By: Tommy Troyer, Consultant and Loan Review Manager
In “Agencies Issue New HELOC Guidance,” published in the August 2014 issue of the 90 Day Note, we presented an overview of what was at that time brand new safety and soundness guidance for HELOC portfolios (Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods). We also presented a few practical steps for community banks to consider in order to address the issues raised in the guidance. As a brief reminder, the guidance was issued by the regulatory agencies to encourage financial institutions to properly manage the risk associated with HELOCs that were reaching the end of their contractual draw period. The draw period is the time during which the borrower has access to the line of credit feature of the HELOC. Minimum monthly payments during this time can be quite low, in many cases interest-only. When the draw period ends, HELOC structures either require a transition to payments that amortize the outstanding debt over a defined number of years or require a balloon payment to repay the outstanding balance in full. The risk associated with this transition is that the borrower will experience a “payment shock” because the terms after the draw period ends can require significantly higher minimum monthly payments than were required during the draw period. Higher monthly debt service, all else equal, increases the risk of delinquency and default.
It was the potential for payment shock risk associated with end-of-draw HELOCs, coupled with the fact that across the industry the peak of HELOCs reaching end-of-draw was expected to occur from 2014-2017, that prompted the interagency guidance. We are now about a year down the road from the issuance of the guidance, and the idea of elevated risk embedded in some HELOC portfolios continues to receive regulatory, media, and analyst attention. We wanted to briefly revisit the issue to point out two important facts for community banks with HELOC portfolios. First, the available evidence is suggesting that regulators and bankers were right to worry about payment shock risk, as borrowers who have reached the end-of-draw period thus far have demonstrated, in the aggregate, the intuitively expected decline in timely payments. Secondly, it is important to note that it is not too late to take important steps to help mitigate end-of-draw risk.
End-of-Draw Performance Thus Far
Aggregate data on HELOC and mortgage delinquencies does not demonstrate any notable increases that we can attribute to end-of-draw risk. However, one needs to dig deeper to measure the issue with any accuracy, primarily because end-of-draw HELOCs still represent a relatively small share of the overall mortgage market (and even the HELOC market), and any increases in delinquency due to end-of-draw payment shocks can easily be masked by the overall improvements in mortgage delinquency rates associated with continued economic improvement and continued progress in most states in working through foreclosure backlogs (which reduces the number of long-term, seriously delinquent loans and improves overall delinquency rates).
Several more specific pieces of data on end-of-draw risk are worth noting:
- The OCC’s Semiannual Risk Perspective for Spring 2015, published June 30, 2015, shows that 30+-day delinquency rates for loans that have reached end-of-draw at the nine largest OCC-regulated banks have essentially doubled in the three-months following the end of the draw period, and have remained persistently high. The OCC also notes that, “many lenders have found the early stages more challenging than expected,” which should provide a wake-up call for any banks that still believe this issue will take care of itself without proactive management on the part of the bank.
- Data provided by Equifax, which was cited in a front-page Wall Street Journal article in June, indicated that just four months after reaching the end-of-draw period, HELOC borrowers from the 2004 vintage saw 30+-day delinquency rates increase by over 50% from the month prior to when they reached end-of-draw (2.7% to 4.3%). Similar increases are shown for vintages from 2000-2003 as well.
- A study by Experian, reported on its website, showed that 90-day delinquency rates increased three-fold during the 12 months of 2014 for those borrowers that reached their end-of-draw period between December 2013 and March 2014.
- Research published in the May 2015 RMA Journal by the other primary credit reporting agency, TransUnion, does not provide as directly comparable data as the previously mentioned studies, but does indicate that its data set of HELOCs showed overall 30+-day delinquencies of 2.2% while HELOCs 12 months after their payment shock showed a 60+-day delinquency rate of 3.1%.
The overall takeaway from all of this data is that the intuitive and expected impact of HELOC payment shock—increases in delinquency and eventually default and loss rates—does in fact appear to be occurring.
Impact on Community Banks and Risk Management Steps
The experience of any individual community bank will by no means mirror the overall industry experience. For one thing, the minimum payment required during the draw period does vary across banks, and banks that require significant principal reduction each month during the draw period may be less vulnerable to payment shock than those that required just interest-only payments. (Requiring principal reduction during the draw period certainly does not make a bank immune from payment shock, as it is important to keep in mind that the borrower also loses access to the line of credit as a source of funds when the draw period ends.) Further, community banks may have some advantages over larger lenders in terms of customer familiarity that may assist in working through end-of-draw issues with borrowers.
With that said, it is important to recognize that both the theory and the data are in line on this issue so far: all else equal, payment shock results in increased risk for the lender. In fact, the credit reporting agency research cited above also provides data indicating that the negative effects of payment shocks carry over to other credit facilities of borrowers, which presents an additional source of risk to relationship-minded community banks who may have multiple loans with a HELOC borrower. For these reasons, it is important that all community banks with HELOC exposures evaluate the interagency guidance’s recommendations and take the actions appropriate for their portfolio. We discussed these issues in more detail last year, but important steps include: 1) defining consistent and prudent options for borrowers approaching the end of their draw period that take into account the borrowers’ current financial and home value positions; 2) proactively initiating contact with borrowers who are approaching the end of their draw periods; 3) ensuring that all relevant parties within the bank have a voice in the bank’s approach to mitigating risk and are well-versed in the steps to follow with end-of-draw borrowers; and 4) gathering and analyzing enough data specific to your bank to fully understand the nature of the risk your bank faces.
End-of-draw risk does not need to lead to a massive amount of charge-offs to materially impact a community bank’s performance, especially given the low level of charge-offs many banks have been experiencing in that portfolio. Though there are very few, if any, banks for which end-of-draw concerns may represent an existential risk, a failure to properly manage end-of-draw risk could easily have a notable impact on earnings over the next several years, and could also result in weak regulatory assessments of a bank’s risk management. The OCC has publicly noted that it is pursuing a review of HELOC practices, and while this targeted horizontal review is unlikely to directly affect community banks, it would be a good bet that HELOC end-of-draw practices will be a point of emphasis in many community banks’ next safety and soundness exam, regardless of the examining agency.
The evidence continues to suggest that proper risk management of end-of-draw HELOCs is important. One consideration not directly mentioned above is that some banks may also find it beneficial to use their end-of-draw experience to consider whether any changes to their existing HELOC product’s structure would be appropriate. If you have questions or would like to discuss your end-of-draw risk management, please contact me at [email protected] or 1.800.525.9775.