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Home Equity Lending: A HELOC Hangover Helper*
by Michael Webb, Managing Examiner, Federal Reserve Bank of Richmond

I recall many years ago when my Aunt Marie took my brother and me on an all-day shopping spree. I had noticed her buying various items that day with a plastic card, and being a curious six-year-old, I asked her about it. I distinctly recall her sitting back in her chair, eyeing us in a cagey manner, and replying, "Don’t you worry about that, honey. Buying on credit is a whole lot of fun, but you get one doozy of a hangover later on."

For many in the banking industry, the wreckage of the 2007 financial crisis is still painfully recent. One can wonder whether Aunt Marie’s analogy can apply not just to borrowers but to those who extend credit as well. Few community banks outside of the nation’s heartland completely escaped the acute pain of unplanned provisions for credit losses and large credit charge-offs. The conventional view is that most of the loss is currently behind us, but the pain of the credit boom may still linger, at least for certain loan products. Some national data seem to suggest that home equity lines of credit (HELOCs) may still pose significant credit risk to the banking system; therefore, community banks that are involved in HELOC lending should be mindful of their potential risks.

Yet Another "Perfect Storm" Clichè

The banking industry continues to face strong headwinds, including a high unemployment rate, slow growth in consumer lending, and residential real estate values that are at off-peak levels in certain regions. In the past, most banks fared reasonably well when making interest-only HELOCs with a seven- to 10-year duration. These loans were commonly underwritten in the industry, as many investors assumed that property values would appreciate substantially over the course of a decade and that consumer wage levels would increase in response to steady economic growth and normal inflationary pressures. But those traditional assumptions have proved questionable with the numerous economic and demographic challenges in the recent past.

Although interest rates are at historical lows today and may remain so for some time, we can expect that this low-rate environment will not last forever. Community banks involved in HELOC lending activity should ask themselves a critical question: Will most borrowers be able to amortize their HELOC obligations in an environment of even moderately higher interest rates, let alone more normalized interest rates? Consider a hypothetical HELOC relationship with a standard 10-year, interest-only period followed by 10 years on amortizing terms. Assuming an interest rate of 4 percent and a funded balance of $100,000 without fluctuations in draws or pay downs, the monthly debt service requirement is roughly $333. Assuming the loan resets to amortizing status at 7 percent for the latter 10 years, the monthly debt service requirement more than triples to $1,161. Banks need to consider this factor at initial underwriting and implement procedures to measure, monitor, and control the risks associated with portfolio resets if conversion to amortizing status was not considered at origination.

Other trends may not be as apparent but may nevertheless have particular implications for HELOC lending. The potential loss given default (essentially, the percentage of an exposure that a bank is likely to lose if a borrower defaults) inherent in certain HELOC loans and any other residential products in a junior-lien position can be substantial in an environment of lower property values. Depending on the originating loan-to-value ratio, losses can approach 100 percent for second-lien HELOCs, especially for those loans that were underwritten during periods when market values were particularly "frothy," such as during the real estate boom leading up to the financial crisis. Exercising rights and remedies can also be logistically more problematic when the lender is in a second-lien position.

In the past year or two, regulators and others have renewed their focus on analyzing national HELOC data, and two observations from the data have raised concerns. First, a research study conducted by the Federal Reserve Bank of Richmond in 2012 indicated that a large volume of HELOC products were underwritten without factoring in the borrower’s ability to amortize the obligation. Second, a large portion of outstanding HELOC loans are vintage 2004 to 2008 originations — that is, loans made at the height of the real estate boom. Federal Reserve staff estimates indicate that just under 60 percent of outstanding HELOC balances nationally will reach the end of their draw period between 2014 and 2017. While HELOCs in this group are made up of numerous payment structures, seven- and 10-year interest-only terms with balloon payments are fairly common in the industry.

Another potential area of concern is the rise in strategic defaults in recent years. A fair portion of future consumer default risk to banks is likely to be caused by potentially distressed borrowers forced to choose among multiple creditors. Traditionally, distressed consumers opted to make their monthly mortgage payment before servicing other types of consumer installment debt. With many mortgages still underwater and the backlog of national foreclosures, many distressed consumers are now upending traditional payment hierarchies by meeting automobile loan and credit card obligations while allowing first mortgages to go delinquent.¹ Much of this can be ascribed to consumers electing to service debts most closely tied to immediate household funding needs and day-to-day expenses. In the current environment, consumers also have a strong incentive to keep available credit lines on HELOCs open by maintaining current payment status. As a result of this dynamic, current payment status on a HELOC loan does not necessarily imply that the borrower is current on his primary mortgage; the bank may not recapture unpaid principal on the HELOC in a foreclosure if the outstanding principal on the primary mortgage exceeds the value of the collateral. Community banks need to be aware of this dynamic, and monitoring the payment status on a borrower’s first-lien position is, therefore, a critical component to strong HELOC risk management.

So, to summarize the "perfect storm" perspective, a large volume of potentially unsecured loans with uncertainty regarding the borrowers’ ability to amortize the loans are to reset at potentially higher interest rates in the near term. Several events may help to reduce the fallout. Possible mitigants could include, for example, a wave of debt consolidation or refinancing over the next few years or interest rates staying low for an extended period. With luck, much of this concern will be alleviated. The key takeaway from this article is that community banks need to understand the risks in their HELOC portfolios and, if necessary, take early action to manage those risks.

Now that we have identified some of the key risks in HELOC loans, the second article in this series will discuss internal controls, management information systems, policies and procedures, board reporting, and risk mitigation strategies.