Credit Risk Management Guidance for Home Equity Lending

CUNA Lending Council
August 25, 2005

In response to the exceptionally strong growth in home equity lending over the past few years, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration have issued a white paper entitled “Credit Risk Management Guidance for Home Equity Lending.”

The purpose of the paper is to promote sound risk-management practices at financial institutions with home-equity lending programs, including open-end home equity lines of credit (HELOCs) and closed-end home equity loans (HELs). 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 rise in home values, coupled with low interest rates and favorable tax treatment, have made home equity loans and lines attractive to consumers. To date, delinquency and loss rates for home equity loans and lines have been low, due at least in part to the modest repayment requirements and relaxed structures that are characteristic of much of this lending. The risk factors listed below, combined with an inherent vulnerability to rising interest rates, suggest that financial institutions may not be fully recognizing the risk embedded in these portfolios. Specific product, risk management, and underwriting risk factors and trends that have attracted scrutiny are:

• Interest-only features that require no amortization of principal for a protracted period
• Limited or no documentation of a borrower’s assets, employment, and income
• Higher loan-to-value (LTV) and debt-to-income (DTI) ratios
• Lower credit-risk scores for underwriting home equity loans
• Greater use of automated valuation models and other collateral evaluation tools for the development of appraisals and evaluations
• An increase in the number of transactions generated through a loan broker or other third party

Like most other lending, home-equity lending can be conducted in a safe and sound manner if pursued with the appropriate risk-management structure, including adequate allowances for loan and lease losses and appropriate capital levels. Sound practices call for fully articulated policies that address marketing, underwriting standards, collateral valuation management, individual account and portfolio management, and servicing.

Financial institutions should ensure that risk-management practices 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.

This paper describes sound credit-risk management systems for product development and marketing, origination and underwriting, third-party originations, collateral valuation management, account management, portfolio management, operations, servicing, collections, secondary market activities, and portfolio classifications.

This most recent white paper can be found at http://www.cunalendingcouncil.org/tools/research.html.