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National Banking Trends
A Closer Look at HELOCs
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.
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:
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.
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.
Sixth District bank home equity loan portfolios
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.
Today's special factors
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.