Given the growth in home equity lending during the 1990s, it is imperative that lenders and regulators understand the risks associated with this segment of the residential mortgage market. Using a unique panel data set of over 135,000 homeowners with second mortgages, our analysis indicates that significant differences exist in the prepayment and default probabilities of home equity loans and lines, providing insights into bank minimum capital requirements. We find that households with equity loans are relatively more sensitive to changes in interest rates. By contrast, households with equity lines are more sensitive to appreciation in property value.

This paper examines the effect of a regulatory action (the Home Valuation Code of Conduct) that was designed to reduce the incidence of inflated collateral valuations. We identify the impact of the regulation using a difference-in-difference identification strategy. Our baseline results confirm that the regulation reduced inflated valuations in refinance transactions by 16% in the large lender sample, compared to small lenders and a placebo sample. The effect is most significant in low-liquidity and low-distress markets, but not in other markets. We find that the regulation had a significant impact on loan to value ratio and interest rate, and it also led to a significant increase in defaults but a decrease in prepayments.