In May 2005, interagency regulatory guidance was issued, which outlined sound credit risk management practices for financial institutions involved in home equity lending. For the Federal Reserve, this was issued as SR Letter 05-11.1 The guidance is a result of the rapid growth in both open-end home equity lines of credit and closed-end home equity loans within the financial services industry.
This growth trend stems from a material rise in residential real estate values, the low interest rate environment, and the favorable tax treatment accorded individuals who mortgage their primary and secondary residences. These reasons have made this form of borrowing an attractive alternative to consumers, and regulatory agencies have found that, in many cases, credit risk management practices for this form of lending have not kept pace with the strong growth trend.
Numerous factors increase the risk associated with this type of lending. These factors include:
These risk factors can be mitigated by a robust risk management program that includes fully articulated policies, practices, and procedures that address product development and marketing, underwriting standards, third-party originations, collateral valuation, account and portfolio management, and operations and servicing.
Product Development and Marketing
When developing and marketing home equity loan products, management should establish a review and approval process to ensure compliance with internal policies and all applicable laws and regulations. If possible, risk management personnel should be involved in the product development stage to evaluate the risks. Otherwise, management should evaluate all associated risks, including credit, market, operational, reputational, and legal risks. Furthermore, when home equity products are marketed or closed by a third party, management should review the third party for compliance. There should also be appropriate monitoring tools in place, including effective MIS, to measure ongoing performance of marketing initiatives.
Consistent with regulatory guidance on real estate lending standards,2 prudent underwriting standards should include an assessment of a borrower’s capacity to service the debt. Consideration should be given to a borrower’s income and debt levels in addition to the credit score. While credit scores are based on historical performance and may be an indicator of future performance characteristics, a change in the income or debt levels of borrowers may diminish their ability to repay the debt. Furthermore, home equity loans and lines may not have interest rate caps. As a result, a significant rise in interest rates would result in materially higher payments for borrowers and could impair their ability to service the debt.
Financial institutions often use third parties to originate loans, typically brokers or correspondents. It is a common practice for brokers and correspondents to be compensated based on their volume of loan originations. This approach may create an implicit incentive to produce as many loans as possible, regardless of the quality. There should be strong controls in place to ensure the quality of the originations and compliance with all applicable laws and regulations and to help reduce the incidence of fraud.
It is essential for management to perform comprehensive due diligence on third-party originators prior to establishing a relationship. Furthermore, once a relationship has been established, there should be ongoing monitoring to ensure the completeness and accuracy of the information provided by the third parties and to confirm that they are not receiving referral fees or other income contrary to Real Estate Settlement Procedures Act prohibitions.
Increased competition, cost pressures, and advancements in technology have resulted in an increase in the use of streamlined appraisal and collateral valuation processes. Given the current underwriting environment, which allows for higher loan to value (LTV), the need for strong collateral valuation policies and procedures is especially important. Policies and procedures should be in compliance with the regulatory agencies’ appraisal regulations3 and Interagency Appraisal Evaluation Guidelines.4
Management should establish collateral valuation methodologies commensurate with the risk profile of both the individual loan and the loan portfolio, ensure that expected collateral values are not communicated to the appraiser, and require sufficient documentation to support a collateral value. If several different valuation tools are used for the same property, management should establish a policy for selecting the most reliable method, rather than the highest value.
When automated valuation models (AVMs) are used to support evaluations or appraisals, management should have a clear understanding of how the model works and periodically validate any uncertainty in the models. The validation’s analysis, assumptions and conclusions should be adequately documented. The validation process should also include back-testing of a representative sample of the valuations against market data of actual sales, when sufficient information is available.
Finally, when tax assessment valuations are used as a basis for the model, the financial institution should validate the correlation between the taxing authority’s value and the market value of the collateral.
Account and Portfolio Management
Account management activities should be tailored to the size and risk level of the loans. Because of the nature of some home equity products, such as interest-only and no or low documentation loans, as well as the long-term nature of some loans, management should employ risk management practices to identify high risk accounts and to monitor any change in these accounts. The frequency of these actions should be in line with the risk in the institution’s portfolio. Some of the characteristics of effective account management include the following:
Robust portfolio management practices are necessary to monitor the risk in a home equity lending portfolio. First, management must clearly communicate the loan portfolio objectives, including growth targets, utilization, rate of return hurdles, default and loss expectations and concentration limits. Management should then measure against these expectations by establishing effective management information systems (MIS) to segment the portfolio and assess key risks.
Effective MIS also includes monitoring for policy and underwriting exceptions and high LTV transactions. All high LTV transactions should be tracked, and aggregate amounts should be reported to the board of directors. There should also be adequate controls in place to manage any high LTV lending.
Ongoing monitoring will enhance overall portfolio management and enable risk mitigation. Based on the results of monitoring, effective risk mitigation techniques could include private mortgage insurance, pool insurance, and securitizations. Finally, interest rate sensitivity testing of a portfolio should also be an important consideration.
Operations and Servicing
Strong processes should also be established for important back-office support functions such as lien perfection and documentation, property tax payments, and loan collections. Credit risk management practices must be in place for these support functions to effectively manage operational risks. Management should have policies and procedures in place to govern problem loan workouts and loss mitigation strategies. However, management should exercise caution to ensure that loss mitigation strategies are not used to defer losses.
Home equity lending is not only an attractive product for consumers, it can also be a profitable business for banks if the risks are managed effectively. If you have any questions about the home equity lending guidance, please contact your institution’s central point of contact or assigned manager at the Reserve Bank. You may also contact Stephen Harter at (215) 574-4385.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.