Is Your Financial Institution Prepared for the Rising Credit Risk of HELOCs?

The Federal Reserve is set to end its downward pressure on interest rates by the end of 2014, coinciding with the end-of-draw period for many HELOC borrowers. It poses what many in the housing and financial industries are labeling a crisis level risk. 

History has shown that rates can change quickly. In fact, the Federal Reserve raised the target federal funds rate from 1% to a high of 5.25% from 2004 to 2007. 

As we know, even small interest rate increments can cause major pain for borrowers. And many HELOC loans are already experiencing credit problems. Delinquency rates rose from 1.69% at the end of 2013, to 1.78% in the first quarter of 2014¹. With the number of HELOC loans practically doubling year-over-year between 2012 and 2018, these delinquency rates are certain to rise.

Between rising interest rates and new payback requirements, there is very real risk that HELOC borrowers will experience financial difficulties, and that those difficulties will impact lenders. To mitigate the risks, financial institutions need to utilize a structured framework for managing their portfolio and customers.

Know Your Portfolio

Lenders must understand the possible exposures and appropriate responses within their portfolio. Timely and accurate portfolio reporting, including performance and composition reports, is critical. Depending on the size and risk characteristics of the portfolio, a HELOC analysis could evaluate:

• Product types
• Contractual draw period transition dates
• Maturity schedules
• Performing and non-performing borrowers
• Delinquencies
• Modification status of associated first liens
• Utilization rates
• Payment characteristics (such as interest-only, balloon payments, amortization periods)
• Expected pay-offs and attrition
• Origination channels (such as retail, broker, correspondent, merger)
• Credit score bands
• Combined loan-to-value ratios 

For high-volume portfolios, HELOCs approaching end-of draw should be segmented within the ALLL estimation process to clarify the nature and magnitude of exposures. Potential HELOC default risks from payment shock, loss of line availability and home value changes also should be considered. 

Know Your Customer

Because the HELOC end-of-draw period increases the chance of payment shock, lenders need to be proactive about knowing their customer, specifically their ability and inclination to repay.

Lenders should reach out to borrowers (especially high-risk borrowers) six to nine months before their scheduled end-of-draw date, and then monitor and follow up with structured messaging and information. Be aware of compliance requirements with consumer protection laws and notification timing. 

In the instance in which a customer is unwilling or unable to repay, the lender is encouraged to work with the borrower to determine sustainable modification terms, avoiding unnecessary payment shock and modifications that do not amortize principal in a timely manner. When modifications² are not in compliance with loan policy, payment arrangements should decrease exposure while keeping payments sustainable. 

End-of-Draw Risk Management Principles

Examiners will review end-of-draw risk management programs for lenders using the following core operating principles:

• Prudent underwriting for renewals, extensions and rewrites
• Compliance with pertinent existing HELOC guidance
• Use of well-structured and sustainable modification terms
• Appropriate accounting, reporting and disclosure of TDRs
• Appropriate segmentation and analysis of end-of-draw exposure in the ALLL estimation process 

These principles govern a financial institution’s oversight of HELOCs and reiterate that lenders must know their portfolios and know their customers. 

What HELOC end-of-draw issues are your customers facing? How have you prepared to navigate the risks associated with this repayment period?

 ¹ American Bankers Association 

² A modification is considered a troubled debt restructuring (TDR) when a lender grants a concession to a borrower that it would not otherwise consider because of the borrower’s financial difficulties.  Since HELOC end-of-draw period renewals and extensions are an increased risk indication of a borrower’s financial distress, these types of modifications should be reviewed for the appropriate identification of TDR and accrual status.