on the cash flows from the pools, and the

sale of these securities to investors. Securitization is commonly done for a

wide range of financial assets, including mortgages, car loans, and other

forms of consumer debt.

The process of HLTV securitization has three major steps. In the first step,

the borrowers take out loans from the lender, and the lender organizes the

pool and sells the HLTV loans to the pool. In addition, the lender hires a

credit rating agency and a securities underwriter. The pool is established

as a legal entity that is independent of the lender. Second, the credit rating

5

Even though some borrowers with higher scores could become delinquent or default and some

borrowers with lower scores could pay the loan as required, statistics showed that borrowers with

higher scores would be more likely to pay the loan on time, and in full, than would borrowers with

lower scores.

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agency rates the securities that will be issued by the pool and the

securities underwriter sets initial prices for the securities, buys the

securities from the pool, and immediately sells the securities to investors.

Third, the lender services the pool by collecting payments from HLTV

borrowers and disbursing payments to investors. This securitization

process is depicted in figure 1.

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Figure 1 : Steps in a HLTV Securitization

Step 1:

Lender creates

the pool HLTV borrower

 takes out loan from lender

Lender

Hires a

credit rating agency

Creates a legally

independent pool and

sells loans to the

pool

Hires a

securities underwriter

Step 2:

Pool sells

securities to

investors

Credit rating agency

rates securities to be

issued by the pool

Pool

issues securities

and sells securities

to securities underwriter

Securities underwriter

sets initial price for

securities and sells to

investors

Investors

Step 3:

Lender

continues to

service the pool

Lender

services the pool

by collecting payments

from HLTV borrowers

and disbursing cash to

investors

Lender collects payments

Disburses

cash 

Note: In this diagram, the lender both originates the loans and creates the pool.

Source: GAO

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Since the pool is a separate legal entity, its credit quality is considered to

be separate from that of the lender that formed the pool. The credit quality

of the pool depends on the credit quality of the loans in the pool. In

addition, the credit quality of the assets in the pool may also be enhanced,

either internally or externally. One form of internal credit enhancement

occurs if the value of loans in the pool exceeds the value of the securities

sold; this is a form of over-collateralization. Common forms of external

credit enhancements include insurance policies that pay in the event of

loan defaults.

HLTV Loans Have

Unique

Characteristics

HLTV loans have often been referred to as “hybrid” loans because they have

characteristics of both mortgage loans and unsecured consumer loans.

According to lenders, borrowers have used HLTV loans primarily to

consolidate credit card debt or to make home improvements. Although

industrywide data were not available, FirstPlus officials had compiled an

“average HLTV loan profile” that identified the average amount of an

approved HLTV loan, the interest rate charged, the duration of the loan, and

the percent of property value the loan represented. Further, FirstPlus

officials identified the “average HLTV borrower profile,” which was a

creditworthy borrower (based on credit scores) who had a stable income.

Officials representing federal regulators and a consumer advocacy group

were not aware of any borrowers’ complaints about the disclosure of the

terms and conditions of HLTV loans.

HLTV Loans Are Hybrid

Loans

HLTV loans have characteristics of both mortgage loans and unsecured

consumer loans. On the one hand, HLTV loans share characteristics with

mortgage loans in that both types of loans are secured with a lien on the

property in the event of borrower default. On the other hand, HLTV loans

are like unsecured consumer loans because, in both cases, the lending

decisions are based primarily on the creditworthiness of the borrower.

Creditworthiness is the primary basis for the lending decision because, in

the event of a default, there might be little or no value in the house left to

pay off the HLTV loan, once the first mortgage loan is covered by the sale of

the house.

Average HLTV Loan Profile Although industrywide data were not available, FirstPlus—which

accounted for about one-third of the HLTV loan volume in 1997—provided

us with information on its average HLTV loan profile. According to FirstPlus

officials, the average HLTV loan they made in 1997 was for about $30,000

Page 7 GAO/GGD-98-169 High-Loan-to-Value Lending
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with a 25-year term. Also, in the same year, FirstPlus charged an average

contract interest rate of 13 to 14 percent on its HLTV loans, but any

origination fees or “points charged” would raise the effective interest rate

of the loan. A FirstPlus official told us that FirstPlus charged an average of

five “points.”6

 Thus, a 25-year loan with a 13.5 percent contract rate and 5

points would have an effective interest rate of 14.3 percent. In addition,

the average combined debt of a first mortgage and a FirstPlus HLTV loan

with a second lien generally represented about 110 percent of a borrower’s

property value, although some reached as high as 125 percent of value.

Average HLTV Borrower

Profile

Although there were no comprehensive industry data, FirstPlus provided

us with information on its borrowers. Generally speaking, FirstPlus made

HLTV loans to borrowers with a stable average annual income of $60,000.

These borrowers had, on average, at least 5 years of job tenure and were

in their late thirties. Also, while the borrower had an average of about

$20,000 in outstanding nonmortgage debt, as previously mentioned, the

HLTV loans were on average about $30,000. Virtually all of these borrowers

occupied the house they were using as collateral. The borrower owed an

average of about $110,000 on a first mortgage, backed by property worth

about $130,000. However, a key FirstPlus official told us that approval of a

HLTV loan was not strongly tied to the amount of equity the borrower had

in the house; rather, it was primarily tied to the borrowers’

creditworthiness, as measured by a credit score.7

 In addition, FirstPlus

officials told us that they review the borrower’s credit histories,

debt-to-income ratios, and disposable-income levels.

Public and private sector officials—including representatives of

FirstPlus—told us that credit scores for HLTV borrowers were, on average,

about 680 and that this score was considered to be “high.” According to

the leading provider of credit scoring models, a score of 700 predicts the

odds of 30 to 1 that the borrower will be current on the loan payments.8

 An

official with a government-sponsored enterprise active in the secondary

mortgage market told us that 85 percent of all mortgage borrowers have

credit scores of 620 or higher.

6

OTS officials told us that some lenders have charged as many as 12 points.

7

HLTV lending differed from subprime lending, which is lending to less creditworthy borrowers. HLTV

lending primarily depended on the borrowers’ creditworthiness, not on the value of equity in their

collateral. Subprime lending, on the other hand, heavily depended on collateral equity and, to a lesser

extent, borrower creditworthiness.

8

The precise definition of being current on the loan payments that this provider used was that the

borrower would not be over 60 days delinquent in payments.

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The Survey of Consumer Finances, a triennial survey of family finances

sponsored by the Federal Reserve with the cooperation of the Department

of the Treasury, provides a basis to compare the profile of the HLTV

borrower with the broader U.S. population. In 1995, the most recent

Survey at the time of our review, average family income was estimated to

be $44,300 for all families and $54,600 for homeowners. The Survey also

found that 64.7 percent of families were homeowners, with the median

value of the house being $90,000. Further, 41.1 percent of the homeowners

in the Survey had mortgages or home equity loans, the median total loan

amount being $51,000. Credit cards were held by 47.8 percent of the

homeowners in the Survey, who owed a median amount of about $1,500.

A comprehensive comparison of the HLTV and Survey profiles was not

possible because some Survey data on families are reported as medians,

while the HLTV data are based on averages. Further, available data we

obtained on HLTV borrowers were from the FirstPlus borrower profile;

other lenders’ borrower profiles may be different. With these cautions in

mind, however, some general similarities and differences between the HLTV

and Survey profiles can be delineated. The HLTV borrower had a slightly

higher average income: the FirstPlus borrower had an average annual

income of about $60,000, while the average homeowner in the Survey had

an income of $51,000. The average value of housing in the HLTV profile

($130,000) is higher than the median value of housing in the Survey

($90,000), although this comparison of an average and a median is

inherently limited. Since housing values do not have an upper limit, the

mean or average value would increase more than the median with the

inclusion of high-valued houses. HLTV borrowers appear to have had higher

mortgage balances even before taking on the HLTV loans: the FirstPlus

profile reported an average first mortgage of $110,000, while the median

mortgage and home equity balance for homeowners in the Survey was

$51,000.

HLTV Loan Disclosure of

Requirements to

Borrowers

Federal law and regulations set forth requirements concerning the

information on a loan that must be disclosed to a borrower. In addition,

state law may require disclosure to borrowers. Specifically, to promote the

informed use of consumer credit, the Truth in Lending Act9

 requires that

creditors disclose credit terms and the cost of credit as an annual

percentage rate (APR). For loans secured by a consumer’s home, additional

disclosures are required, and the act permits consumers to cancel certain

9

Truth in Lending Act, 15 U.S.C. 1601 et seq. The act is implemented by the Federal Reserve Board’s

Regulation Z, 12 CFR part 226.

Page 9 GAO/GGD-98-169 High-Loan-to-Value Lending
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transactions that involve a lien on their principal dwelling. The Home

Ownership and Equity Protection Act of 199410 added new disclosure

requirements for home equity loans that have credit terms in excess of a

certain amount. To be covered by these new disclosure requirements, the

loan must meet either of the following tests: (1) the APR must be more than

10 percentage points over the yield on Treasury securities with a maturity

comparable to the loan, or (2) total points and fees payable by the

borrower must exceed the greater of either 8 percent of the total loan

amount or $435.11 A special early disclosure is required at least 3 days

before the loan closing. This disclosure generally includes (1) a warning

that the house may be lost in the event of a default, (2) the APR, and (3) the

amount of payments. The Home Ownership and Equity Protection Act also

limits the use of certain contract terms and other practices in loan

transactions covered by the act. These limitations address, among other

things, rebates, prepayment penalties, advance payments, and negative

amortization. Moreover, the Real Estate Settlement Procedures Act12

requires use of a standard form for the statement of settlement costs, as

prescribed by the Secretary of Housing and Urban Development, in all

transactions involving federally related mortgage loans.13

Officials representing banking and thrift regulators, the Federal Trade

Commission, and a consumer advocacy group told us that they were not

aware of any complaints regarding disclosure of HLTV loan terms to the

borrower. We reviewed a standard, blank package of settlement papers

provided by FirstPlus. While we did not determine compliance with

applicable disclosure requirements, our review found that the papers

contained information that appeared to address these requirements. Also,

our review of these settlement papers indicated that some of the HLTV

loans may be covered by the Home Ownership and Equity Protection Act.

10The Home Ownership and Equity Protection Act of 1994, Subtitle B of the Riegle Community

Development and Regulatory Improvement Act of 1994, P.L. 103-325, 108 Stat. 2106 (1994).

11The $435 figure applies to 1998. The Federal Reserve Board adjusts the amount annually based on

changes to the consumer price index.

1212 U.S.C. 2601 et seq. The act is designed to, among other things, provide for more effective advance

disclosure to home buyers and sellers of settlement costs.

13Federally related mortgage loans include first or subordinate mortgages on residential homes made

by depository institutions or by certain creditors who make more than $1,000,000 in residential loans

per year, or which are intended to be sold to Fannie Mae or Freddie Mac.

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While Hundreds of

Institutions Originated

HLTV Loans, 10

Institutions

Collectively Served

Most of the HLTV

Market

According to industry officials, hundreds of institutions originated HLTV

loans. There is no comprehensive, publicly available information regarding

the identity of these institutions or their HLTV activity, and they are not

tracked by regulatory agencies or industry associations. However, many of

the institutions acted as correspondents, generally transferring the loans

to other institutions that in turn securitized the loans.

According to interviews with numerous industry officials and our review

of limited available industry data, 10 institutions have collectively led the

HLTV market since 1995. The 10 institutions either received HLTV loans

originated by correspondent institutions or originated HLTV loans

themselves. One institution in particular—FirstPlus—has made about

one-third of all HLTV loans since 1995, either directly or through

correspondent relationships with other lenders. The following are the 10

institutions that led the market, in order of the volume of HLTV loans they

provided in 1997.

• FirstPlus,

• Cityscape,

• Empire Funding,

• Master Financial,

• PSB Lending Corporation,14

• Life Financial,15

• First Keystone,

• The Money Store,16

• Mego Mortgage, and

• Preferred Mortgage.

According to public and private sector officials, regulated depository

institutions were not heavily involved in originating HLTV loans from 1995

to 1997. The degree of involvement of these institutions would be

important to assess any potential exposure of federal deposit insurance

funds to defaults on HLTV loans. For instance, of the 10 institutions that led

the market, only one—Life Financial—was a regulated depository

institution. Other institutions were affiliated with depository institutions.

14In June 1998, PSB Lending Corporation was in the process of being purchased by Bay View Capital

Corporation. However, the acquisition was put on temporary hold pending review of possible federal

regulatory guidelines affecting HLTV lending.

15As of June 1998, FirstPlus had applied to acquire Life Financial, a thrift holding company. According

to OTS officials, this application is subject to regulatory review.

16The Money Store was purchased by First Union Corporation in June 1998.

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HLTV Lending Is

Growing but Still

Represents Only a

Small Percentage of

the Total Mortgage

and Unsecured

Lending Markets

Data on the volume of HLTV loans are limited to those loans that were

subsequently sold to investors as securities. Lenders and securities firms

involved in this process of securitization agreed that about 95 percent of

HLTV loans were sold as securities. According to private sector officials, the

total securitized volume of HLTV lending has more than doubled from year

to year from 1995, the year it was introduced, through 1997. The officials

also expected total securitized HLTV lending to increase in 1998, with

estimates of total volume of $12 billion or higher. (See figure 2.)

Figure 2: Available Data Show Total

Industry Volume of HLTV Lending Has

Continued to Grow

0

2

4

6

8

10

12

14

1

3

8

12

1995 1996 1997

Billions of dollars outstanding

1998 Est.

Year

Note: 1998 estimates include $12 billion and higher estimates.

Source: GAO review of reports from an investment bank and the Home Improvement Lenders

Association (HILA), interviews with private sector officials, and various published articles.

While available data show that HLTV lending has continued to grow, the

total outstanding debt represents a small percentage of the total debt

Page 12 GAO/GGD-98-169 High-Loan-to-Value Lending
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outstanding for all consumer-oriented lending. Even if no loans were

repaid, total debt outstanding for HLTV loans would be almost $12 billion in

1997. In contrast, total residential mortgage debt outstanding reached

about $3.8 trillion in 1997, and total unsecured consumer debt outstanding

reached about $1.3 trillion in 1997, according to Federal Reserve statistics.

Estimated Securitized

Volume of Major

Organizations

Industry officials we interviewed agreed that the 10 institutions shown in

table 1 have provided almost all HLTV loans since their introduction in 1995.

As shown, FirstPlus has provided a significant part of the HLTV

lending—offering about one-third of HLTV loans since 1995.

Table 1: HLTV Loan Volumes by the 10

Leading Lenders, 1995-1997 Dollars in billions

Lender 1995 1996 1997

FirstPlusa $0.30 $1.10 $3.10

Cityscape 0 0 0.80

Empire Funding 0 0 0.90

Master Financial 0 0 0.70

PSB Lending Corporation n/a n/a 0.70

Life Financialb n/a n/a 0.40

First Keystone 0.50 0.80 0.40

Money Store 0 0 0.40

Mego Mortgage 0 0.03 0.30

Preferred Mortgageb n/a n/a 0.20

Estimated Totalc $1.0 billion $3.0 billion $8.0 billion

Note: n/a = not available.

aAccording to a key company official, in 1997, FirstPlus provided $3.10 billion in HLTV loans in 42

states; about 27 percent of these loans were made to borrowers in California.

bVolume data for 1995 and 1996 for these institutions were not readily available because they

were not members of HILA as of May 1998, when the Executive Director sent questionnaires to

industry officials.

cTotals represent estimates made by industry officials and estimates reported in various

published articles. The data in the columns may not add up to the estimated totals because of

rounding or because not all data were available.

Source: Compiled by GAO from industry responses to a HILA questionnaire and other industry

data.

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Benefits and Risks

Associated With HLTV

Lending

There were limited data on the losses resulting from HLTV lending.

However, based on the characteristics of the loans and available

performance data on HLTV loans, public and private sector officials

identified many inherent trade-offs between the benefits and the risks

associated with HLTV lending that face borrowers, lenders, and investors.

These officials told us that regulated depository institutions have not made

many HLTV loans, but that the practice appears to be growing.

Limited Data Available to

Identify Losses on HLTV

Loans

Public and private sector officials told us that data on losses from HLTV

loans experienced by institutions making loans were limited for a variety

of reasons, such as that the loans (1) were a recent lending practice

adopted in 1995 (and losses are usually experienced over longer periods of

time); (2) were offered during a period of strong economic growth; and

(3) were not specifically tracked by regulators because HLTV loans were

generally made by unregulated, nondepository institutions.

A recent academic study17 concluded that there is “no credible economic

argument” to suggest that HLTV lending would increase consumer default

risk or destabilize the economy. The study noted, however, that several

HLTV lenders had substantial losses in 1997. According to the study, some

lenders experienced problems due to unrealistic assumptions on how

rapidly the loans would be repaid, inadequate underwriting standards, and

poor management.

In addition, one securities firm reported on possible HLTV loan losses by

comparing them to losses expected in mortgage and credit card lending.

The firm noted that possible HLTV losses might be higher than losses

experienced in the mortgage lending market. First, the delinquency and

default rates on HLTV loans might be higher than those rates on mortgages.

Second, in the event of a default and subsequent sale of the house securing

the loan, the proceeds of the sale may not be sufficient to pay off both the

first mortgage and the HLTV loan. Because first mortgages have first claim

on the house sale proceeds, there may be little or nothing left to pay off

the HLTV loan. On the other hand, the securities firm also noted that

possible HLTV charge-off rates (i.e., the percentage of total loan value that

would be written off because no further payments were expected) would

compare favorably with losses on “higher quality credit card pools.” For

instance, the HLTV charge-off rates were estimated to peak at a 4.7 percent

annualized rate for recently originated pools. By comparison, the

17Charles W. Calomiris and Joseph R. Mason, “High Loan-to-Value Mortgage Lending: Problem or

Cure?” July 10, 1998, unpublished working paper, American Enterprise Institute.

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charge-off rate on Moody’s aggregate credit card index was reported as

6.65 percent in December 1997.

Borrowers With HLTV

Loans Experienced

Benefits and Risks

Lenders and independent analysts agreed that most borrowers decreased

their monthly debt burden payments by using HLTV loans to consolidate

their credit card debts, for two reasons. First, because borrowers

rescheduled their debts over a longer period of time, the monthly debt

burden would decrease even if they paid the same interest rates they were

paying on the credit cards. Second, to the extent that the interest rate was

lower than the credit card rates, the monthly debt service would be further

decreased.18 In 1997, the average contract HLTV loan charged 13 to

14 percent interest, while the average interest rate on credit cards was

16 percent. However, any advantages of a HLTV loan relative to credit card

debt would depend on the terms and conditions of the credit card debt

agreement, and these vary across the industry. In addition, as previously

mentioned, the effective interest rate on an HLTV loan would vary

depending on the number of points charged on the loan. Finally, some

industry officials said that HLTV loans might allow borrowers some tax

deductions for interest expenses that would not be available for credit

card interest expenses.19

Public and private sector officials pointed out that HLTV lending involves

three primary risks on the part of the borrower. First, officials questioned

whether borrowers would have the ability to make HLTV loan payments in

the future if they encountered economic difficulties, such as job losses or

unemployment. While borrowers might have benefited from restructuring

debt by using HLTV loans during good economic conditions, officials

pointed out that there were no data on how well the borrowers could

make loan payments during any future economic downturn. Default rates

on all loans generally increase during economic downturns.

Second, some analysts expressed concern that HLTV borrowers could

increase their credit card debt after taking out an HLTV loan because they

could retain their credit cards and/or be approved for new credit cards.

Given lower monthly debt service, once credit card debt was restructured

as an HLTV loan, it is possible that borrowers’ credit scores could rise. For

18Conversely, the credit card monthly debt service would decrease over time if no new debt was added

to the credit cards and at least minimum payments were being made regularly. The monthly debt

service on the HLTV loan would remain unchanged for the full term of the mortgage if payments were

made regularly.

19The Internal Revenue Code provides that interest paid can only be deducted to the extent that the

amount of the home equity loan plus the first mortgage does not exceed the market value of the house.

Page 15 GAO/GGD-98-169 High-Loan-to-Value Lending
B-279255 

instance, Brittain Associates, a marketing research firm, reported in 1998

that some HLTV borrowers had already begun to build up sizable credit card

debt soon after getting the previous debt paid off with a home equity loan.

Finally, some officials believed that HLTV loans might decrease borrowers’

financial flexibility by limiting their ability to sell their houses or to

refinance first mortgages. The combined value of the HLTV loan and first

mortgage often exceeds the value of the house. Upon sale, the borrower

would usually need to pay off both loans. If sufficient funds were not

available, either from the sale or from other sources, the borrower might

not be able to sell. In addition, officials at a government-sponsored

enterprise noted that the presence of second loans secured by the value of

houses generally made it more complicated to refinance first mortgages.

In addition, housing prices can be particularly sensitive to changes in

economic conditions. In some cases, this sensitivity can affect loan

payments by borrowers. For example, when the price of oil fell during the

mid 1980s, residential housing values in Houston, Texas, fell 23 percent.

Similarly, when the California economy went into a recession in the early

1990s, average housing prices declined by 21.1 percent in Southern

California and 9.6 percent in Northern California. During these times,

defaults on mortgages increased because borrowers lost jobs and, in some

cases, were unwilling to pay on mortgages whose balances far exceeded

the current market values of their houses.

Lenders of HLTV Loans

Experienced Benefits and

Some Risks

HLTV loans offered several benefits to HLTV lenders. For example, when the

loans were securitized, the lender could continue to service the loans,

which would generate service fee income for the lender. A securities

industry study noted that several securitization offerings during 1997

provided for service fees of 0.75 to 1.0 percent of the loan amount. On a

$30,000 loan, this fee would equal between $225 and $300.

More generally, officials representing securities firms told us that HLTV

loans could be profitable for lenders because these loans could be sold at

a premium over the face value of the loan to the pools, which subsequently

would be securitized. As noted earlier, the lenders organize the pools of

assets in the securitization process, but the pools are established as

separate legal entities. The lenders sell the HLTV loans to the pool. Under

current accounting rules, any such profits must be immediately recognized

on those sales where certain equity interests are maintained by the seller

Page 16 GAO/GGD-98-169 High-Loan-to-Value Lending
B-279255 

as part of the deal and recorded as an asset. The estimated fair value of the

asset is added to sales proceeds when calculating profit.

Officials representing securities firms also noted several ways in which the

lenders would retain some risk. First of all, some HLTV loans were not

securitized and were held on the lenders’ books. The officials we talked

with estimated that 5 percent of the HLTV loans were not securitized, but

there is no way to reliably know how many loans were not securitized or

to identify their value. In addition, even when the HLTV loans were

securitized (about 95 percent), the officials said the lenders often retained

a stake in the retained assets pools. The lender might hold a class of

securities that was designed to absorb credit risk to protect investors, for

example. By taking on the credit risk with these securities, the lender

provides an internal credit enhancement to the other investors in the pool.

In addition, by absorbing these credit risks, the lender may protect the

pool and its reputation as a securitizer from the consequences of securities

that do not perform. In cases where the seller retains an equity interest as

part of the securitization, the retained asset carries risk for the lender

because the value of the asset is based on assumptions about the future

performance of the loans sold and assumptions about future cash flows. If

these assumptions do not hold and the value of the retained asset

decreases, previously recognized accrued income will not be realized in

cash.

Investors of HLTV Loans

Experienced a Trade-off

Between Benefits and

Risks

Several classes of securities were created from each pool of HLTV loans and

sold to investors. Different securities classes offered different mixes of

expected returns, credit risk, and interest rate risk (the risk that cash

flows will vary as interest rates change in the future) to investors. In

general, classes with higher risks were designed to pay higher expected

returns. Although it is difficult to identify investors of HLTV lending pools

because of a lack of data, officials from a securities firm told us that

investors were mainly large insurance companies.

To protect investors, securitization redistributes credit risks so that one

class of securities is designed to absorb all or much of the credit risk in

return for a higher expected return. Such structuring is a common internal

credit enhancement. Another common internal credit enhancement is

over-collateralization, where the difference between the interest paid on

the loans and interest paid to investors (the “excess spread”) absorbs

losses. In addition, to improve the liquidity or marketability of certain

securities, lenders can also provide external credit enhancements to

Page 17 GAO/GGD-98-169 High-Loan-to-Value Lending
B-279255 

protect the owners of these securities from losses from loan defaults.

These external credit enhancements can include insurance policies that

protect a pool’s securities against default losses on the loans in the pool.

Private sector officials told us that external credit enhancements were a

popular technique in the securitization of HLTV loans in 1995 and 1996 but

that during 1997 and 1998 internal credit enhancements were more

prevalent.

Different classes in the securitization would be attractive to investors

taking different approaches to managing interest rate risk because each

class of securities would receive different parts of the pool’s interest and

principal payments over different time periods. For example, investors can

manage interest rate risk by buying securities with specific payoff periods.

Nevertheless, there is always some intrinsic risk in any investment, and

this is increased in the case of securities only recently introduced in the

market. Investment bank and government-sponsored enterprise officials

noted several risks associated with the securities based on the HLTV loans.

While these securities were designed to mitigate risks to the investors,

there were risks associated with the underlying loans. For instance, the

rate at which defaults are expected to occur on HLTV loans is a crucial

factor in putting together the pools and the resulting securities. The

expected average default rate on HLTV loans, with an average term of

maturity of 25 years, is based on the creditworthiness of the borrower as

predicted by credit scoring models. According to the leading provider of

credit scoring models, the models are designed to optimize their predictive

power over a 2-year period. Although the models will rank borrowers over

longer periods, the separation between good and bad borrowers will

degrade over a longer time horizon (for instance, 10 years).

Similarly, the likelihood that HLTV loans will be paid before they are due

has only been estimated based on the prepayment rate of other forms of

consumer debt. If the actual rate of prepayment differs from the predicted

rate, the cash flow from the pool of loans will not match the predicted

cash flow that would yield the expected payments to investors. This, in

turn, would change the realized rate of return on pools of mortgages and

on those securities sensitive to interest rate risk created by prepayments.

Page 18 GAO/GGD-98-169 High-Loan-to-Value Lending
B-279255 

Regulated Depository

Institutions Were Not

Heavily Involved in

Originating HLTV Loans

It does not appear that regulated depository institutions have experienced

many benefits or risks because these institutions did not originate many

HLTV loans or invest in the securitized pools. Their minimal benefits,

however, might have included service fee income from any HLTV loans that

banks originated and sold.

Officials at Fannie Mae and Freddie Mac told us that HLTV lending, at

current levels, did not pose a greater risk to their portfolios of first

mortgages than did the credit card debt HLTV loans generally refinanced.

The risks to the portfolios exist because a high total debt burden on

consumers could increase the risk of default on the mortgages that

comprise the portfolios of these government-sponsored enterprises. HILA’s

executive director said, however, that HLTV loans might reduce the

possibility of defaults on first mortgages because HLTV loans allowed

borrowers to lower their monthly payments on debt. In any event, Fannie

Mae and Freddie Mac officials noted that they, as first mortgage holders,

would maintain their equity position and be the first to obtain the

proceeds from the sale of a house in the event of default.

Moreover, because the data available at the time of our review show that

most institutions making HLTV loans were not regulated depository

institutions and did not have federally insured deposits, a failure of these

institutions was unlikely to impose any direct costs on the government.

This condition could change, however, in the event that (1) the size of the

HLTV market were to increase and (2) regulated depository institutions

were to become substantially involved in making HLTV loans and carrying

them on their books. Federal banking and thrift regulatory officials have

recognized this possibility, and some have begun efforts to identify and

monitor HLTV lending done by regulated financial institutions. In addition,

officials from the Office of Thrift Supervision told us that they are

clarifying their regulatory guidelines as they affect HLTV lending.

As agreed with you, unless you publicly release its contents earlier, we

plan no further distribution of this report until 30 days from its issue date.

At that time, we will provide copies to the Ranking Minority Member of

your Subcommittee, the Chairman and Ranking Minority Member of other

congressional committees with jurisdiction over financial issues, the

Chairman of the Board of Governors of the Federal Reserve System, the

Comptroller of the Currency, the Director of the Office of Thrift

Supervision, the Chairman of the Federal Deposit Insurance Corporation,

the Chief Executive Officer of the Federal National Mortgage Association,

Page 19 GAO/GGD-98-169 High-Loan-to-Value Lending
B-279255 

the Chief Executive Officer of the Federal Home Loan Mortgage

Corporation, the chief executive officers of various HLTV lenders, and other

interested parties. We will also make copies available to others upon

request.

This report was prepared under the direction of James McDermott,

Assistant Director, Financial Institutions and Markets Issues. Other major

contributors include Becky Kennedy, Evaluator-in-Charge; Mitchell

Rachlis, Senior Economist; and Edwin Lane, Evaluator. If you have any

questions about this report, please call me on (202) 512-8678.

Sincerely yours,

Susan S. Westin

Associate Director, Financial Institutions

 and Markets Issues

Page 20 GAO/GGD-98-169 High-Loan-to-Value Lending
Page 21 GAO/GGD-98-169 High-Loan-to-Value Lending
Appendix I 

Objectives, Scope, and Methodology

This report was prepared in response to a request from the Chairman,

Senate Subcommittee on Financial Institutions and Regulatory Relief,

Committee on Banking, Housing, and Urban Affairs. Our objectives were

to provide information regarding (1) the characteristics of HLTV loans;

(2) the major organizations that provided HLTV lending; (3) the volume of

HLTV lending in 1995, 1996, and 1997, and the expected volume in 1998; and

(4) the benefits and risks of HLTV lending for borrowers, lenders, investors,

and regulated depository institutions.

To determine the characteristics of HLTV loans, we gathered background

information on various aspects of individual loans by interviewing officials

representing FirstPlus (the institution that provided about one-third of

total HLTV lending from 1995 through 1997), industry associations, a rating

agency, and investment banks, as well as by reviewing publicly available

information, including published articles that reported such

characteristics. To identify the average loan profile and the average

borrower profile of HLTV loans, we obtained data on HLTV loans made by

FirstPlus. We interviewed company officials and reviewed their literature

as well as other published reports. Although we did not independently

verify this—or any—industry data, we corroborated evidence with other

independent sources whenever possible.

To identify the major organizations that provided HLTV lending, we

interviewed numerous officials representing the private sector. We

selected officials to talk to, in part, on the basis of industry

recommendations of knowledgeable people. We also conducted a

literature search and reviewed selected articles that reported on HLTV

lenders and their activities. Moreover, we collected and reviewed

numerous mail solicitations sent to GAO staff from many different lenders

advertising HLTV loans. We compiled a list of the top 10 HLTV lenders by

corroborating information we collected. The Executive Director of the

Home Improvement Lenders Association (HILA) confirmed that we had

identified the top 10 HLTV lenders.

We obtained the industry volume of HLTV lending in 1995, 1996, and 1997,

as well as the expected volume in 1998, by interviewing various officials

representing HLTV lending institutions, industry associations, and

investment banks and by reviewing published information, such as

company prospectuses and relevant articles obtained through our

literature searches. We obtained volume amounts—for the same

years—for individual HLTV lenders from the Executive Director of HILA. For

our review, the Executive Director surveyed individual lenders that were

Page 22 GAO/GGD-98-169 High-Loan-to-Value Lending
Appendix I 

Objectives, Scope, and Methodology

members of HILA and provided us with the survey responses. In addition,

we contacted officials representing another selected lender to obtain

additional volume data. We did not independently verify this industry data.

To identify the benefits and risks of HLTV lending for borrowers, lenders,

investors, and regulated depository institutions, we interviewed public

sector officials representing federal banking and thrift regulatory agencies

and the Federal Trade Commission, as well as private sector

representatives from First Plus, industry associations, a rating agency,

investment banks, and a consumer advocacy group. We also reviewed

numerous published journal articles, academic and industry studies, and

congressional testimonies that reported benefits and risks associated with

HLTV lending and investing. In addition, we reviewed published literature to

generally denote the securitization process as well as the common

accounting treatment of profits. Finally, we interviewed public and private

sector officials and reviewed selected federal and state regulations and

laws to gain an understanding of lender protection laws relevant to HLTV

lending.

We conducted our work between January and June 1998 in accordance

with generally accepted government auditing standards. To ensure that its

contents were factually accurate, we provided a draft of this report to

officials at federal banking and thrift regulatory agencies, the Federal

Trade Commission, Fannie Mae, and Freddie Mac. We also provided a

draft of the relevant sections of this report to the officials representing

FirstPlus for their review. In addition, to ensure that we accurately

reported volume data, we contacted officials representing the other nine

institutions that collectively served most of the HLTV market. We

incorporated their technical comments where appropriate.

(233546) Page 23 GAO/GGD-98-169 High-Loan-to-Value Lending
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