Federal Regulatory Update

Federal Regulatory Update

The Federal Financial Institutions Regulatory Agencies (the “Agencies”) and the Conference of State Bank Supervisors (“CSBS”) on July 1, 2014 issued the Interagency Guidance on Home Equity Lines of Credit Nearing End-of-Draw Periods (the “Guidance”).

 

OCC BULLETIN 2014-29: INTERAGENCY GUIDANCE ON HOME EQUITY LINES OF CREDIT NEARING END-OF-DRAW PERIODS

 

The Agencies in conjunction with the CSBS recognize that financial institutions and residential mortgage borrowers may face challenges as home equity lines of credit (“HELOCs”) near their end-of-draw periods.  As HELOCs transition from their draw periods to full repayment, many borrowers will have the financial capacity to pay as agreed.  Some borrowers, however, may have difficulty meeting higher payments resulting from principal amortization or interest rate reset, or renewing existing loans due to changes in their financial circumstances or declines in property values.

 

When borrowers experience financial difficulties, financial institutions and borrowers generally find it beneficial to work together to avoid unnecessary defaults.  As HELOC draw periods approach expiration, lenders should communicate clearly and effectively with borrowers and prudently manage exposures in a disciplined manner.

 

The Guidance describes core operating principles that should govern management’s oversight of HELOCs nearing their end-of-draw periods.  The guidance also describes components of a risk management approach that promotes an understanding of potential exposures and consistent, effective responses to HELOC borrowers who may be unable to meet contractual obligations.  Additionally, the Guidance highlights concepts related to financial reporting for HELOCs.  The HELOC end-of-draw guidance should be applied in a manner commensurate with the size and risk characteristics of a financial institution’s HELOC portfolio.

 

Background

 

A HELOC is a dwelling-secured line of credit that generally provides a draw period followed by a repayment period.  During the draw period, a borrower has revolving access to unused amounts under a specified line of credit.  This line of credit often requires interest-only payments.  During the repayment period, borrowers can no longer draw on the line of credit, and the outstanding principal is either due immediately in a balloon payment or is repaid over the remaining loan term through higher monthly payments, resulting in payment shock.

 

General supervisory expectations for appropriate HELOC underwriting, account management, accounting and reporting, and loss mitigation activities are addressed in publications that cover the following topics:

  • Credit Risk Management Guidance for Home Equity Lending
  • Uniform Retail Credit Classification and Account Management Policy
  • Interagency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings
  • Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties (“Interagency Junior Lien Allowance Guidance”)
  • Glossary Entries for Loan Impairment and Troubled Debt Restructurings (“TDR”) in the Instructions for the Consolidated Reports of Condition and Income (“Call Reports”)
  • Real Estate Lending Standards Regulations and the Interagency Guidelines for Real Estate Lending Policies

 

End-of-Draw Risk Management Principles

 

As part of the supervisory process, examiners will review financial institutions’ end-of-draw risk management programs for provisions that address 5 risk management principles:

  • Prudent underwriting for renewals, extensions, and rewrites.  Management should apply prudent underwriting and loss mitigation strategies whenever existing loans for borrowers nearing the end of their contractual period are modified.  Prior to extending draw periods, modifying notes, and establishing amortization terms for existing balances, lenders should conduct a thorough evaluation of the borrower’s willingness and ability to repay the loan.
  • Compliance with pertinent existing guidance, including but not limited to the Credit Risk Management Guidance for Home Equity Lending and Interagency Guidelines for Real Estate Lending Policies.  Management’s criteria for HELOC underwriting and credit analysis should be consistent with regulatory guidance for prudent real estate lending.  A financial institution’s underwriting criteria should include debt service capacity standards, creditworthiness standards, equity and collateral requirements, maximum loan amounts, maturities, and amortization terms. Management also should establish review and approval procedures for policy exceptions and require ongoing timely and accurate portfolio reporting, including performance and composition reports.
  • Use of well-structured and sustainable modification terms.  For those borrowers who may be experiencing financial difficulties, management should participate in or establish workout and modification programs where feasible.  Terms of such programs should be consistent with the nature of the borrower’s hardship, have sustainable payment requirements, and promote orderly, systematic repayment of amounts owed. Restructuring to an interest-only or balloon loan is generally inappropriate for higher-risk borrowers, as these types of loans do not directly address repayment issues.  Where modifications are out of compliance with a financial institution’s current underwriting criteria, for example, when combined loan-to-value ratios (“CLTV”) exceed a financial institution’s established guidelines, payment arrangements should bring exposures into compliance in a structured and orderly manner while keeping payments sustainable.
  • Appropriate accounting, reporting, and disclosure of troubled debt restructurings (“TDRs”).  Management should review end-of-draw modifications for appropriate identification of TDRs and accrual status.  TDR treatment is appropriate when a lender grants a concession to a borrower that it would not otherwise consider because of the borrower’s financial difficulties.  Financial difficulties can include the probable inability of a borrower to meet the loan terms, assuming no modification takes place when the borrower is facing a scheduled balloon payment at maturity or the payment shock associated with a contractual increase in the monthly payments.
  • Appropriate segmentation and analysis of end-of-draw exposure in allowance for loan and lease losses (“ALLL”) estimation processes.  Estimates of the ALLL, including TDR impairment estimates, should consider the impact of payment shock and loss of line availability associated with the end-of-draw period.  In accordance with the “Interagency Junior Lien Allowance Guidance,” HELOCs approaching their end-of-draw periods should, when volumes warrant, generally be a separate portfolio segment in the ALLL estimation process.  Before significant HELOC volumes reach their end-of-draw periods, management should be capturing information and preparing analyses that clarify the nature and magnitude of exposures.

 

End-of-Draw Management Expectations

 

Management should implement policies and procedures for managing HELOCs nearing their end-of-draw periods that correspond to the size and complexity of the portfolio.  Prudent riskmanagement expectations generally include:

·        Developing a clear picture of scheduled end-of-draw period exposures. Management reports should provide a clear understanding of end-of-draw exposures and identify higher-risk segments of the portfolio.  Management reports should also identify contractual draw period transition dates for all HELOCs, showing maturity schedules in the aggregate and by significant segments of performing and non-performing borrowers (including distinguishing between performing borrowers that are higher risk and those that are not).  Segments typically include product types, post-draw payment characteristics (such as interest-only payments, balloon payments, and amortization periods), origination channels (such as retail, broker, correspondent, and mergers), or borrower characteristics (such as credit score bands and utilization rates) where performance may vary.  Refer to the Interagency Junior Lien Allowance Guidance for further information on account and portfolio management.  Additional analyses that include expected payoffs, attrition, utilization rates, delinquency, or modification status of associated first liens, or other factors that might change risk levels before contractual end-of-draw periods may also be helpful to assess risk.  For example, pre-end-of-draw payment history for a borrower may indicate that contractual payment shock will have a limited effect on that borrower if the payments made have consistently exceeded the minimum amount due.

·        Ensuring a full understanding of end-of-draw contract provisions.  Transition issues such as payment changes, interest rate options, amortization terms, lockout and debt consolidation options, and payment processing should be controlled and programmed correctly into servicing systems.  This task can be challenging when existing portfolios are the result of numerous mergers, acquisitions, or origination channel over the years.  This exercise often includes a detailed inventory of contracts and contract provisions to ensure management understands all parties’ rights and obligations.  Institutions should monitor options available to lenders and borrowers such as draw period extensions or interest rate locks, and institutions should be aware of the timing of any required notifications to borrowers.

·        Evaluating near-term risks.  Some HELOCs approaching the end of their periods may already have line availability suspended due to collateral value declines or borrower repayment performance problems.  These accounts warrant attention and may require workout arrangements or modifications if not already addressed. Management should also evaluate borrowers making only the contractual minimum interest-only payments to consider whether those borrowers will meet current underwriting standards or qualify for renewal or rewrite programs.

·        Contacting borrowers through outreach programs.  Management should begin reaching out to borrowers well before their scheduled end-of-draw dates to establish contact, engage in periodic follow-up with borrowers, and respond effectively to issues.  Lenders often find that successful outreach efforts start at least 6 to 9 months or more before the end-of-draw dates, with simple, direct messaging.  Many successful programs have required several attempts to contact borrowers to achieve the most effective timing and messaging.

·        Ensuring that refinancing, renewal, workout, and modification programs are consistent with regulatory guidance and expectations, including consumer protection laws and regulations.  Financial institutions are encouraged to work prudently with higher-risk borrowers to avoid unnecessary defaults.  Well-designed and consistently applied workout and modification programs can minimize losses and help borrowers resume structured, orderly repayment.  Such programs should include payment terms that, in conjunction with of all of the borrower’s other obligations, are sustainable and promote the orderly and systematic repayment of principal. Management should structure end-of-draw period renewal, workout, and modification programs to:

o       Base eligibility and payment terms on a thorough analysis of a borrower’s financial condition and reasonable ability to repay.

o       Provide payment terms that are sustainable and avoid unnecessary payment shock.

o       Avoid modifications that do not amortize principal in an orderly and timely fashion.

 

Prudent refinancing, renewal, workout, and modification programs are generally in the long-term best interest of both the financial institution and the borrower. Financial institutions must ensure regulatory reports and financial statements are prepared in accordance with generally accepted accounting principles and regulatory reporting instructions.  Reporting should fairly present a financial institution’s condition and performance, including an appropriate ALLL for HELOC exposures and appropriate accounting and disclosure for TDR loans.

 

Financial institutions must also comply with the applicable consumer protection laws, which include, but are not limited to, the Equal Credit Opportunity Act, the Fair Housing Act, federal and state prohibitions against unfair or deceptive acts or practices (such as section 5 of the Federal Trade Commission Act), the Real Estate Settlement Procedures Act, the Servicemembers Civil Relief Act, and the Truth-in-Lending Act (“TILA”), and the regulations issued pursuant to those laws.  For example, TILA limits the circumstances under which a lender may prohibit additional extensions of credit or reduce the credit limit applicable to HELOCs and set forth related requirements for notice to affected borrowers.

·        Establishing clear internal guidelines, criteria, and processes for end-of-draw actions and alternatives (renewals, extensions, and modifications).  Even financial institutions with moderate volumes of HELOCs nearing their end-of-draw periods should direct borrowers to trained customer account representatives familiar with the characteristics of the products, the borrower and property information needed, and the range of alternatives available.  Refinance options should designate targeted products, terms, and qualification standards, with exception processes and limits clearly noted. Management should establish requirements, and the order of modification steps, so that well-trained account representatives can quickly and efficiently process requests.

·        Providing practical information to higher-risk borrowers.  Financial institutions that offer loan modifications or other options to borrowers having financial difficulties should provide practical information that explains the basic options available, general eligibility criteria, and the process for requesting a modification.  Such information should be clear and easily accessible to borrowers and should include information on how to contact the lender or servicer to discuss programs that might best fit the individual borrower’s specific needs.

·        Establishing end-of-draw reporting that tracks actions taken and subsequent performance.  Management should structure and distribute end-of-draw period reports to all involved personnel to understand and respond to exposures, activity, and performance results.  Reporting should track end-of-draw period actions and subsequent account performance in the aggregate and separately by response type.  Response types should include transition according to contract, short-term extensions, temporary modifications, permanent modifications, and renewals into new draw periods or longer-term amortization.  Reporting should be frequent and contain a sufficient amount of detailed information to provide timely feedback to management, including exceptions to thresholds or guidelines that prompt additional analysis or actions.

·        Documenting the link between ALLL methodologies and end-of-draw performance.  ALLL methodologies should consider potential HELOC default risk from payment shock, loss of line availability, and home value changes.  Higher-risk borrowers whose HELOCs are nearing their end-of-draw periods generally pose greater repayment risk for ALLL purposes, and management should monitor them separately for appropriate consideration in the ALLL estimation process.

·        Ensuring that control systems provide adequate scope and coverage of the full end-of-draw period exposure.  Commensurate with the volume of the financial institution’s HELOC exposure, management should have quality assurance, internal audit, and operational risk management functions perform appropriate targeted testing of the full process for managing the end-of-draw transactions.  Even when an institution outsources all or a portion of the HELOC-management, the financial institution remains responsible for ensuring that the service provider complies with applicable laws, regulations, and supervisory guidance.  Testing should confirm that:

o       Draw terms and interest-only periods are not extended without credit approval.

o       Servicing systems accurately consolidate balances, calculate required payments, and process billing statements for the full range of potential HELOC repayment terms that exist once draw periods end.

o       Staffing and resources can efficiently handle expected volumes and the breadth and scope of program activities.

o       Borrower notifications of upcoming draw period expirations are timely and made in accordance with contractual terms and management guidelines.

o       Reports provide reliable and timely information that enables management to monitor and evaluate end-of-draw activities.

 

Financial institutions with a significant volume of HELOCs, portfolio acquisitions, or exposures with higher-risk characteristics generally should have comprehensive systems and procedures to monitor and assess their portfolios.  Community banks and credit unions with small portfolios of HELOCs, few portfolio acquisitions, or exposures with lower-risk characteristics may be able to use existing less-sophisticated processes.