'Payment Shock' on HELOCs Is a Looming Concern for Regional Banks

A new report from Moody's suggests that roughly a dozen regional banks are at risk of sustaining meaningful credit losses on home equity lines of credit that were originated in the boom years and are scheduled to reset over the next three years.

Analysts with Moody's Investors Service are warning that banks face higher delinquencies and incremental losses on home equity lines because borrowers are susceptible to "payment shock," when the loans start resetting after 10 years and the borrowers have to start paying both interest and principal.

"The big pool we're concerned about are the HELOCs that start to amortize in 2015 to 2017, because it's 10 years from the height of the bubble," says Allen Tischler, a Moody's senior vice president. "The payment shock component could become problematic."

The top 19 banks held $352 billion in HELOCs at the end of the third quarter, according to Moody's. The vast majority are held by the three largest banks. Bank of America (BAC) has the largest overall exposure to HELOCs at $83 billion, followed by Wells Fargo (WFC), with $80 billion, and JPMorgan Chase (JPM) with $70 billion.

But regional banks have an even greater exposure to HELOCs than the top three banks relative to their tangible common equity, Moody's says. Several regionals have home equity lines of credit that exceed by 100% or more their tangible common equity, which Moody's considers the best measure of loss-absorbing capital. They include TCF Financial (TCB), American Savings Bank, First Horizon National (FHN), the RBS Citizens Financial unit of Royal Bank of Scotland (RBS), and First Citizens (FCNCA).

Many of the HELOCs were originated at the height of the housing boom between 2005 and 2007 when credit underwriting standards were more lax than they are now. At that time, many borrowers used HELOCs to fund the purchase of a larger house that they otherwise could not afford, or to finance consumption. Lenders were not required at that time to evaluate borrowers for their ability to repay the lines, which are normally secured by a second lien on the borrower's home, at the fully amortized rate.

Moody's is reiterating concerns raised late last year by the Office of the Comptroller of the Currency, which is urging banks it regulates reach out to borrowers and restructure home equity lines when their draw periods come to an end.

The OCC estimates that 60% of all HELOC balances will start amortizing between 2014 and 2017, resetting to higher payments that could cause a jump in delinquencies and a new round of potential credit losses for banks. Roughly $29 billion in HELOCs will recast this year. The numbers ramp up to $52 billion next year, $62 billion in 2016 and peak at $68 billion in 2017, the OCC says.

"We want to see that banks are actively monitoring this," Tischler says. "This is a warning, but it could become a bigger issue over time."

Because borrowers face a potential payment shock of 30% or more, most banks are reaching out to refinance borrowers into a new product or extend existing terms.

Stephen Steinour, chairman and CEO of the $59 billion-asset Huntington Bancshares in Columbus, Ohio, says his bank has undertaken "a huge advance effort to inform and work with customers" whose home equity lines are maturing in 2014.

"Those customers have all been getting calls from us since last year letting them know that there's a rate reset on the horizon, what it is and what their options are," Steinour says. Roughly $250 million in HELOCs will reset this year, he says.  

But reaching out to borrowers can also be labor intensive, an issue banks have encountered with loan modifications. For example, if a bank decides to extend the interest-only period on a home equity line, it has to contact the borrower, who not only has to agree to the new terms but also must sign a modification agreement that often has to be notarized.

The outreach effort on HELOCs also comes at a time when banks are laying off mortgage and servicing staff, so some are turning to third-party vendors for help.

Frank Pallotta, a managing partner at Loan Value Group, a Rumson, N.J., marketing firm, has designed HELOC outreach and education programs for three of the top 20 banks.

"Banks are trying to be both proactive and more surgical with their approach," Pallotta says, describing how one bank offered to extend the interest-only period to one group of borrowers but for another group just wanted to gather more financial information to determine if borrowers could repay at higher rates.

The process itself can be arduous.

"It involves notifying the borrower, filling out new applications and getting the new documents notarized and back to the lender to ensure they've complied with all the OCC's terms," Pallotta says. "The payment shock is a kick in the teeth, because when a HELOC goes down, banks often are looking at 97% severities."

Bank of America has warned that HELOCs that have already started to amortize this year have experienced a higher percentage of early-stage delinquencies and defaults when compared to its HELOC portfolio as a whole. Roughly 4% of B of A's HELOCs were delinquent at the end of the third quarter. Of the $2.3 billion that had reset to higher payments, 3% were 30 days or more delinquent and 9% were nonperforming.

B of A also disclosed that 63% of home equity borrowers did not pay any principal on their HELOCs. Meanwhile, Wells Fargo has disclosed that 45% of its HELOC borrowers paid only the minimum amount due. Roughly 2.5% of Wells' HELOCs were delinquent at the end of the third quarter.

Wells has created a program "to inform, educate and help borrowers transition from interest-only to fully amortizing payments or full repayment," the San Francisco company said in a third-quarter filing.

Borrowers face the risk of rising interest rates because most HELOCs are adjustable and interest rates have been so low for so long. Some borrowers also may be unable to refinance if the value of their home is lower than when the HELOC was originated, though rising home prices have somewhat offset this concern.

Ironically, the risk of higher delinquencies on existing HELOCs comes as banks are moving full bore back into home equity lending. But more often they are giving new HELOCs only to borrowers with high credit scores, low debt ratios and low loan-to-value ratios.

Alan Kline contributed to this story.