What to do about your home equity line portfolio when real estate values shrink?

August 2008

Sometimes you just can't win. After years of trying to encourage customers to open and use home equity lines of credit, many lenders are wondering how they can discourage use of existing lines now that the "equity" has disappeared from their home equity line portfolio. Shutting down performing lines of credit doesn't seem to be an option because Regulation Z generally prohibits lenders from making unilateral unfavorable changes to home equity lines of credit ("HELOC"s). There is, however, a provision in Regulation Z's rules that can help lenders deal effectively with the current melt down in real estate values.

Introduction

After years of doing everything possible to encourage customers to obtain and then make use of home equity lines of credit, this once popular loan product has suddenly fallen into disfavor as property values nosedive and lenders realize that there is no longer any "equity" remaining to support existing home equity lines. Homes values which two years ago put HELOC lenders in a well secured position even when lines were fully advanced now no longer fully collateralize the first lien purchase mortgage, let alone the junior lien home equity line that stands behind it. So as HELOC lenders begin to doubt how safe and secure their HELOC portfolio is, they are looking at ways to limit or lessen their exposure to a soft and continually declining real estate market. The provisions of Section 226.5(b)(f) of Regulation Z provide some welcome relief.

The Option and How to Exercise It

If your loan agreement provides for it and if you have properly disclosed it in your initial HELOC program disclosures, you can prohibit additional extensions of credit or reduce the credit limit while one of the circumstances designated in section 226.5b(f) of the regulation exists. While this section of Regulation Z provides for a number of conditions which lenders can use to justify curtailment of advances or reduction of credit lines, we will concentrate on only one condition in this article. Section 226.5b(f)(3)(vi)(A) provides that lenders are allowed to curtail additional advances or reduce lines when the value of the dwelling that secures the plan declines "significantly" below the dwelling's original appraised value for purposes of the plan. The commentary to Regulation Z clarifies this standard some and sets guidelines you will need to follow if you intend to take advantage of this rule. Let's look at what you are allowed to do and how you need to go about doing it.

"Significant" Decline in Value

Before you can take advantage of this option, you must be able to document that there has been a "significant" decline in the value of the property securing your loan. Commentary says the following about suspending additional advances or lowering credit lines because of a "significant" decline in property value. " ...if the value of the dwelling declines such that the initial difference between the credit limit and the available equity (based on the property's appraised value for purposes of the plan) is reduced by fifty percent, this constitutes a significant decline in the value of the dwelling for purposes of §226.5b(f)(3)(vi)(A). For example, assume that a house with a first mortgage of $50,000 is appraised at $100,000 and the credit limit is $30,000. The difference between the credit limit and the available equity is $20,000, half of which is $10,000. The creditor could prohibit further advances or reduce the credit limit if the value of the property declines from $100,000 to $90,000. This provision does not require a creditor to obtain an appraisal before suspending credit privileges although a significant decline must occur before suspension can occur."

So under this standard, if the value of the property securing your loan declines by at least half of the original difference between the total loan or loans secured by the property and the original appraised value of the property, then you can suspend additional advances or lower the line amount until such time as the value of the property increases enough to cure the condition.

Monitoring for Reinstatement

The suspension or reduction can't last forever. Under Regulation Z's rules, creditors are required to either monitor the value of the property and restore the line when the reason for the suspension or line reduction is no longer present, or to notify the borrower that the creditor will consider restoring privileges whenever the borrower believes the market has improved and the borrower requests that the creditor consider restoring the line. Since most creditors will choose to place the monitoring burden on the shoulders of the borrowers rather than on their own shoulders, they will need to provide an appropriate notice to their borrowers advising them of their obligations. Commentary indicates the following in this regard:

"Reinstatement of credit privileges. Creditors are responsible for ensuring that credit privileges are restored as soon as reasonably possible after the condition that permitted the creditor's action ceases to exist. One way a creditor can meet this responsibility is to monitor the line on an ongoing basis to determine when the condition ceases to exist. The creditor must investigate the condition frequently enough to assure itself that the condition permitting the freeze continues to exist. The frequency with which the creditor must investigate to determine whether a condition continues to exist depends upon the specific condition permitting the freeze. As an alternative to such monitoring, the creditor may shift the duty to the consumer to request reinstatement of credit privileges by providing a notice in accordance with §226.9(c)(3). A creditor may require a reinstatement request to be in writing if it notifies the consumer of this requirement on the notice provided under §226.9(c)(3). Once the consumer requests reinstatement, the creditor must promptly investigate to determine whether the condition allowing the freeze continues to exist. Under this alternative, the creditor has a duty to investigate only upon the consumer's request."

Provide the Notice to Shift the Burden

As noted above in the bolded part of Commentary, creditors are allowed to "shift" the duty to the consumer to request reinstatement. Most creditors will undoubtedly choose this option. If you elect this option, you will need to provide notice as required under 226.9(c)(3) which reads as follows: "(3) Notice for home equity plans. If a creditor prohibits additional extensions of credit or reduces the credit limit applicable to a home equity plan pursuant to §226.5b(f)(3)(i) or §226.5b(f)(3)(vi), the creditor shall mail or deliver written notice of the action to each consumer who will be affected. The notice must be provided not later than three business days after the action is taken and shall contain specific reasons for the action. If the creditor requires the consumer to request reinstatement of credit privileges, the notice also shall state that fact."

Summary

As real estate values decline and collateral protection evaporates, lenders are allowed under Regulation Z's rules to take reasonable actions to protect themselves from becoming unwilling unsecured creditors with respect to their home equity lines of credit. Lenders do not have to wait for loans to go into default before they curtail advances or lower lines. Proactive protective actions are allowed with respect to performing loans when significant declines in collateral value take place.

If all or part of your HELOC portfolio is no longer viable because of a decline in collateral value, you have the ability on a loan by loan basis under Regulation Z's rules to temporarily curtail additional advances or to lower the credit line until such time that the value of your collateral again becomes adequate to protect your loan. If you elect this option, you should first determine that your collateral's decline in value meets Regulation Z's standard for a "significant" drop in collateral coverage. You must provide a notice to each customer no later than three business days after taking the action and tell the customer the specific reason for the action that is being taken. If you do not want to be obliged to monitor collateral value and to automatically reinstate the account when the value of your collateral rises again, you must indicate in the notice that the consumer is obliged to do so and to request reinstatement of credit privileges at such time as the consumer has a sound reason to believe that reinstatement is again possible. Under Regulation Z's rules, you are allowed to require a new appraisal to support current value prior to reinstatement and the cost of the appraisal can be passed on to your customer.

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