Comptroller of the Currency, John C. Dugan, recently addressed significant problems banks were encountering with home equity loans and lines of credit.
Mr. Dugan indicated that the accelerating losses in this sector showed banks need to build reserves and return to stronger underwriting.
Mr. Dugan noted that home equity loans and lines of credit more than doubled sinc 2002, to $1.1 trillion. The increase was, at least In part, because of rapid appreciation in home prices, tax deductibility, and low interest rates. But the increase also came, he said, from weak underwriting.
The consequences, Mr. Dugan noted, were that house price declines beginning in 2007 have caused unprecedented losses. Losses have traditionally run at about 20 basis points (2/10 of 1 percent). In 4th quarter 2007, however, losses were at nearly 1 percent. In 1st quarter 2008, losses were at 1.73 percent.
In perspective, losses were still far lower than other types of retail credit, such as credit cards. But prompt and determined action are necessary, including building sufficient reserves and strengthening underwriting.
Among the practices that need particular scrutiny, Mr. Dugan highlighted:
- The use of home equity lines to finance down payments.
- The appropriate use of collateral valuation tools, such as asset valuation models, which the Comptroller said must be closely managed, periodically validated, and supported with sound business rules.
- Income documentation. Although the overt use of stated income has been largely abandoned, some lenders now ask for income information and authorization to verify it, but do not follow through. “This practice is only marginally better than expressly relying on stated income, since it is questionable whether the borrower’s belief that income will actually be verified will really induce a higher level of honesty in providing information,” Mr. Dugan said. “We need to think carefully about whether anything short of actual verification of income is acceptable from a safety and soundness perspective for most borrowers.”
- The extended interest-only structure that home equity credit lines have in the early years of the loan term. Payment patterns can only be a proxy for a borrower’s capacity to handle a given debt level if he or she is asked to make payments that are meaningful. “Interest-only payments reflect a borrower’s capacity to pay interest on a debt, but not the debt itself,” Mr. Dugan said. “Further, this lack of structured payment discipline encourages borrowers to assume greater levels of debt, often to the limit of their ability to make minimum monthly payments. In contrast, higher payments that reduce principal address both these concerns.”
For a copy of Mr. Dugan’s prepared remarks, click here.
For a copy of the OCC’s press release, click here.
Tags: Home Equity Lines of Credit/HELOCs, Home Equity Loans, Loss Reserves, OCC, Regulations by the Editor
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