View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal Reserve Bank of Dallas
2200 N. PEARL ST.
DALLAS, TX 75201-2272

June 14, 2005

Notice 05-30
TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District

SUBJECT
Interagency Credit Risk Management Guidance
for Home Equity Lending
DETAILS
The Federal Reserve and the other federal financial institutions regulatory agencies have
issued an interagency guidance to promote sound risk management practices at financial
institutions with home equity lending programs. This guidance is intended to highlight the sound
risk management practices that an institution should follow to keep pace with the growth and risk
in its home equity portfolio.
ATTACHMENTS
A copy of the Board’s SR letter 05-11 and the interagency guidance are attached.
MORE INFORMATION
For more information, please contact Bobby Coberly, (214) 922-6209, or Randy Steinley,
(713) 483-3117. Paper copies of this notice or previous Federal Reserve Bank notices can be
printed from our web site at www.dallasfed.org/banking/notices/index.html.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

BOARD OF GOVERNORS
OF THE

FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551

DIVISION OF BANKING
SUPERVISION AND
REGULATION

SR 05-11
May 16, 2005
TO THE OFFICER IN CHARGE OF SUPERVISION AND
APPROPRIATE SUPERVISORY AND EXAMINATION STAFF
AT EACH FEDERAL RESERVE BANK AND BANKING
ORGANIZATIONS SUPERVISED BY THE FEDERAL
RESERVE
SUBJECT: Interagency Credit Risk Management Guidance for Home Equity Lending
The Federal Reserve and the other federal financial institutions regulatory
agencies have issued the attached interagency guidance to promote sound risk management
practices at financial institutions with home equity lending programs. While delinquency and
loss rates for home equity loans and lines have historically been low, the agencies have
observed a rapid growth in home equity lending activity, involving products with higher
embedded risk. At the same time, the agencies have noted an easing of underwriting
standards. This guidance is intended to highlight the sound risk management practices that
an institution should follow to keep pace with the growth and risk in its home equity portfolio.
Further, this guidance should be considered in the context of existing regulations and
guidelines that are listed as cross references at the end of this letter.
Federal Reserve Banks are asked to distribute this letter and the interagency
guidance to banking organizations supervised by the Federal Reserve, as well as to their
supervisory and examination staff. If you have any questions concerning this guidance,
please contact Sabeth Siddique, Manager, Credit Risk Section, at (202) 452-3861 or
Virginia Gibbs, Senior Supervisory Financial Analyst, at (202) 452-2521.
Richard Spillenkothen
Director

Attachment:
Cross References:

1 of 2

Credit Risk Management Guidance for Home Equity Lending
Real Estate lending Standards Regulation and Interagency

Guidelines for Real Estate Lending Policies (12 CFR 208.51 and
Appendix)
Interagency Guidance on High Loan-to-Value Residential Real
Estate Lending (SR letter 99-26)
Regulation Z – Truth in Lending (12 CFR 226)
Interagency Guidelines Establishing Standards for Safety and
Soundness (12 CFR 208, Appendix D-1)
Appraisal Regulations (12 CFR 208 subpart E and 12 CFR 225
subpart G)
Interagency Appraisal and Evaluation Guidelines (SR letter 94-55)
Risk-Based Capital Guidelines (12 CFR 208, Appendix A,III.D.4.
and 12 CFR 225, Appendix A,III.D.4.)
Interagency Questions and Answers on Capital Treatment of
Recourse, Direct Credit Substitutes, and Residual Interests in
Asset Securitizations (SR letter 02-16)
Interagency Expanded Guidance for Subprime Lending Programs
(SR letter 01-4)
FFIEC Uniform Retail Credit Classification and Account
Management Policy (SR letter 00-8)
Risk Management and Capital Adequacy of Exposures Arising
from Secondary Market Credit Activities (SR letter 97-21)

2 of 2

Office of the Comptroller of the Currency
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Office of Thrift Supervision
National Credit Union Administration
CREDIT RISK MANAGEMENT GUIDANCE FOR HOME EQUITY LENDING

Purpose
In response to the exceptionally strong growth in home equity lending over the past few years,
the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve
System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the
National Credit Union Administration (collectively, the agencies) are issuing this guidance to
promote sound risk management practices at financial institutions with home equity lending
programs, including open-end home equity lines of credit (HELOCs) and closed-end home
equity loans (HELs). The agencies have found that, in many cases, institutions’ credit risk
management practices for home equity lending have not kept pace with the product’s rapid
growth and easing of underwriting standards.
Overview
The rise in home values coupled with low interest rates and favorable tax treatment has made
home equity loans and lines attractive to consumers. To date, delinquency and loss rates for
home equity loans and lines have been low, due at least in part to the modest repayment
requirements and relaxed structures that are characteristic of much of this lending. The risk
factors listed below, combined with an inherent vulnerability to rising interest rates, suggest that
financial institutions may not be fully recognizing the risk embedded in these portfolios.
Specific product, risk management, and underwriting risk factors and trends that have attracted
scrutiny are:
•
•
•
•
•
•

Interest-only features that require no amortization of principal for a protracted period;
Limited or no documentation of a borrower’s assets, employment, and income (known as
“low doc” or “no doc” lending);
Higher loan-to-value (LTV) and debt-to-income (DTI) ratios;
Lower credit risk scores for underwriting home equity loans;
Greater use of automated valuation models (AVMs) and other collateral evaluation tools
for the development of appraisals and evaluations; and
An increase in the number of transactions generated through a loan broker or other third
party.

Like most other lending, home equity lending can be conducted in a safe and sound manner if
pursued with the appropriate risk management structure, including adequate allowances for loan
and lease losses and appropriate capital levels. Sound practices call for fully articulated policies
1
5/16/2005

that address marketing, underwriting standards, collateral valuation management, individual
account and portfolio management, and servicing.
Financial institutions should ensure that risk management practices keep pace with the growth
and changing risk profile of home equity portfolios. Management should actively assess a
portfolio’s vulnerability to changes in consumers’ ability to pay and the potential for declines in
home values. Active portfolio management is especially important for financial institutions that
project or have already experienced significant growth or concentrations, particularly in higher
risk products such as high-LTV, “low doc” or “no doc,” interest-only, or third-party generated
loans. This guidance describes sound credit risk management systems for:
•
•
•
•
•
•
•
•
•

Product Development and Marketing
Origination and Underwriting
Third-Party Originations
Collateral Valuation Management
Account Management
Portfolio Management
Operations, Servicing, and Collections
Secondary Market Activities
Portfolio Classifications, Allowance for Loan and Lease Losses (ALLL), and Capital

CREDIT RISK MANAGEMENT SYSTEMS
Product Development and Marketing
In the development of any new product offering, product change, or marketing initiative,
management should have a review and approval process that is sufficiently broad to ensure
compliance with the institution’s internal policies and applicable laws and regulations 1 and to
evaluate the credit, interest rate, operational, compliance, reputation, and legal risks. In
particular, risk management personnel should be involved in product development, including an
evaluation of the targeted population and the product(s) being offered. For example, material
changes in the targeted market, origination source, or pricing could have significant impact on
credit quality and should receive senior management approval.
When HELOCs or HELs are marketed or closed by a third party, financial institutions should
have standards that provide assurance that the third party also complies with applicable laws and
regulations, including those on marketing materials, loan documentation, and closing procedures.
(For further details on agent relationships, refer to the “Third-Party Originations” Section.)
Finally, management should have appropriate monitoring tools and management information
systems (MIS) to measure the performance of various marketing initiatives, including offers to
increase a line, extend the interest-only period, or adjust the interest rate or term.
1

Applicable laws include Federal Trade Commission Act; Equal Credit Opportunity Act (ECOA); Truth in Lending
Act (TILA), including the Home Ownership and Equity Protection Act (HOEPA); Fair Housing Act; Real Estate
Settlement Procedures Act (RESPA); and the Home Mortgage Disclosure Act (HMDA), as well as applicable state
consumer protection laws.

-2-

Origination and Underwriting
All relevant risk factors should be considered when establishing product offerings and
underwriting guidelines. Generally, these factors should include a borrower’s income and debt
levels, credit score (if obtained), and credit history, as well as the loan size, collateral value
(including valuation methodology), lien position, and property type and location.
Consistent with the agencies’ regulations on real estate lending standards, 2 prudently
underwritten home equity loans should include an evaluation of a borrower’s capacity to
adequately service the debt. 3 Given the home equity products’ long-term nature and the large
credit amount typically extended to a consumer, an evaluation of repayment capacity should
consider a borrower’s income and debt levels and not just a credit score. 4 Credit scores are
based upon a borrower’s historical financial performance. While past performance is a good
indicator of future performance, a significant change in a borrower’s income or debt levels can
adversely alter the borrower’s ability to pay. How much verification these underwriting factors
require will depend upon the individual loan’s credit risk.
HELOCs generally do not have interest rate caps that limit rate increases. 5 Rising interest rates
could subject a borrower to significant payment increases, particularly in a low interest rate
environment. Therefore, underwriting standards for interest-only and variable rate HELOCs
should include an assessment of the borrower’s ability to amortize the fully drawn line over the
loan term and to absorb potential increases in interest rates.
Third-Party Originations
Financial institutions often use third parties, such as mortgage brokers or correspondents, to
originate loans. When doing so, an institution should have strong control systems to ensure the
quality of originations and compliance with all applicable laws and regulations, and to help
prevent fraud.
Brokers are firms or individuals, acting on behalf of either the financial institution or the
borrower, who match the borrower’s needs with institutions’ mortgage origination programs.
Brokers take applications from consumers. Although they sometimes process the application
and underwrite the loan to qualify the application for a particular lender, they generally do not
2

In 1992, the agencies adopted uniform rules on real estate lending standards and issued the “Interagency
Guidelines for Real Estate Lending Policies.” See 12 CFR Part 34, Subpart D (OCC); 12 CFR Part 208.51 and
Appendix C (FRB); 12 CFR Part 365 (FDIC) and 12 CFR 560.100-101 (OTS).
3
The OCC also addressed national banks’ need to assess a borrower’s repayment capacity in 12 CFR 34.3(b). This
safety and soundness-derived anti-predatory lending standard states that national banks should not make consumer
real estate loans based predominantly on the bank’s realization of the foreclosure or liquidation value of the
borrower's collateral, without regard to the borrower's ability to repay the loan according to its terms. See also
Regulation Z (Truth in Lending – 12 CFR 226.34(a)(4)).
4
“Interagency Guidelines Establishing Standards for Safety and Soundness” also call for documenting source of
repayment and assessing ability of the borrower to repay the debt in a timely manner. See 12 CFR 30, Appendix A,
II.C.2 (OCC); 12 CFR 208, Appendix D-1 (FRB); 12 CFR Part 364, Appendix A (FDIC); and 12 CFR Part 570,
Appendix A (OTS).
5
While there may be periodic rate increases, the lender must state in the consumer credit contract the maximum
interest rate that may be imposed during the term of the obligation. See 12 CFR 226.30(b).

-3-

use their own funds to close loans. Whether brokers are allowed to process and perform any
underwriting will depend on the relationship between the financial institution and the broker.
For control purposes, the financial institution should retain appropriate oversight of all critical
loan-processing activities, such as verification of income and employment and independence in
the appraisal and evaluation function.
Correspondents are financial companies that usually close and fund loans in their own name and
subsequently sell them to a lender. Financial institutions commonly obtain loans through
correspondents and, in some cases, delegate the underwriting function to the correspondent. In
delegated underwriting relationships, a financial institution grants approval to a correspondent
financial company to process, underwrite, and close loans according to the delegator’s
processing and underwriting requirements and is committed to purchase those loans. The
delegating financial institution should have systems and controls to provide assurance that the
correspondent is appropriately managed, financially sound, and provides mortgages that meet the
institution’s prescribed underwriting guidelines and that comply with applicable consumer
protection laws and regulations. A quality control unit or function in the delegating financial
institution should closely monitor the quality of loans that the correspondent underwrites.
Monitoring activities should include post-purchase underwriting reviews and ongoing portfolio
performance management activities.
Both brokers and correspondents are compensated based upon mortgage origination volume and,
accordingly, have an incentive to produce and close as many loans as possible. Therefore,
financial institutions should perform comprehensive due diligence on third-party originators
prior to entering a relationship. In addition, once a relationship is established, the institution
should have adequate audit procedures and controls to verify that third parties are not being paid
to generate incomplete or fraudulent mortgage applications or are not otherwise receiving
referral or unearned income or fees contrary to RESPA prohibitions. 6 Monitoring the quality of
loans by origination source, and uncovering such problems as early payment defaults and
incomplete packages, enables management to know if third-party originators are producing
quality loans. If ongoing credit or documentation problems are discovered, the institution should
take appropriate action against the third party, which could include terminating its relationship
with the third party.
Collateral Valuation Management
Competition, cost pressures, and advancements in technology have prompted financial
institutions to streamline their appraisal and evaluation processes. These changes, coupled with
institutions underwriting to higher LTVs, have heightened the importance of strong collateral
valuation management policies, procedures, and processes.

6

In addition, a financial institution that purchases loans subject to TILA’s rules for HELs with high rates or high
closing costs (loans covered by HOEPA) can incur assignee liability unless the institution can reasonably show that
it could not determine the transaction was a loan covered by HOEPA. Also, the nature of its relationship with
brokers and correspondents may have implications for liability under ECOA, and for reporting responsibilities under
HMDA.

-4-

Financial institutions should have appropriate collateral valuation policies and procedures that
ensure compliance with the agencies’ appraisal regulations 7 and the “Interagency Appraisal and
Evaluation Guidelines” (guidelines). 8 In addition, the institution should:
•

•
•

•

Establish criteria for determining the appropriate valuation methodology for a particular
transaction based on the risk in the transaction and loan portfolio. For example, higher
risk transactions or non-homogeneous property types should be supported by more
thorough valuations. The institution should also set criteria for determining the extent to
which an inspection of the collateral is necessary.
Ensure that an expected or estimated value of the property is not communicated to an
appraiser or individual performing an evaluation.
Implement policies and controls to preclude “value shopping.” Use of several valuation
tools may return different values for the same property. These differences can result in
systematic overvaluation of properties if the valuation choice becomes driven by the
highest property value. If several different valuation tools or AVMs are used for the
same property, the institution should adhere to a policy for selecting the most reliable
method, rather than the highest value.
Require sufficient documentation to support the collateral valuation in the
appraisal/evaluation.

AVMs –When AVMs are used to support evaluations or appraisals, the financial institution
should validate the models on a periodic basis to mitigate the potential valuation uncertainty in
the model. As part of the validation process, the institution should document the validation’s
analysis, assumptions, and conclusions. 9 The validation process includes back-testing a
representative sample of the valuations against market data on actual sales (where sufficient
information is available). The validation process should cover properties representative of the
geographic area and property type for which the tool is used.
Many AVM vendors, when providing a value, will also provide a “confidence score” which
usually relates to the accuracy of the value provided. Confidence scores, however, come in
many different formats and are calculated based on differing scoring systems. Financial
institutions that use AVMs should have an understanding of how the model works as well as
what the confidence scores mean. Institutions should also establish the confidence levels that are
appropriate for the risk in a given transaction or group of transactions.
When tax assessment valuations are used as a basis for the collateral valuation, the financial
institution should be able to demonstrate and document the correlation between the assessment
value of the taxing authority and the property’s market value as part of the validation process.

7

12 CFR 34, subpart C (OCC); 12 CFR 208 subpart E and 12 CFR 225 subpart G (FRB); 12 CFR 323 (FDIC); 12
CFR Part 564 (OTS); and 12 CFR 722 (NCUA).
8
Comptroller’s Handbook for Commercial Real Estate and Construction Lending; SR letter 94-55 (FRB); FDIC
(Financial Institution Letter (FIL-74-94), dated November 11, 1994; Thrift Bulletin 55a (OTS); and LTCU 03-CU17 (NCUA).
9
National banks should refer to OCC Bulletin 2000-16, “Risk Modeling – Model Validation.”

-5-

Account Management
Since HELOCs often have long-term, interest-only payment features, financial institutions
should have risk management techniques that identify higher risk accounts and adverse changes
in account risk profiles, thereby enabling management to implement timely preventive action
(e.g., freezing or reducing lines). Further, an institution should have risk management
procedures to evaluate and approve additional credit on an existing line or extending the interestonly period. Account management practices should be appropriate for the size of the portfolio
and the risks associated with the types of home equity lending.
Effective account management practices for large portfolios or portfolios with high-risk
characteristics include:
•
•
•
•
•
•

Periodically refreshing credit risk scores on all customers;
Using behavioral scoring and analysis of individual borrower characteristics to identify
potential problem accounts;
Periodically assessing utilization rates;
Periodically assessing payment patterns, including borrowers who make only minimum
payments over a period of time or those who rely on the line to keep payments current;
Monitoring home values by geographic area; and
Obtaining updated information on the collateral’s value when significant market factors
indicate a potential decline in home values, or when the borrower’s payment performance
deteriorates and greater reliance is placed on the collateral.

The frequency of these actions should be commensurate with the risk in the portfolio. Financial
institutions should conduct annual credit reviews of HELOC accounts to determine whether the
line of credit should be continued, based on the borrower’s current financial condition.10
Where appropriate, financial institutions should refuse to extend additional credit or reduce the
credit limit of a HELOC, bearing in mind that under Regulation Z such steps can be taken only
in limited circumstances. These include, for example, when the value of the collateral declines
significantly below the appraised value for purposes of the HELOC, default of a material
obligation under the loan agreement, or deterioration in the borrower’s financial circumstances. 11
In order to freeze or reduce credit lines due to deterioration in a borrower’s financial
circumstances, two conditions must be met: (1) there must be a “material” change in the
borrower’s financial circumstances, and (2) as a result of this change, the institution has a
reasonable belief that the borrower will be unable to fulfill the plan’s payment obligations.

10

Under the agencies’ risk-based capital guidelines, an unused HELOC commitment with an original maturity of
one year or more may be allocated a zero percent conversion factor if the institution conducts at least an annual
credit review and is able to unconditionally cancel the commitment (i.e., prohibit additional extensions of credit,
reduce the credit line, and terminate the line) to the full extent permitted by relevant federal law. See Appendix A to
12 CFR 3, Section 3(b)(4)(ii) for OCC; 12 CFR 208, Appendix A, III.D.4 and 12 CFR 225, Appendix A, III.D.4 for
FRB; Appendix A to 12 CFR 325, II(D)(4) (FDIC); and 12 CFR 567.6 (OTS).
11
Regulation Z does not permit these actions to be taken in circumstances other than those specified in the
regulation. See 12 CFR 226.5b(f)(3)(vi)(A) – (F).

-6-

Account management practices that do not adequately control authorizations and provide for
timely repayment of over-limit amounts may significantly increase a portfolio’s credit risk.
Authorizations of over-limit home equity lines of credit should be restricted and subject to
appropriate policies and controls. A financial institution’s practices should require over-limit
borrowers to repay in a timely manner the amount that exceeds established credit limits.
Management information systems should be sufficient to enable management to identify,
measure, monitor, and control the unique risks associated with over-limit accounts.
Portfolio Management
Financial institutions should implement an effective portfolio credit risk management process for
their home equity portfolios that includes:
Policies - The agencies’ real estate lending standards regulations require that an institution’s real
estate lending policies be consistent with safe and sound banking practices and that an
institution’s board of directors review and approve these policies at least annually. Before
implementing any changes to policies or underwriting standards, management should assess the
potential effect on the institution’s overall risk profile, which would include the effect on
concentrations, profitability, and delinquency and loss rates. The accuracy of these estimates
should be tested by comparing them with actual experience.
Portfolio objectives and risk diversification - Effective portfolio management should clearly
communicate portfolio objectives such as growth targets, utilization, rate of return hurdles, and
default and loss expectations. For institutions with significant concentrations of HELs or
HELOCs, limits should be established and monitored for key portfolio segments, such as
geographic area, loan type, and higher risk products. When appropriate, consideration should be
given to the use of risk mitigants, such as private mortgage insurance, pool insurance, or
securitization. As the portfolio approaches concentration limits, the institution should analyze
the situation sufficiently to enable the institution’s board of directors and senior management to
make a well-informed decision to either raise concentration limits or pursue a different course of
action.
Effective portfolio management requires an understanding of the various risk characteristics of
the home equity portfolio. To gain this understanding, an institution should analyze the portfolio
by segment using criteria such as product type, credit risk score, DTI, LTV, property type,
geographic area, collateral valuation method, lien position, size of credit relative to prior liens,
and documentation type (such as “no doc” or “low doc”).
Management information systems - By maintaining adequate credit MIS, a financial institution
can segment loan portfolios and accurately assess key risk characteristics. The MIS should also
provide management with sufficient information to identify, monitor, measure, and control home
equity concentrations. Financial institutions should periodically assess the adequacy of their
MIS in light of growth and changes in their appetite for risk. For institutions with significant

-7-

concentrations of HELs or HELOCs, MIS should include, at a minimum, reports and analysis of
the following:
•
•
•
•
•

Production and portfolio trends by product, loan structure, originator channel, credit
score, LTV, DTI, lien position, documentation type, market, and property type;
Delinquency and loss distribution trends by product and originator channel with some
accompanying analysis of significant underwriting characteristics (such as credit score,
LTV, DTI);
Vintage tracking;
The performance of third-party originators (brokers and correspondents); and
Market trends by geographic area and property type to identify areas of rapidly
appreciating or depreciating housing values.

Policy and underwriting exception systems - Financial institutions should have a process for
identifying, approving, tracking, and analyzing underwriting exceptions. Reporting systems that
capture and track information on exceptions, both by transaction and by relevant portfolio
segments, facilitate the management of a portfolio’s credit risk. The aggregate data is useful to
management in assessing portfolio risk profiles and monitoring the level of adherence to policy
and underwriting standards by various origination channels. Analysis of the information may
also be helpful in identifying correlations between certain types of exceptions and delinquencies
and losses.
High LTV Monitoring - To clarify the agencies’ real estate lending standards regulations and
interagency guidelines, the agencies issued “Interagency Guidance on High LTV Residential
Real Estate Lending” (HLTV guidance) in October 1999. The HLTV guidance clarified the
“Interagency Real Estate Lending Guidelines” and the supervisory loan-to-value limits for loans
on one- to four-family residential properties. This statement also outlined controls that the
agencies expect financial institutions to have in place when engaging in HLTV lending. In
recent examinations, supervisory staff has noted several instances of noncompliance with the
supervisory loan-to-value limits of the “Interagency Real Estate Lending Guidelines.” Financial
institutions should accurately track the volume of HLTV loans, including HLTV home equity
and residential mortgages, and report the aggregate of such loans to the institution’s board of
directors. Specifically, financial institutions are reminded that:
•

Loans in excess of the supervisory LTV limits should be identified in the institution's
records. The aggregate of high LTV one- to four-family residential loans should not
exceed 100 percent of the institution's total capital. 12 Within that limit, high LTV loans
for properties other than one- to four-family residential properties should not exceed 30
percent of capital.

12

For purposes of the “Interagency Real Estate Lending Standards Guidelines,” high LTV one-to four-family
residential property loans include: (i) a loan for raw land zoned for one-to four-family residential use with a LTV
ratio greater than 65 percent; (ii) residential land development loan or improved lot loan with a LTV greater than 75
percent; (iii) a residential construction loan with a LTV ratio greater than 85 percent; (iv) a loan on non-owner
occupied one-to four-family residential property with a LTV greater than 85 percent; and (v) a permanent mortgage
or home equity loan on an owner-occupied residential property with a LTV equal to or exceeding 90 percent without
mortgage insurance, readily marketable collateral, or other acceptable collateral.

-8-

•

•
•

In calculating the LTV and determining compliance with the supervisory LTVs, the
financial institution should consider all senior liens. All loans secured by the property
and held by the institution are reported as an exception if the combined LTV of a loan
and all senior liens on an owner-occupied one- to four-family residential property equals
or exceeds 90 percent and if there is no additional credit enhancement in the form of
either mortgage insurance or readily marketable collateral.
For the LTV calculation, the loan amount is the legally binding commitment (that is, the
entire amount that the financial institution is legally committed to lend over the life of the
loan).
All real estate secured loans in excess of supervisory LTV limits should be aggregated
and reported quarterly to the institution’s board of directors.

Over the past few years, new insurance products have been introduced to help financial
institutions mitigate the credit risks of HLTV residential loans. Insurance policies that cover a
“pool” of loans can be an efficient and effective credit risk management tool. But if a policy has
a coverage limit, the coverage may be exhausted before all loans in the pool mature or pay off.
The agencies will consider pool insurance as a sufficient credit enhancement to remove the
HLTV designation in the following circumstances: 1) the policy is issued by an acceptable
mortgage insurance company, 2) it reduces the LTV for each loan to less than 90 percent, and 3)
it is effective over the life of each loan in the pool.
Stress testing for portfolios - Financial institutions with home equity concentrations as well as
higher risk portfolios are encouraged to perform sensitivity analyses on key portfolio segments.
This type of analysis identifies possible events that could increase risk within a portfolio segment
or for the portfolio as a whole. Institutions should consider stress tests that incorporate interest
rates increases and declines in home values. Since these events often occur simultaneously, the
agencies recommend testing for these events together. Institutions should also periodically
analyze markets in key geographic areas, including identified “soft” markets. Management
should consider developing contingency strategies for scenarios and outcomes that extend credit
risk beyond internally established risk tolerances. These contingency plans might include
increased monitoring, tightening underwriting, limiting growth, and selling loans or portfolio
segments.
Operations, Servicing, and Collections
Effective procedures and controls should be maintained for such support functions as perfecting
liens, collecting outstanding loan documents, obtaining insurance coverage (including flood
insurance), and paying property taxes. Credit risk management should oversee these support
functions to ensure that operational risks are properly controlled.
Lien Recording - Institutions should take appropriate measures to safeguard their lien position.
They should verify the amount and priority of any senior liens prior to closing the loan. This
information is necessary to determine the loan's LTV ratio and to assess the credit support of the
collateral. Senior liens include first mortgages, outstanding liens for unpaid taxes, outstanding
mechanic's liens, and recorded judgments on the borrower.

-9-

Problem Loan Workouts and Loss Mitigation Strategies - Financial institutions should have
established policies and procedures for problem loan workouts and loss mitigation strategies.
Policies should be in accordance with the requirements of the FFIEC’s “Uniform Retail Credit
Classification and Account Management Policy,” issued June 2000, and should, at a minimum,
address the following:
•
•
•

Circumstances and qualifying requirements for various workout programs including
extensions, re-ages, modifications, and re-writes. Qualifying criteria should include an
analysis of a borrower’s financial capacity to service the debt under the new terms;
Circumstances and qualifying criteria for loss-mitigating strategies, including
foreclosure; and
Appropriate MIS to track and monitor the effectiveness of workout programs, including
tracking the performance of all categories of workout loans. For large portfolios, vintage
delinquency and loss tracking also should be included.

While the agencies encourage financial institutions to work with borrowers on a case-by-case
basis, an institution should not use workout strategies to defer losses. Financial institutions
should ensure that credits in workout programs are evaluated separately for the ALLL, because
such credits tend to have higher loss rates than other portfolio segments.
Secondary Market Activities
More financial institutions are issuing HELOC mortgage-backed securities (i.e., securitizing
HELOCs). Although such secondary market activities can enhance credit availability and an
institution’s profitability, they also pose certain risk management challenges. An institution’s
risk management systems should address the risks of HELOC securitizations. 13
Portfolio Classifications, Allowance for Loan and Lease Losses, and Capital
The FFIEC’s “Uniform Retail Credit Classification and Account Management Policy” governs
the classification of consumer loans and establishes general classification thresholds based on
delinquency. Financial institutions and the agencies’ examiners have the discretion to classify
entire retail portfolios, or segments thereof, when underwriting weaknesses or delinquencies are
pervasive and present an excessive level of credit risk. Portfolios of high-LTV loans to
borrowers who exhibit inadequate capacity to repay the debt within a reasonable time may be
subject to classification.
Financial institutions should establish appropriate ALLL and hold capital commensurate with the
riskiness of their portfolios. In determining the ALLL adequacy, an institution should consider
how the interest-only and draw features of HELOCs during the lines’ revolving period could
13

Refer to “Interagency Questions and Answers on Capital Treatment of Recourse, Direct Credit Substitutes, and
Residual Interests in Asset Securitizations” (May 23, 2002), OCC Bulletin 2002-22 (OCC); SR letter 02-16 (FRB);
Financial Institution Letter (FIL-54-2002) (FDIC); and CEO Letter 163 (OTS). See OCC’s Comptroller Handbook
for Asset Securitization, dated November 1997. The Federal Reserve also addressed risk management and capital
adequacy of exposures arising from secondary market credit activities in SR letter 97-21.

- 10 -

affect the loss curves for its HELOC portfolio. Those institutions engaging in programmatic
subprime home equity lending or institutions that have higher risk products are expected to
recognize the elevated risk of the activity when assessing capital and ALLL adequacy. 14
Conclusion
Home equity lending is an attractive product for many homeowners and lenders. The quality of
these portfolios, however, is subject to increased risk if interest rates rise and home values
decline. Sound underwriting practices and effective risk management systems are essential to
mitigate this risk.

14

See the “Interagency Expanded Guidance for Subprime Lending Programs” issued in January 2001 for
supervisory expectations regarding risk management processes, allowance for loan and lease losses, and capital
adequacy for institutions engaging in subprime lending programs.

- 11 -


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102