Comptroller Tells Lenders to Build Reserves and Return to Stronger Underwriting
John C. Dugan,
Comptroller of the Currency
Washington, D.C.
www.occ.treas.gov
Comptroller of the Currency John C. Dugan said on May 22 that “accelerating losses in the home equity business show the need to build reserves and to return to the strong underwriting standards of past years.”
According to the news release, home equity loans and lines of credit grew dramatically in recent years, more than doubling, to $1.1 trillion, since 2002. In part, the growth was because of the rapid appreciation in house prices, the tax deductibility feature of home equity loans, and low interest rates.
(Editor’s note: Home equity loans became available in TX for the first time in January 1998. In September 2003, the voters of TX approved an amendment to the TX constitution which permitted home equity lines of credit (HELOCs) for the first time.)
Dugan said in a speech to the Financial Services Roundtable’s Housing Policy Council, “Another contributing factor was ...not so obvious: liberalized underwriting standards. These relaxed standards helped more people qualify for loans, and more people to qualify for significantly larger loans.”
These relaxed standards included limited verification of a borrower’s assets, employment, or income; higher debt to equity ratios; and the use of home equity loans as “piggyback” loans that helped borrowers qualify for first mortgages with low down payments and without mortgage insurance, resulting in ever-higher cumulative loan-to-value ratios.
Consequently, once house prices began to decline in 2007, home equity lenders began to experience unprecendented losses. While losses have traditionally run at about 20 basis points, or two tenths of a percent of loans, they increased to nearly one percent in the fourth quarter of 2007 and 1.73 percent in the first quarter of 2008.
Looked at in dollar terms, losses on all home equity loans, including HELOCs and junior home equity liens, rose from $273 million in the first quarter of 2007 to almost $2.4 billion in the first quarter of 2008, a nine-fold increase. And, the largest home equity lenders are now saying that they expect losses to continue to escalate in 2008 and beyond, Dugan said.
Dugan said these loss numbers need to be viewed in perspective. Though accelerating quickly, they are still much lower than the loss ratios for other types of retail credit, such as credit card loans.
He said, “...the higher level of losses and projected losses — even under stress scenarios — are what we at the OCC would describe generally as an earnings issue, not a capital issue. That is, while these elevated losses, depending on their magnitude, could have a significant effect on earnings over time, with few exceptions they are not in and of themselves likely to be large enough to impair capital.”
For the near term, Dugan said the OCC expects national banks to continue to build reserves. He said, “At some banks, the portion of reserves attributable to home equity loans just barely covers 2007 chargeoffs. With losses accelerating, those reserves are simply not going to be adequate, and that’s why our examiners are encouraging more robust portfolio analysis and loss reserve levels.”
According to the comptroller, circumstances have changed fundamentally, and historical trends have little relevance in estimating credit losses.”As a result, qualitative factors such as environmental analysis and changing consumer behavior clearly should be factored into the reserve calculation. Likewise, lenders should take into account the very real possibilities that unemployment or interest rates will increase from their quite low current levels.
Among the practices that warrant close scrutiny, according to Dugan, are the following:
• The use of home equity lines to finance down payments.
• The appropriate use of collateral valuation tools, i.e., asset valuation models, which Dugan said must be closely managed, periodically validated, and supported with sound business rules.
• Income documention. 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. 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,” 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 contast, higher payments that reduce principal address both these concerns.””
Related links:
Comptroller of the Currency John C. Dugan (http://www.occ.gov/dugan.htm)
Speech to the Financial Services Roundtable’s Housing Policy Council’(http://www.occ.gov/ftp/release/2008-58a.pdf)’
