Consumer Compliance Outlook
HELOC Plans: Compliance and Fair Lending Risks When Property Values Change
In the wake of the financial crisis, home property values declined significantly in many parts of the country. In response, many creditors suspended home equity lines of credit (HELOCs) or reduced credit limits, creating compliance and fair lending risks. While housing prices have rebounded from the lows of the crisis, creditors must still be mindful of their obligations under Regulation Z when a significant decline in a property’s value that allowed a creditor to take these actions has been cured. Creditors must also recognize the fair lending risk associated with these actions. This article provides an overview of the compliance requirements and risks when a creditor takes action on a HELOC because of a change in property value.1
Regulation Z Compliance Requirements
Section 1026.40 of Regulation Z imposes significant compliance requirements on HELOC creditors. This section not only requires disclosure of plan terms and conditions but also generally prohibits a creditor from changing them, except in specified circumstances. One circumstance permitting a creditor to suspend a HELOC or reduce its credit limit is when the property securing the HELOC experiences a significant decline in value, as provided in 12 C.F.R. §1026.40(f)(3)(vi)(A):
No creditor may, by contract or otherwise … change any term, except that a creditor may… prohibit additional extensions of credit or reduce the credit limit applicable to an agreement during any period in which the value of the dwelling that secures the plan declines significantly below the dwelling’s appraised value for purposes of the plan.2 (Emphasis added.)
The regulation does not define a “significant decline.” However, Comment 1026.40(f)(3)(vi)-6 of the Official Staff Commentary (Commentary) provides creditors with a safe harbor: If the difference between the initial credit limit and the available equity is reduced by 50 percent because of a property value decline, the decline is deemed significant, permitting creditors to refuse additional credit extensions or reduce the credit limit for a HELOC plan.
When determining whether a significant decline in value has occurred, creditors should compare the dwelling’s appraised value at origination against the current appraised value. The bank should not, however, try to impose any current lending standards to evaluate the HELOC plan under review. The table below provides an example.3
|House Appraised Value
|Less First Mortgage Amount
|Less HELOC Credit Limit
|Equals Residual Equity
In this example, the creditor could prohibit further advances or reduce the credit limit if the value of the property declines from $100,000 to $90,000. Management should be mindful that although they may be permitted to reduce the credit limit, the reduction cannot be below the amount of the outstanding balance if doing so would require the consumer to make a higher payment.4
Property Value Methods
The creditor is not required to obtain an appraisal before reducing or freezing a HELOC when the home value has dropped.5 However, for examination and recordkeeping purposes, the creditor should retain the documentation upon which it relied to establish that a significant decline in property value occurred before taking action on the HELOC.
In May 2005, the Interagency Credit Risk Management Guidance for Home Equity Lending was published, which includes a discussion of collateral valuation management.6 The guidance provides examples of risk management practices to adopt when using automated valuation models (AVMs) or tax assessment valuations (TAVs). Further guidance on appropriate practices for using AVMs or TAVs is provided in the Interagency Appraisal and Evaluation Guidelines.7 Management may want to consider the guidance when using AVMs or TAVs to determine whether a significant decline has occurred.
In addition to regulatory compliance, institutions should be aware that a number of class action suits have been filed challenging the use of AVMs to reduce credit limits or suspend HELOCs.8 The plaintiffs in these cases have challenged various aspects of compliance, including the use of geographic location, rather than individual property valuation, as a basis for a lender’s finding of reduction in value; the AVM’s accuracy; and the reasonableness of the appeals process in place by which a borrower may challenge the reduction of the line of credit. In light of this litigation risk, it is important for institutions to pay careful attention to compliance requirements.
Notice to Consumer
When a creditor prohibits additional extensions of credit or reduces the credit limit under §1026.40(f)(3)(i) or (f)(3)(vi), it must provide notice to the consumer within three business days after taking this action.9 The notice must indicate why the creditor took the action. If the bank requires the consumer to request that credit privileges be reinstated when the conditions triggering the action have been cured, this requirement must be stated in the notice. This notice is required by Regulation Z (Truth in Lending Act) and should not be confused with adverse action requirements under the Equal Credit Opportunity Act (ECOA) and the Fair Credit Reporting Act (FCRA), which are discussed later in this article.
Management should be mindful that borrowers may have questions about the action or need further clarification after receiving the notice. Staff should be trained and prepared to assist consumers with understanding the reasons for the action, which can in turn help the consumer take steps to have the credit line reinstated to its original amount.
Creditor’s Responsibility When Significant Decline in Value Is Cured
It is important to note that a HELOC suspension or reduction of the credit limit is temporary and can only continue while one of the permissible circumstances in the regulation for such action exists, such as a significant decline in property value. As stated in Comment 1026.40(f)(3)(vi)-2: “When the circumstance justifying the creditor’s action ceases to exist, credit privileges must be reinstated, assuming that no other circumstance permitting such action exists at that time.” (Emphasis added.) Thus, if the property value increases sufficiently, and no other conditions justify a reduction or suspension of the credit limit, the bank must reinstate the HELOC credit privileges as soon as reasonably possible.10 This requirement is particularly significant in light of recent reports that real estate prices are rising appreciably from the low point of the financial crisis. According to the Case-Shiller index, real estate prices in May 2013 were on average 12.2% higher than a year earlier for the index’s twenty-city composite. In May 2013, prices in two cities exceeded the highs from before the financial crisis — Dallas in June 2007 and Denver in August 2006.11
This requirement raises the question of who bears the responsibility for monitoring whether a property no longer is experiencing a significant decline in value, triggering a creditor’s duty to remove the suspension of the credit line or restore the prior credit limit. By default, the regulation requires the creditor to monitor whether the significant decline has been cured. However, the Commentary allows creditors to shift this duty to the consumer by stating in the initial suspension/reduction in credit limit notice under 12 C.F.R. §1026.9(c)(1)(iii) that the consumer is responsible for requesting reinstatement.12
Under Comment 40(f)(3)(vi)-3, the bank can only impose bona fide and reasonable appraisal fees actually incurred in investigating whether the condition permitting the line of credit freeze or reduction still exists, unless state law prohibits such fees. Further, when the insufficient property value condition no longer exists, the bank cannot charge a fee to reinstate the line of credit.
Adverse Action Notices
Both the ECOA and the FCRA have adverse action requirements that may apply when a creditor suspends a HELOC or reduces the credit limit because of a significant decline in the value of a property.
The regulation defines adverse action to include “an unfavorable change in the terms of an account that does not affect all or substantially all of a class of the creditor’s accounts.”13 If a creditor suspends a HELOC or reduces the credit limit, and the action does not affect all or substantially all of a creditor’s HELOC accounts, the creditor has taken adverse action. However, the regulation also states that adverse action does not include “a change in the terms of an account expressly agreed to by an applicant.”14 Thus, an adverse action notice would not be required if the HELOC agreement specified that the creditor could suspend the HELOC or reduce its credit limit in the event the value of the property significantly declined.15
Section 615 of the FCRA requires adverse action notices in three circumstances:
- when adverse action is taken based on information in a consumer report;
- when consumer credit is denied or a charge for credit is increased based on information obtained from third parties other than consumer reporting agencies bearing upon the consumer’s creditworthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living; or
- when adverse action is taken based on information furnished by a corporate affiliate of the person taking the action bearing upon the consumer’s creditworthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living (unless the information provided by the affiliate relates solely to transactions and experiences between the affiliate and the consumer or is information in a consumer report).16
If a creditor’s decision to suspend a HELOC or reduce its credit limit is based on any of these three circumstances, an FCRA adverse action notice is required. For example, if a creditor learned about the significant decline in value from an affiliate that monitors real estate values, a notice is required. Or suppose a creditor has a policy that when it learns of a significant decline in property value, it automatically pulls the borrower’s credit report. If the creditor takes adverse action, in whole or in part, because of information in the report, an FCRA notice is required. Model forms are available for ECOA and FCRA adverse action notices in Appendix C to Regulation B. When adverse action notices are required under both the FCRA and the ECOA, model forms are available that combine the notices.17
Fair Lending Considerations
The ECOA, as implemented by Regulation B, and the Fair Housing Act (FHA), as implemented by 24 C.F.R. Part 100, apply during all stages of credit transactions within their scope — not simply at origination. Thus, a lender’s decision to review consumer HELOC accounts because of declining property values or to restore a HELOC account when real estate prices rise has fair lending implications. In particular, the manner in which HELOC accounts are selected for review could increase the risk of disparate treatment or disparate impact on a prohibited basis. Disparate impact occurs when a creditor implements a facially neutral policy that disproportionately harms borrowers on a prohibited basis.18 Disparate treatment occurs when a creditor treats borrowers differently on a prohibited basis, such as on the basis of race or gender.19 For example, assume a lender originated HELOCs in two counties that both had significant declines in property values. County A is majority-Hispanic while County B is majority-non-Hispanic white. If the creditor only undertook HELOC reviews in County A, it would have increased the risk of disparate treatment.
Discrimination risk may also be present when different methods are used to value properties to determine whether a significant decline occurred. Using the example described above, if a lender used AVMs in County A while conducting full appraisals in County B, the fair lending risk would be elevated. Finally, a creditor’s discretion in any aspect of the credit transaction, including collection activity, increases fair lending risks. For example, if a lender has the ability to override a decision to suspend a HELOC, the manner in which that discretion is exercised could raise fair lending concerns.
To manage fair lending risks, lenders should ensure that policies are uniformly applied to all affected borrowers. In addition, lender discretion to override a decision to take action on a HELOC plan should be documented and closely monitored to ensure that similarly situated borrowers are treated consistently. To manage disparate impact risk, lenders can analyze whether a proposed policy or action will negatively and disproportionally impact borrowers on a prohibited basis and, if so, whether the lender has a business justification. The Interagency Fair Lending Examination Procedures are available to creditors to assist in analyzing fair lending risks.20
Strong control systems can also help manage risks. Examples of risk controls include policies and procedures approved by the institution’s board that comply with applicable regulations and staff training on the regulatory requirements. Regularly monitoring compliance can confirm that board-approved procedures are implemented, followed, and work as intended. Exceptions to policies and procedures should be appropriately approved, documented, and monitored to help ensure consistency among borrowers. Finally, monitoring customer complaints and providing metrics on consumer HELOC actions can help senior management oversee the process more effectively.
Financial institutions that use third parties for managing HELOC plans should be mindful of the compliance-related risks associated with third-party service providers. See Cathryn Judd and Mark Jennings, “Vendor Risk Management — Compliance Considerations,” Consumer Compliance Outlook, Fourth Quarter 2012. As stated in that article, “If bank management is not monitoring a vendor’s activity, it will not be aware of problems that may be occurring with the vendor.”
When a significant decline in the value of property securing a HELOC occurs and the creditor responds by suspending the HELOC or reducing its credit limit, good communication between the consumer and the creditor is important to ensure the best possible solution for both parties. In addition, if the significant decline is cured, additional compliance obligations can be triggered. Creditors can minimize fair lending and compliance risk by understanding the requirements of the regulations, appropriately identifying compliance-related risks, taking action to mitigate these risks, and monitoring property values where the creditor has originated HELOCs. Specific issues and questions should be raised with your primary regulator.