Banking in the Ninth

Junior Lien Refinancing

Safety and Soundness Update - November 2012

Published November 30, 2012  |  November 2012 issue

Junior Lien Refinancing Wave

Some banks face a potential risk from an upturn in refinancing of junior liens. We discuss this potential risk and identify some risk management practices banks should consider.

Some banks significantly increased home equity lending in the precrisis period. Ten-year, interest-only terms were not uncommon. In the next few years, many of these loans will likely convert to an amortizing loan or require a balloon repayment at maturity. A dramatic payment increase can be a significant problem for troubled borrowers. Moreover, declining real estate values may essentially leave these junior positions unsecured. How should banks manage this potential risk?

Bank management must first consider several key underlying factors about their portfolio and the related risk management response.

  • What are the risk characteristics of your junior lien portfolio?
  • How should you respond to those risk characteristics?
  • What is your strategy for:
    • Maturing junior liens when the first mortgage is delinquent, or
    • Combined loan-to-values (LTV) above the bank’s underwriting guidelines, or
    • Borrowers experiencing financial challenges?

Federal Reserve examiners have observed some good risk management practices at banks that address these considerations. One such practice is periodically analyzing the risk characteristics of the portfolio and individual loans. Some banks set a review threshold for individual loans where the estimated combined LTV is greater than, say, 80 percent. For these loans, credit reports are pulled; estimated global debt-to-income is calculated; and current credit scores, other debt obligations, credit line utilization and historical delinquency are considered. This standardized analysis is documented much like a risk rating form. This process establishes risk parameters that promote early risk identification and a consistent strategy across the bank. Other banks may periodically refresh credit scores for all junior lien borrowers to begin assessing collection risk. Segmenting the junior lien portfolio by loans with similar risk characteristics also enhances the accuracy of the ALLL methodology.

Examiners have also observed good risk management practices when banks renew junior liens at maturity. One example is underwriting loans as new credit relationships by obtaining new credit applications, analyzing and verifying applicants’ incomes, obtaining new appraisals or evaluations, and pulling new credit reports. Conversely, examiners have observed instances where banks have not appropriately reported troubled debt restructurings (TDRs). If a junior lien borrower is experiencing financial difficulties and the bank grants a concession it would not otherwise consider, the loan should be reported as a TDR. Moreover, a practice of granting interest-only extensions to keep loans current that mask repayment problems will be criticized.

Appropriate risk management and a clearly communicated bankwide strategy will allow bank management to identify and effectively respond to risks before the second lien wave arrives. SR letter 12-03 issued in January 2012 provides additional guidance for managing junior lien portfolios.

More information on home equity lending is available in the Consumer Affairs Update, which discusses periodic statement disclosures of home equity lines of credit.