On June 30, 2014, the federal financial institution regulatory agencies1 (the Agencies) published Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of Draw Period (the Guidance), which, as the title suggests, addresses the steps that financial institutions should take, from a risk-management perspective, in order to prepare for and properly handle the upcoming expiration of the draw period for the majority of home equity lines of credit (HELOCs).
Nearly ten years ago, at the height of the mortgage boom, financial institutions began to greatly accelerate the origination of HELOCs. In fact, 58 percent of all currently-outstanding HELOCs were originated between 2004 and 2007. HELOCs typically provide for: (1) a ten-year draw period during which the borrower may draw upon a revolving line of credit and will make interest-only payments; and (2) a repayment period, during which the borrower can no longer draw upon the credit line and the principal becomes due – either as a balloon payment or as a higher monthly payment over the remaining term of the loan.
As the end of the ten-year draw period for the majority of HELOCs approaches (i.e., 2014-2017), the Agencies are concerned that borrowers will face potential issues of: (1) rising interest rates, because most HELOCs are adjustable-rate and interest rates have been very low; (2) payment shock, because HELOC payments will move from interest-only to fully-amortizing; and (3) refinancing issues, because collateral values have declined significantly since such HELOCs were originated. To help financial institutions efficiently address these issues, the Agencies have released the Guidance.
Consistent with the Guidance, as the expiration of HELOC draw periods approaches, financial institutions should communicate clearly and effectively with borrowers and prudently manage exposures in a disciplined manner. Specifically, the Guidance provides five risk management principles that should be incorporated into financial institutions’ end-of-draw risk-management programs and which will be reviewed by examiners as part of the supervisory process. The five principles are:
- prudent underwriting for renewals, extensions, and rewrites
- compliance with pertinent existing guidance with regard to HELOCs
- use of well-structured and sustainable modification terms
- appropriate accounting, reporting, and disclosure of troubled debt restructurings, and
- appropriate segmentation and analysis of end-of-draw exposure in allowance for loan and lease losses (ALLL) estimation processes.
The Guidance goes on to describe certain risk-management expectations that a prudent financial institution should include in its policies and procedures for treatment of HELOCs nearing their end-of-draw periods that are proportionate with the size and complexity of the institution’s loan portfolio. These expectations include:
- developing a clear picture of scheduled end-of-draw period exposures
- ensuring a full understanding of end-of-draw contract provisions
- evaluating near-term risks
- contacting borrowers through outreach programs
- ensuring that refinancing, renewal, workout, and modification programs are consistent with regulatory guidance and expectations, including consumer protection laws and regulations
- establishing clear internal guidelines, criteria, and processes for end-of-draw actions and alternatives
- providing practical information to higher-risk borrowers
- establishing end-of-draw reporting that tracks actions taken and subsequent performance
- documenting the link between ALLL methodologies and end-of-draw performance, and
- ensuring that control systems provide adequate scope and coverage of the full end-of-draw period exposure.
Finally, the Guidance distinguishes between what is expected from a financial institution with a significant volume of HELOCs and higher-risk characteristics (i.e., comprehensive systems and procedures to monitor and assess their portfolios) and community banks/credit unions with smaller HELOC portfolios and lower-risk characteristics (i.e., may be able to use existing, less-sophisticated processes).
- The Guidance is a further example of regulators’ renewed focus on mortgage banking, as predicted earlier this year when the Office of the Comptroller of the Currency published a comprehensive update to the Mortgage Banking component of the Comptroller’s Handbook.
- Financial institutions should ensure that they incorporate the five end-of-draw HELOC risk-management principles, outlined above, when implementing their policies and procedures, especially considering that regulators will be taking such principles into account during supervisory examinations.