Mortgage Banking & Consumer Credit Alert. No Equity Home Equity Lines? The FDIC Offers Guidance on Reducing Credit Risk Without Legal Risk

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1 July 2008 Authors: Steven M. Kaplan Jonathan D. Jaffe K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, visit No Equity Home Equity Lines? The FDIC Offers Guidance on Reducing Credit Risk Without Legal Risk The American Bankers Association announced last week that late payments on home equity lines of credit ( HELOCs ) rose to an 11-year high in the first quarter of With property values dropping and HELOC defaults rising, many lenders and servicers have reduced or suspended home equity lines of credit ( HELOCs ). In response to these lender actions, the Federal Deposit Insurance Corporation ( FDIC ) last week issued supervisory guidance for FDIC-supervised institutions ( FDIC Guidance or Guidance ). While the Guidance applies only to FDIC-supervised institutions, it offers a good legal primer for all holders and servicers of HELOCs who are contemplating reducing credit limits on HELOCs or suspending borrowers ability to make draws on HELOCs. The Guidance, titled Home Equity Lines of Credit: Consumer Protection and Risk Management Considerations When Changing Credit Limits and Suggested Best Practices, was issued June 26, 2008 as Financial Institution Letter The FDIC acknowledges in the Guidance that freezing or suspending HELOCs may be a prudent and appropriate way to manage credit risk. At the same time, the FDIC reminds its institutions of the legal requirements they must follow, including requirements under the Truth in Lending Act ( TILA ), the Equal Credit Opportunity Act ( ECOA ), and Section 5 of the Federal Trade Commission ( FTC ) Act. The FDIC noted that violations of these laws will result in enforcement actions, may have a negative effect on an institution s Community Reinvestment Act ( CRA ) evaluations, and could lead to civil liability. The Guidance does not discuss all legal considerations, but focuses on risk management and consumer protection considerations. We summarize those below. I. Interagency Guidance on HELOCs 2005 and 2006 The FDIC Guidance recognizes that lenders may legitimately reduce or suspend HELOCs under Regulation Z of TILA 1 and interagency guidance on HELOCs. 2 The federal banking agencies, in their Credit Risk Management Guidance for Home Equity Lending ( Interagency Guidance ), recommend strong HELOC account management systems to promote sound risk management, including practices such as: Periodically refreshing credit risk scores on all customers; Using behavioral scoring and analysis of individual borrower characteristics to identify potential problem accounts; Obtaining updated valuation information 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; and Conducting annual reviews of HELOC accounts to determine whether the line of credit should be continued, based on the borrower s financial condition. 3

2 The Interagency Guidance expressly provides that regulated institutions may refuse to extend additional credit or reduce the credit limit on a HELOC when those actions are appropriate and permitted by TILA. II. FDIC Guidance on HELOC Suspensions 2008 The new FDIC Guidance attempts to balance the safety and soundness emphasis of the Interagency Guidance with consumer protection and legal concerns. The FDIC notes that HELOC suspensions or reductions might disrupt the lives of consumers who counted on the availability of HELOC funds. Major medical expenses, daily living costs during a period of unemployment, needed supplemental income in retirement, college tuition funding for these and many other needs may be interrupted when a lender suspends or reduces a HELOC. To address these concerns, the FDIC Guidance reminds its regulated lenders to follow consumer protection laws when suspending or reducing HELOCs and urges them to work with borrowers to minimize hardships where possible. 4 The Guidance briefly discusses the requirements of several consumer protection laws that come into play when considering a HELOC suspension or reduction: TILA/Regulation Z, which establishes rules for HELOC suspensions, reductions, and terminations (although the FDIC Guidance does not itself address terminations). Section 5 of the FTC Act, which prohibits unfair and deceptive acts and practices. ECOA/Regulation B and the Fair Housing Act, which prohibit discrimination in a credit transaction on the basis of a prohibited factor. 5 A. TILA/Regulation Z The FDIC Guidance provides a relatively detailed discussion of TILA/Regulation Z s provisions addressing HELOC suspensions and reductions. Regulation Z allows lenders to suspend or reduce advances only in limited situations. The FDIC Guidance emphasizes two circumstances in which suspensions or reductions are permitted: Where the value of the dwelling that secures the HELOC declines significantly below the dwelling s appraised value 6 ; or Where the creditor reasonably believes that the consumer will be unable to fulfill the consumer s repayment obligations under the plan because of a material change in the consumer s financial circumstances. 7 The value of the dwelling that secures the HELOC declines significantly below the dwelling s appraised value Regulation Z allows a creditor to suspend advances if there is a significant decline in the value of the security property. Neither Regulation Z nor its Official Staff Commentary ( Commentary ) issued by the Federal Reserve Board ( FRB ) defines what constitutes a significant decline. The Commentary does, however, provide a safe harbor of sorts a decline will be considered significant if the initial difference between the credit limit and the available equity decreases by more than 50%. For example, consider a HELOC with a credit limit of $20,000 secured by a house appraised at $100,000 with a $50,000 first-lien mortgage, where the initial difference between the credit limit and the available equity was $30,000. In this instance, if the value of the house fell to $84,000 (a $16,000 decrease), the decline in value would be considered significant because it would be greater than 50%. 8 Adding its gloss to the Commentary, the FDIC Guidance states that full appraisals need not be obtained, but institutions should have a sound factual basis for determining that a property experienced a significant decline in value. 9 According to the Guidance, a sound factual basis may be established by automated valuation models ( AVMs ) or local tax assessments as long as the lender accounts for the Interagency Guidance s recommendations on ensuring the validity of those values. The creditor reasonably believes that the consumer will be unable to fulfill the repayment obligations under the plan because of a material change in the consumer s financial circumstances Regulation Z also permits the creditor to freeze the account if the creditor reasonably believes that the consumer will be unable to fulfill the consumer s repayment obligations under the plan because July

3 of a material change in the consumer s financial circumstances. The Commentary sets forth two elements that must be met for this provision to apply: The consumer s financial circumstances must have materially changed. The creditor must reasonably believe that, as a result of this change, the consumer will be unable to fulfill the payment obligations under the plan. Unfortunately, the FDIC Guidance does not offer any additional insight into what is needed to satisfy these tests. As to the first part of the test that requires a material change in the consumer s financial circumstances, the FRB Commentary offers a single example of a significant decrease in the consumer s income. 10 The FDIC Guidance does not supplement the Commentary on this point. As to the second part of the test that requires a reasonable belief on the part of the creditor that the consumer will be unable to fulfill her HELOC repayment obligations, the FDIC Guidance points out that the Commentary allows, but does not require, reliance on specific evidence (such as a failure to repay other debts). 11 The Guidance states that, nonetheless, institutions should have a factual basis for any actions taken under this provision. Furthermore, that factual basis should be determined consistently, to avoid the risk of prohibited discrimination or unfair practice. 12 Additional Circumstances Permitting HELOC Suspensions or Reductions The Guidance also notes that Regulation Z permits lenders to suspend or reduce HELOCs for a number of additional reasons, including when the consumer is in default of any material obligation under the HELOC agreement. The FDIC Guidance mentions, but does not discuss, this permissible basis for a HELOC freeze. The FRB Commentary permits creditors to specify events that qualify as a material obligation. 13 For example, some HELOC agreements provide that a consumer s failure to provide financial information requested under the HELOC contract could be considered a material obligation. Again, however, the FDIC Guidance does not offer any examples of what the FDIC believes could constitute a material obligation under a HELOC agreement. The FDIC Guidance also restates other circumstances under which a creditor may suspend or reduce a HELOC, without adding any additional insight: The creditor is precluded by government action from imposing the APR provided for in the agreement. The priority of the creditor s security interest is adversely affected by government action to the extent that the value of the security interest is less than 120 percent of the credit line. The creditor is notified by its regulatory agency that continued advances constitute an unsafe and unsound practice. Disclosure Requirements In addition to restricting the circumstances when a lender may suspend a HELOC account, TILA and the Guidance address disclosures the creditor should deliver. This should come as no surprise since TILA is first and foremost a disclosure statute. The Guidance reiterates Regulation Z s requirement that when a HELOC is suspended or reduced for any of the reasons discussed above, the lender must mail or deliver written notice of the termination or suspension to the consumer not later than three business days after the action is taken. The notice must contain the specific reasons for the action. If the creditor requires the consumer to request reinstatement, the notice also must state that fact. 14 Although the FDIC does not mention in its Guidance the possibility of state law disclosure requirements that require more than TILA and Regulation Z, that is a possibility lenders should consider. Reinstatement The Guidance also directs lenders attention to the Commentary that says 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. 15 That Commentary offers creditors two choices. The creditor may either monitor the status of the borrower s condition and reinstate the borrower s privileges when the condition is remedied, or alternatively, the creditor may shift the burden to the borrower to request the reinstatement. To use the alternative, the creditor must include in the mandatory notice of suspension or reduction (discussed above) that the borrower must request reinstatement July

4 of the line of credit when the triggering circumstances have changed. Regulation Z permits the creditor to require that the reinstatement request be in writing. Once the consumer requests reinstatement, the creditor must promptly investigate to determine whether the condition allowing the freeze continues to exist. 16 Interestingly, the FDIC Guidance does not address the creditor s rights under Regulation Z to permanently terminate and accelerate a HELOC under certain circumstances, including, among others: When there is fraud or material misrepresentation by the consumer in connection with the plan. When the consumer fails to meet the repayment terms of the agreement for any outstanding balance. When there is any action or inaction by the consumer that adversely affects the creditor s security for the plan, or any right of the creditor in the security. 17 A creditor may terminate and accelerate the HELOC account under these circumstances, without providing the borrower a right to reinstate draw privileges. B. ECOA/Regulation B and the Fair Housing Act The Guidance also reminds creditors of ECOA s and the Fair Housing Act s general prohibitions against discrimination in any part of a credit transaction on the basis of race, sex, or other specified factors. The Guidance notes that discrimination can occur if a lender suspends or reduces HELOCs: (i) based on policies applied inconsistently ; or (ii) in a manner that could constitute redlining. 18 C. FTC Act Finally, the Guidance recommends that lenders consult guidance that addresses unfair and deceptive trade practices issued by the FDIC and the FRB entitled Guidance on Unfair or Deceptive Acts or Practices. 19 The FDIC explains that it will take action against representations, omissions, or practices that are likely to mislead consumers and cause consumers harm. 20 Of course, although not mentioned by the FDIC, state unfair and deceptive acts and practices provisions also should be considered. III. Best Practices The FDIC Guidance concludes with the following suggestions for best practices in working with borrowers whose HELOCs are suspended or reduced: The creditor should try to offer alternative types of credit or other arrangements where possible, and of course depending on the borrower s creditworthiness and overall financial circumstances. 21 The creditor should also offer borrowers the opportunity to review the creditor s decision to reduce or suspend a credit line based on a significant decline in a property s value. The Guidance emphasizes that an opportunity to offer more detailed information should be afforded, particularly when the lender relies on an AVM. The Guidance also suggests that lenders undertake a periodic re-evaluation of property value information that might result in reinstating a higher credit limit or lifting the suspension. We also suggest the following as additional suggestions that lenders may wish to consider: Calculating revised property values and determining borrower financial circumstances using methods that have a sound factual basis and then applying those methods consistently; Implementing any resulting limitations without regard to prohibited factors ; and Using consistent standards when implementing changes that affect particular geographic areas. 22 The Guidance also offers the following as additional suggestions that lenders may wish to consider: Carefully review the HELOC agreements to ensure that they do not prohibit actions that might otherwise be permissible under the law. Prioritize customer service, since quality customer service is a critical tool in mitigating litigation risk and is especially important when taking actions that could have a significant impact on the customer. Specific measures might include establishing designated telephone lines for customers impacted by HELOC suspensions, reductions, or terminations and ensuring that July

5 well-trained representatives are available to handle potentially sensitive calls and explain alternatives. Set clear policies for, and adequately staff, the process for reviewing requests to reinstate. Creditors should consider, among other things, (i) how to determine whether an appraisal submitted by a borrower to refute an AVM finding is acceptable, and (ii) what financial information to require when the decision was based on the customer s financial condition, and the standards for reviewing this information. The FDIC Guidance does not address all legal issues involved in taking remedial action on HELOC accounts. The Guidance does make clear, however, that consumer protection must be front and center for lenders suspending or reducing HELOC accounts. According to the FDIC, lenders should strive to apply standards and policies fairly and consistently, communicate with consumers clearly, and actively help customers reinstate their HELOCs or find financing alternatives wherever possible. ENDNOTES 1 See 15 U.S.C et seq.; 12 C.F.R b(f)(3)(vi) (Regulation Z provision regarding permissible reasons for suspending or reducing a HELOC). See also id b(f)(2) (permissible reasons for permanently terminating and accelerating a HELOC). 2 See Office o f t h e Co m p t r o l l e r o f t h e Cu r r e n c y, Bo a r d o f Go v e r n o r s o f t h e Fe d e r a l Re s e rv e Sy s t e m, FDIC, Office o f Th r i f t Su p e rv i s i o n, a n d Nat i o n a l Cr e d i t Un i o n Ad m i n i s t r at i o n, Credit Risk Management Guidance for Home Equity Lending, FIL (May 24, 2005), gov/news/news/financial/2005/fil4505.html, and Addendum to Credit Risk Management for Home Equity Lending, FIL (Oct. 5, 2006), Interagency Guidance. 4 FDIC Guidance. 5 The FDIC Guidance also points out that violations of ECOA and the Fair Housing Act can negatively impact an institution s CRA rating. See FDIC Guidance. 6 See 12 C.F.R b(f)(3)(vi)(A). 7 See id b(f)(3)(vi)(B). 8 See 12 C.F.R. Off. Staff Comm b(f)(3)(vi)-6. 9 FDIC Guidance. 10 See 12 C.F.R. Off. Staff Comm b(f)(3)(vi) Id. (cited in the FDIC Guidance). 12 FDIC Guidance C.F.R. Off. Staff Comm b(f)(3)(vi) See 12 C.F.R (c)(3) (cited in FDIC Guidance). 15 See 12 C.F.R. Off. Staff Comm b(f)(3)(vi)-8 (cited in FDIC Guidance). 16 See id. 17 See 12 C.F.R b(f)(2). 18 FDIC Guidance. 19 FIL (May 30, 2002), financial/2002/fil0257.html. 20 Id. 21 FDIC Guidance. The Guidance adds that regulators may favorably consider flexible or innovative lending practices in determining an institution s CRA rating. Id. 22 Id. July

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