Govt Cautions About Home Equity Lending

Home appreciation, coupled with low interest rates and favorable tax treatment, have contributed to the popularity of home equity lending programs. Although delinquency and loss rates for home equity portfolios have so far been low, due in part to modest repayment requirements and relaxed structures of this lending, that may not be the case in the future, according to the Credit Risk Management Guidance for Home Equity Lending.

The guidance report was collectively issued and announced by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration, with the purpose of promoting sound risk management practices at financial institutions with home equity lending programs.

“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,” they said in the report.

In addition to an inherent vulnerability to rising interest rates, specific factors that have drawn scrutiny on home equity portfolios are the growing origination of interest-only loans; “low doc” or “no doc” loans, originations with higher loan-to-value and debt-to- income ratios; lower credit risk scores for underwriting; greater use of automated valuation models and other collateral evaluation tools for the development of appraisals and evaluations; and the higher volume of home equity programs being generated by brokers or other third parties, the researchers said.

“The agencies note that active portfolio management is especially important for financial institutions that project or have already experienced significant growth or concentrations in higher risk products, such as high LTV, limited documentation and no documentation interest-only, and third-party generated loans,” they said in the announcement.

According to the report, an effective portfolio credit risk management process for home equity portfolios includes having real estate lending policies consistent with the agencies’ standards and regulations, and reviewing and approving the policies at least annually; an understanding of the various risk characteristics of the home equity portfolio by analyzing segment criteria of the portfolio such as product type, credit risk score, or LTV; and credit management information systems that at minimum contain reports and analysis of things such as production and portfolio trends by product, loan structure, originator channel, credit score, LTV, DTI, lien position, documentation type, market, and property type.

Lenders were also advised keep close monitoring of high LTV loans as recent examinations have shown several instances of noncompliance with the supervisory loan-to-value limits of the ‘Interagency Real Estate Lending Guidelines’. Lenders should accurately track the volume of high LTV loans, including high LTV home equity and residential mortgages, and report the aggregate of such loans to the company’s board of directors.

When establishing a new product and underwriting guidelines, product change, or marketing initiative, the federal agencies suggested for lenders to have a review and approval process broad enough to ensure compliance with its internal policies and applicable laws and regulations For interest-only and variable rate HELOCs, for example, underwriting standards 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.

In using third party originators, the agencies advised lenders to have strong control systems to ensure the quality of originations and compliance with laws and regulations, and to help prevent fraud. With brokers, lenders 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. With correspondents, lenders should closely monitor the quality of loans, by doing post-purchase underwriting reviews and ongoing portfolio performance management among other activities, the report said.

Strong collateral valuation management policies, procedures, and processes should also be a priority. Among the suggestions the agencies gave lenders to obtain such goals were to avoid communicating to an appraiser performing an evaluation the expected or estimated value of the property, use of several valuation tools as these may return different values for the same property and adhere to a policy for selecting the most reliable method, rather than the highest value, as well as requiring sufficient documentation to support the collateral valuation in the appraisal/evaluation.

The agencies also noted effective account management practices for large portfolios or portfolios with high-risk characteristics include, periodically refreshing credit risk scores and assessing payment patterns on all customers; monitoring home values by geographic area; and obtaining updated information on the collateral’s value when significant market factors indicate a potential decline in home values.