Deploying Risk-Management In Home Equity
In May 2005, a collective team of heavy-hitting financial oversight agencies, including the NCUA, the Office of the Comptroller of the Currency and the Fed, issued a report asserting that, in general, financial institutions' credit risk-management practices for home-equity lending need adjusting based on the market's changing risk profile.
The report, "Credit Risk Management Guidance for Home Equity Lending," reveals that risk-management practices for home-equity lending have not kept pace with the lending industry's rapid growth and eased underwriting standards. This holds true for credit unions-particularly credit unions that are focusing on higher-risk products, such as high loan-to-value, low-document, no-document or interest-only loans.
The implications: The quality of a credit union's lending portfolio is subject to increased risk should home values decline and interest rates rise. The agencies note that sound underwriting policies and active portfolio management are crucial to mitigate such risks and that home-equity lending can be beneficial to both consumers and financial institutions if appropriate risk-management systems are developed and put into practice.
What can credit unions do?
Develop A Strict And Consistent Loan Policy
Credit unions should look at all viable risk factors associated with establishing new loans. Such factors include a borrower's income and debt levels, credit score, credit history, loan size, collateral value, lien position and property location. Credit unions need to make sure they are doing everything they can to ensure a borrower will satisfactorily service the debt.
As each credit union can have members with vastly different demographic and financial characteristics, it's very important to have automated underwriting tools that allow customizable credit criteria, scores and attributes. Credit unions then can set their own threshold for credit scores and other credit characteristics that are determined to be most predictive for their members. In addition, this allows risk-based pricing for the most competitive rates or interest rate adjustments based on the level of risk.
Use Risk-Based Lending Practices
To stay competitive with retail banks and other lenders, most credit unions use risk-based lending practices for loan originations. Credit unions set proper credit score criteria for different individuals based on their loan payback performance over time. This means that those individuals with good credit would get the best rate, those with moderate credit would get a moderate rate and so forth.
While credit scoring is a great determiner of what kind of interest rate each potential borrower should receive, it's also important to ensure that the scores remain accurate over the course of the loan. This means that credit unions should not only look at how a member's previous loans have performed over time, but also how they are performing on a regular basis. There are tools available on the market today that enable credit unions to develop credit-scoring decisioning models that score for risk, predict future member behavior and monitor a member's behavior over time, which can alert credit unions to changes in a member's credit score.
Actively Manage Home-Equity Lending Portfolios
The "Credit Risk Management Guidance for Home Equity Lending" report suggests that credit unions should employ risk-management techniques that identify higher-risk accounts and adverse changes in account risk profiles. Such techniques would enable a credit manager to take proactive preventative action, such as freezing a loan or reducing a line of credit. While this recommendation might seem cumbersome and costly to credit unions, there are cost-effective and easy-to-use applications available today to help streamline and automate this process.
Account-management solutions can be used to notify a credit union's credit manager about adverse changes in a borrower's loan or other relevant information. Sophisticated solutions available today enable a credit manager to run regular reviews on current members with outstanding loans to identify if they have taken on additional debt and review their loan payback history with other creditors, and other activities affecting their credit score.
While a credit score shows whether a potential borrower has a good credit history, an account management solution would enable a credit union to take an active role in knowing if the borrower has maintained or changed specific behaviors. For example, some account management solutions enable a credit manager to identify a member's current loan payback patterns, allowing the manager to immediately determine if they are 60 days delinquent with another creditor. Such knowledge could prompt the loan manager to freeze that borrower's line of credit or take other appropriate action.
An account-management solution also can mitigate risk by enabling credit unions to run regular checkups-generally on a quarterly basis-on their existing outstanding loans. Such checkups enable credit unions to refresh credit risk scores on all customers, analyze individual borrower characteristics to identify problems with an account, periodically assess payment patterns and obtain updated information on collateral value.
Ensure Accurate Collateral Valuation Processes
Because of increased competition, cost pressures and technology advancements, many credit unions have automated their home appraisal processes. However, streamlining the collateral valuation process for all potential borrowers can be a more costly proposition. Such practices have highlighted the importance of the implementation of a strong collateral valuation management process.
Instead of automating the appraisal process for all potential borrowers, credit unions should use their account management solutions to help establish risk-based valuation methodologies based on the deemed risk of the loan. Those borrowers looking for a higher-risk transaction or with low credit scores should have a more thorough valuation process, while credit unions can continue to streamline appraisals for low-risk borrowers. Using an account management program can assist credit unions in easily identifying changes in collateral valuations, helping the credit union make better decisions about offering specific loans to specific individuals.
Enlist Help In Developing Policies
While the "Credit Risk Management Guidance for Home Equity Lending" report highlights the importance of financial institutions putting sound risk-management systems into place, it also illustrates that credit unions are not alone in their quest to limit risks associated with home-equity lending. There are numerous products, solutions and tools available today to help credit unions ensure that their risk-management procedures keep pace with the rapidly growing and changing risk profile associated with home-equity portfolios.
By taking an active role in assessing their portfolio's vulnerabilities and by monitoring changes in a borrower's ability to pay, credit unions will be able to limit future risks and maximize their lending profitability for years to come.
Frank Metzger is the national marketing manager for credit unions, and Martin Carr is the national sales director for credit unions, both of Experian's Credit Information Solutions. For info: www.experian.com or frank.metzger