On January 31, 2012, four federal financial regulatory agencies issued interagency "Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties" (the guidance). The guidance is directed at federally regulated financial institutions as a reminder to monitor all credit quality indicators relevant to credit portfolios, including junior liens, which primarily includes second mortgages and home equity lines of credit (HELOC).
While the guidance is not new or different from existing guidance, the elevated risk related to junior liens, especially in today’s economy, warranted a reminder about the importance of monitoring the credit in these types of loans and properly assessing the allowance for loan and lease loss (ALLL) as it relates to junior liens.
The guidance reminds management of the following responsibilities:
- Gather sufficient information to adequately assess the probable loss incurred within junior liens. The information should generally include the delinquency status of the senior lien associated with the junior lien, and whether the senior lien has been modified. If the institution does not own or service the senior lien, they should use reasonably available tools to determine the payment status of the senior lien, such as obtaining credit reports or data from third party servicers.
- Institutions with significant holdings of junior liens should adequately segment these loans within their ALLL calculation. Inclusion of junior liens in a general, 1-4 family real estate segmentation will most likely not be sufficient.
- The ALLL methodology should address the elevated borrower default risk associated with payment shocks such as rising interest rates on adjustable rate junior liens, and HELOCs converting from interest-only to amortizing loans.
- Adjustments to historical loss rates for junior liens using qualitative factors should be fully supported by an analysis related to the characteristics and trends in the junior lien portfolio, and should be directionally consistent with risks and trends in the portfolio.
The complete guidance is located at www.occ.gov.