Banking

A Closer Look at HELOCs
Since the financial crisis began, all types of real estate loans on the books of Sixth District banks have been high on the Atlanta Fed's list of supervisory priorities. Even as employment and the economy show signs of strength, continued declines in home prices in most Sixth District markets are creating more properties with values less than the debt owed. This situation is variously called "negative equity," "underwater" or "upside down."

By whatever name, the prospect of continued declines in home values, combined with meaningful exposures by some Sixth District banks, may put more pressure on institutions' home equity loan portfolios, which usually consist of junior mortgage liens. (For the purposes of this article, the term "home equity loans" includes both closed-end junior liens and the more prevalent junior lien loans structured as an open end line of credit, often called HELOCs.) Moreover, the potential use of "strategic default" by savvy borrowers means that bankers need to monitor these portfolios carefully and continuously and establish sufficient reserves to cover potential losses.

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Strategic default
Several studies have shown that one of the differences between this recession and prior ones is that homeowners often default on their mortgage obligations "strategically." In short, "strategic default" occurs when the most important factor in a borrower's default decision is not whether the borrower can afford to continue to pay that mortgage—although that factor is usually also present—but whether the value of the borrower's home is less than the mortgage obligation. As District housing markets continue to struggle, more homeowners are finding themselves in a negative equity position.

In days prior to the financial crisis, one reason the first mortgage on a primary residence was considered a relatively safe bet for a lender was that it was usually the first bill the borrower paid each month. As housing values have fallen in the last several years, this time-honored tradition seems have changed for a number of borrowers. A December 2010 working paper—"Strategic Default on First and Second Mortgages During the Financial Crisis" by Jalapa Jagtiani and William W. Lang and published by the Philadelphia Fed—looked at default behavior on first- and second-lien single-family mortgages using data from a national credit bureau and reached a number of conclusions about recent mortgage borrower behaviors that are of interest to mortgage lenders and bank regulators alike. For instance, the study found that home equity loans, particularly those structured as HELOCs, were creating the ability for borrowers to default strategically on their first- and second-mortgage loans:

"As with prior research, we find that people default strategically as their home value falls below the mortgage value... While some of these homeowners default on both first mortgages and second lien home equity lines, a large portion of the delinquent borrowers have kept their second lien current during the recent financial crisis."

The study's main findings were the following:

1. Beginning in 2008, the rate of first-lien defaults began to exceed second-lien defaults, which contradicts long-held market views about the relative risk in first and second lien loans
2. Second liens, which are current but stand behind a seriously delinquent first mortgage, are subject to a high risk of default
3. About 20 percent of borrowers in the process of foreclosure due to defaults on the first mortgage actually kept their second-lien mortgage current
4. A substantial number (20–30 percent) of HELOC borrowers continue to draw on their lines after having defaulted on their first mortgage
5. Negative equity has been the primary reason for homeowners to default on their mortgages overall

In other words, the fact that a home equity loan is current may not necessarily indicate that the loan is a good loan. The lender needs to know the true condition of the borrower, including the payment status of the first mortgage and whether the borrower is under water.

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Negative equity
A March 2012 report from CoreLogic, a data and analytics company, showed that 11.1 million residential properties nationwide, or 22.8 percent, with a mortgage were in a negative equity position at the end of the fourth quarter of 2011, up from 10.7 million properties and 22.1 percent in the third quarter of 2011. After declining somewhat in 2010, the number and percent of all loans under water has returned to about the same level as November 2009, when the company began reporting these numbers. (CoreLogic also includes properties with values up to 5 percent higher than the loan balance as "near negative equity.")

The two states with the highest percentage of underwater mortgages nationally were Nevada and Arizona, while the Sixth District states of Florida and Georgia ranked third and fourth. Since November 2009 the percentage of underwater loans in Georgia and Tennessee has increased. The percentage of underwater properties in Florida, while still twice the national average, has actually declined very slightly (see chart 1).

The Core Logic report also highlighted the significant difference between properties encumbered by only a first lien and properties that had both a first and second lien. Eighteen percent of properties with a first mortgage only were under water, while properties with both a first and second lien, at 39 percent, were almost twice as likely to be under water.

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Sixth District bank home equity loan portfolios
Home equity lending, especially HELOCs, have been an important source of loan growth for Sixth District banks since the early 2000s. As chart 2 shows, these loans have been primarily a large-bank product. Although the largest six banks in the District hold almost 80 percent of all home equity loans held on Sixth District bank balance sheets (see chart 2), it is also true that relatively few District banks have no home equity loans. (These percentages represent home equity loans held by banks headquartered in the Sixth District. They are only approximations of the percentage of home equity loans on properties located in the District since some of the larger banks have offices outside the district that likely hold home equity loans on properties outside the District.)

In addition, the largest banks hold proportionately more of their assets and capital in home equity loans than smaller banks.

The median concentration risk exposure of Sixth District banks is not outsized. Looking at the 75th, and 90th percentiles, however, indicates that there are some banks in the Sixth District with meaningful exposures in these loans in banks of all asset sizes (see chart 3).

Having said that, it is hard to make general statements about Sixth district home equity loan portfolios based on high-level analysis alone. In addition to underwriting and product design differences, there are a significant number of loans in some portfolios that are secured by first mortgage liens. That is, even though the loan is made as a HELOC, there are no other outstanding liens. In addition, in the very early years of the crisis, when values began falling, many banks reviewed their portfolios and in many cases reduced commitments to reflect lower values. These portfolios often include many loans that are made for business purposes.

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Today's special factors
The above discussions on negative equity, potential strategic defaults, and meaningful exposures at some banks indicate that risk management around these portfolios is very important. There are two factors that can make monitoring and evaluation of junior lien portfolios challenging in the current environment:

1. The potential for strategic default behavior suggests that portfolio risk managers should seek to know the home equity loan borrower's true financial condition, including the status of the first mortgage, and whether the borrower is under water.
   
   In cases where the home equity lender does not also hold the first mortgage, however, such monitoring can be difficult. Since most home equity loans are relatively small, it can also be expensive. Delays can mean, however, that the lender will not learn the true condition of the borrower until the property is under water and the lender is in a loss position.
   
   
2. Many HELOC loans were made in the 2003–07 period with draws permitted for 10 years, at which time amortization begins or a balloon payment is required. These amortization and balloon payment requirements are beginning to occur but will accelerate significantly by 2014. Without a better economy and rising or at least stable home values, defaults will likely increase since borrowers will be required to make higher payments that include principle.

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Supervisory considerations
Bank regulators in general have become increasingly concerned. On January 31, 2012, the Office of the Comptroller of the Currency issued guidance pertaining to loan and lease loss estimation for some residential properties.

This guidance reiterates the need for strong policies and practices in estimating reserves for junior lien loans. The guidance also discusses portfolio segmentation and analysis, credit quality indicators, qualitative and environmental adjustments, charge-off and nonaccrual policies, and responsibilities of management and examiners.

As a result of reviewing their portfolios under this guidance or otherwise a number of banks have amended their allowance for loan and lease loss (ALLL) policies to place on nonaccrual those home equity loans in a current payment status that are behind delinquent first liens. This action reflects the realities that have been discussed in this article.

The prospect of continued declines in home values and the potential for strategic default behavior on the part of borrowers, combined with meaningful exposures by some Sixth District banks, contributes to increasing concern about the potential pressure on Sixth District home equity loan portfolios in some banks. Atlanta Fed examiners are looking more closely at their case loads at the institutions where they have responsibility and elevating reviews of home equity portfolios with the recent guidance and today's special factors in mind.

This article was written by Bill Chalker, director of examinations in the Atlanta Fed's supervision and regulation division.

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