I. INTRODUCTION
The federal financial institutions regulatory agencies (FFIEC) issued an interagency guidance in 2005 in order to promote sound risk management practices at financial institutions with home equity lending programs and to highlight sound risk management practices that institutions should follow to keep pace with growth and risk in home equity portfolios. The risk factors listed below, combined with an inherent vulnerability to rising interest rates, suggest that financial institutions may not recognize the risk embedded in these portfolios. Specific product, risk management and underwriting risk factors and trends that have attracted scrutiny are:
The FFIEC, while acknowledging that home equity lending, like most other lending, can be conducted in a safe and sound manner, it must be pursued with the appropriate risk management structure and practices that keep pace with the growth and changing risk profile of home equity portfolios. Management should actively assess a portfolio’s vulnerability to changes in consumers’ ability to pay and the potential for declines in home values. Active portfolio management is especially important for financial institutions that project or have already experienced significant growth or concentrations, particularly in higher risk products such as high-LTV, “low doc” or “no doc,” interest-only or third party generated loans.
II. CREDIT RISK MANAGEMENT SYSTEMS
A. Product Development and Marketing
In the development of any new product offering, product change, or marketing initiative, management should have a review and approval process that is sufficiently broad to ensure compliance with the institution’s internal policies and applicable laws and regulations (applicable laws include Federal Trade Commission Act; Equal Credit Opportunity Act; Fair Housing Act; Real Estate Settlement Procedures Act [RESPA]; and the Home Mortgage Disclosure Act, as well as applicable state consumer protection laws) and to evaluate the credit, interest rate, operational, compliance, reputation, and legal risks.
Management should also have appropriate monitoring tools and management information systems (MIS) to measure the performance of various marketing initiatives, including offers to increase a line, extend the interest-only period, or adjust the interest rate or term.
B. Home Equity Lines of Credit (HELOCs)
When promoting or describing HELOCs that permit interest-only payments, institutions should provide consumers with information that is designed to help them make informed decisions regarding product selection and use. Meeting this objective requires appropriate attention to the timing, content, and clarity of information presented to consumers.
Communications with consumers, including advertisements, oral statements, promotional materials, and periodic statements, should provide clear and balanced information about the relative benefits and risks of HELOCs with interest-only features. This includes information about the risk of increased future payment obligations. Information about potential increases in payment obligations should address, among other things, circumstances in which interest rates reach a contractual limit.
If applicable, these materials should also alert the consumer to any prepayment penalty, (a fee that will be imposed if the borrower pays off the balance and terminates the account in advance of the contractual end date) and the need to seek additional information on the amount of any penalty. Consumers should also be informed of any premium that may be charged for a reduced documentation program.
This information should be provided in a timely manner, to assist the consumer in the product selection process. Clear and balanced information should be provided at the time a consumer is shopping for a loan, not just when an application form is provided or at consummation. For example, this information could be provided when a consumer inquires about a home equity product and receives information about products with interest-only features, or when the institution provides the consumer with marketing materials for such products
C. Origination and Underwriting
All relevant risk factors should be considered with establishing product offerings and underwriting guidelines. Generally, these factors should include a borrower’s income and debt levels, credit score (if obtained), and credit history, as well as the loan size, collateral value (including valuation methodology), lien position, and property type and location.
Consistent with the agencies’ regulations on real estate lending standards, prudently underwritten home equity loans should include an evaluation of a borrower’s capacity to adequately service the debt. Given the home equity products’ long-term nature and the large credit amount typically extended to a consumer, an evaluation of repayment capacity should consider a borrower’s income and debt levels and not just a credit score.
HELOCs generally do not have interest rate caps that limit rate increases. Rising interest rates could subject a borrower to significant payment increases, particularly in a low interest rate environment. Therefore, underwriting standards for interest-only and variable rate HELOCs should include an assessment of the borrower’s ability to amortize the fully drawn line over the loan term and to absorb potential increases in interest rates.
D. Third-Party Originations
Financial institutions often use third parties, such as mortgage brokers or correspondents, to originate loans. When doing so, an institution should have strong control systems to ensure the quality of originations and compliance with all applicable laws and regulations, and to help prevent fraud.
1. Brokers are firms or individuals, acting on behalf of either the financial institution or the borrower’s needs with institutions’ mortgage origination programs. Brokers take applications from consumers. Although they sometimes process the application and underwrite the loan to qualify the application for a particular lender, they generally do not use their own funds to close loans. Whether brokers are allowed to process and perform any underwriting will depend on the relationship between the financial institution and the broker. For control purposes, the financial institution should retain appropriate oversight of all critical loan processing activities, such as verification of income and employment and independence in the appraisal and evaluation function.
2. Correspondents are financial companies that usually close and fund loans in their own name and subsequently sell them to a lender. Financial institutions commonly obtain loans through correspondents and, in some cases, delegate the underwriting function to the correspondent. The delegating financial institution should have systems and controls to provide assurance that the correspondent is appropriately managed, financially sound, and provides mortgages that meet the institution’s prescribed underwriting guidelines and that comply with applicable consumer protection laws and regulations.
Both brokers and correspondents are compensated based upon mortgage origination volume and, accordingly, have an incentive to produce and close as many loans as possible. Therefore, financial institutions should perform comprehensive due diligence on third-party originators prior to entering a relationship. In addition, once a relationship is established, the institution should have adequate audit procedures and controls to verify that third parties are not being paid to generate incomplete or fraudulent mortgage applications or are not otherwise receiving referral or unearned income or fees contrary to RESPA prohibitions.
E. Collateral Valuation Management
Competition, cost pressures, and advancements in technology have prompted financial institutions to streamline their appraisal and evaluation processes. These changes, coupled with institutions underwriting to higher LTVs, have heightened the importance of strong collateral valuation management policies, procedures, and processes.
Financial institutions should have appropriate collateral valuation policies and procedures that ensure compliance with the agencies’ appraisal regulations and the “Interagency Appraisal and Evaluation Guidelines” (guidelines). In addition, the institution should:
When tax assessment valuations are used as a basis for the collateral valuation, the financial institution should be able to demonstrate and document the correlation between the assessment value of the taxing authority and the property’s market value as part of the validation process.
F. Account Management
Since HELOCs often have long-term, interest-only payment features, financial institutions should have risk management techniques that identify higher risk accounts and adverse changes in account risk profiles, thereby enabling management to implement timely preventive action (e.g., freezing or reducing lines). Further, an institution should have risk management procedures to evaluate and approve additional credit on an existing line or extending the interest-only period. Account management practices should be appropriate for the size of the portfolio and the risks associated with the types of home equity lending.
Effective account management practices for large portfolios or portfolios with high-risk characteristics include:
The frequency of these actions should be commensurate with the risk in the portfolio. Financial institutions should conduct annual credit reviews of HELOC accounts to determine whether the line of credit should be continued, based on the borrower’s current financial condition.
G. Portfolio Management
Financial institutions should implement an effective portfolio credit risk management process for their home equity portfolios that includes:
1. Policies - The agencies’ real estate lending standards regulations require that an institution’s real estate lending policies be consistent with safe and sound banking practices and that an institution’s board of directors review and approve these policies at least annually. Before implementing any changes to policies or underwriting standards, management should assess the potential effect on the institution’s overall risk profile, which would include the effect on concentrations, profitability, and delinquency and loss rates. The accuracy of these estimates should be tested by comparing them with actual experience.
2. Portfolio Objectives and Risk Diversification - Effective portfolio management should clearly communicate portfolio objectives such as growth targets, utilization, rate of return hurdles, and default and loss expectations. For institutions with significant concentrations of HELs or HELOCs, limits should be established and monitored for key portfolio segments, such as geographic area, loan type, and higher risk products. As the portfolio approaches concentration limits, the institution should analyze the situation sufficiently to enable the institution’s board of directors and senior management to make a well-informed decision to either raise concentration limits or pursue a different course of action.
3. Management Information Systems - By maintaining adequate credit MIS, a financial institution can segment loan portfolios and accurately assess key risk characteristics. The MIS should also provide management with sufficient information to identify, monitor, measure, and control home equity concentrations. Financial institutions should periodically assess the adequacy of their MIS in light of growth and changes in their appetite for risk.
4. Policy and Underwriting Exception Systems - Financial institutions should have a process for identifying, approving, tracking, and analyzing underwriting exceptions. Reporting systems that capture and track information on exceptions, both by transaction and by relevant portfolio segments, facilitate the management of a portfolio’s credit risk.
5. High LTV Monitoring - To clarify the agencies’ real estate lending standards regulations and interagency guidelines, the agencies issued “Interagency Guidance on High LTV Residential Real Estate Lending” (HLTV guidance) in October 1999. The HLTV guidance clarified the “Interagency Real Estate Lending Guidelines” and the supervisory loan-to-value limits for loans on one- to four-family residential properties. This statement also outlined controls that the agencies expect financial institutions to have in place when engaging in HLTV lending. Financial institutions should accurately track the volume of HLTV loans, including HLTV home equity and residential mortgages, and report the aggregate of such loans to the institution’s board of directors.
6. Stress Testing for Portfolios - Financial institutions with home equity concentrations as well as higher risk portfolios are encouraged to perform sensitivity analyses on key portfolio segments. This type of analysis identifies possible events that could increase risk within a portfolio segment or for the portfolio as a whole. Institutions should consider stress tests that incorporate interest rates increases and declines in home values. Since these events often occur simultaneously, the agencies recommend testing for these events together.
H. Operations, Servicing, and Collections
Effective procedures and controls should be maintained for such support functions as perfecting liens, collecting outstanding loan documents, obtaining insurance coverage (including flood insurance), and paying property taxes. Credit risk management should oversee these support functions to ensure that operational risks are properly controlled.
1. Lien Recording – Institutions should take appropriate measures to safeguard their lien position. They should verify the amount and priority of any senior liens prior to closing the loan.
2. Problem Loan Workouts and Loss Mitigation Strategies – Financial institutions should have established policies and procedures for problem loan workouts and loss mitigation strategies. Policies should be in accordance with the requirements of the FFIEC’s “Uniform Retail Credit Classification and Account Management Policy,” issued June 2000.
I. Secondary Market Activities
More financial institutions are issuing HELOC mortgage-backed securities (i.e., securitizing HELOCs). Although such secondary market activities can enhance credit availability and an institution’s profitability, they also pose certain risk management challenges. An institution’s risk management systems should address the risks of HELOC securitizations.
III. CONCLUSION
Home equity lending is an attractive product for many homeowners and lenders. The quality of these portfolios, however, is subject to increased risk if interest rates and home values decline. Sound underwriting practices and effective risk management systems are essential to mitigate this risk.