Positive Payment Shocks, Liquidity and Refinance Constraints and Default Risk of Home Equity Lines of Credit at End of Draw

Abstract

Using a unique and comprehensive dataset of loan-level home equity lines of credit serviced by large US national banks, we confirm that default risk of home equity lines of credit increases at end of draw. More importantly, we quantify the increase in default risk with the size of positive payment shock at end of draw. Furthermore, we find the effects are more pronounced when borrowers are under greater liquidity or refinance constraints and less pronounced if banks manage the credit risk proactively by freezing the credit lines. Our findings are robust across various model specifications and risk segments, payment shock definitions, and after controlling for sample selection bias from HELOC payoffs. These results have important implications for evaluating and managing HELOC credit risk: (i) the need to capture payment shocks, liquidity and refinance constraints in credit risk models, (ii) the benefit of smoothing payment shocks in contract design as well as the workout process, and (iii) the need to consider proper timing for tightening HELOC lending standards.