Citing the increasing popularity of home equity loans, the agencies which regulate the nations lenders have issued a new guide to credit risk management for these loans.
The document, jointly issued by the Office of the Comptroller of the Currency,
the Federal Reserve, The Federal Deposit Insurance Corporation,
the Office of Thrift Supervision, and the National Credit Union
Administration was issued because the agencies "have found that,
in many cases, institutions' credit risk management practices for home
equity lending have not kept pace with the product's rapid growth
and easing of underwriting standards."
The document states that, to date, delinquency and losses associated with both open-end home equity lines of credit (HELOC) and closed-end home equity loans (HELs) have been low. This, the guide says, is partially due to the modest repayment requirements (often interest only for a period of or (or followed by) payments of interest plus 1/2 to 1 percent of principal balance) and other "relaxed structures" but warned of an inherent vulnerability to rising interest rates as many of these loans are pegged to the prime and almost all are variable rate instruments.
In addition to the current expectation of rising rates, the agencies cited six other risk factors to institutions involved in HELOC or HEL lending:
- Interest only loans that require no principal payment for a protracted period;
- Limited or no documentation of borrowers' assets, employment, and income;
- High loan-to-value (LTV) or debt-to-income (DTI) ratios;
- Lower credit scores for underwriting home equity loans;
- Greater use of automated valuation models (AVMs) for evaluating collateral;
- Increasing reliance on third party origination and/or third party underwriting.
While many of the recommendations fell into the category of reminders of best practices (i.e. perfect the lien, make sure insurance is in place, etc,) some are interesting in light of our earlier discussions about predatory lending, appraisals, and the stripping of home equity.
Product development and marketing
In the process of developing a new product, changing an old one, or initiating a new marketing initiative, there should be a review and approval process sufficiently broad to insure compliance with the institution's own policies. In other words, once the loan officers and marketing gurus have come up with a bright idea such as a 110 percent LTV or 2 percent under prime loans, bring in the risk management people for their input and make sure the Board of Directors and senior management are kept in the loop.
Origination and underwriting
Because of the long term nature of home equity loans, the large loan amounts typically extended, and the possibility of rate increases, institutions should not rely so heavily on credit scores but more carefully evaluate repayment capacity. Past performance is instructive, but loan approvals should include an assessment of the borrower's ability to amortize the fully drawn line of credit over the entire loan term and to absorb potential increases in interest rates.
Third Party Originations
This topic seems to have given the agencies the most pause.
Citing the role that commissions play in a third party relationship, the guide emphasizes the necessity for financial institutions to perform "comprehensive due diligence on third-parties (brokers and correspondent lenders) prior to entering into a relationship. The financial institutions should, however, also have adequate audit procedures to assure that applications are not incomplete or fraudulent, and to monitor the quality of loans by originating source - identifying such problems as early payment defaults or incomplete documentation - and terminating any unsatisfactory third party relationship quickly.
Collateral Valuation Management
Citing the technology driven trend to streamline appraisals and evaluations coupled with the tendency of institutions to write loans with increasingly higher LTVs, the guidelines urge "strong collateral valuation management policies, procedures, and processes. Among the recommendations that should sound familiar to readers:
Ensure that an expected or estimated value of the property is not communicated to an appraiser or individual performing an evaluation of the property.
Implement policies and controls to preclude "value shopping." Use of several valuation tools may return different values for the same property. These differences can result in systematic overvaluation of properties if the valuation choice becomes driven by the highest property value... The institution should adhere to a policy for selecting the most reliable method, rather than the highest value.
Require sufficient documentation to support the collateral valuation in the appraisal/evaluation.
The guidelines continue with recommendations for account and portfolio management, operations, servicing, and collections; management information systems, and allowances for losses which are probably most of interest to banking professionals. If you wish to read the entire document, Credit Risk Management Guidance for Home Equity Lending, it can be accessed at www.federalreserve.gov/boarddocs/press/bcreg/2005/20050516/