Federal money system regulators are concerned lenders are over burdened with too many risky home equity loans and suggest they tighten their lending belts with a host of tougher underwriting measures.

The new federal recommendations could make it tougher for some consumers -- especially those who barely qualify -- to land home equity loans and other mortgages.

Coinciding with a heightened level of warnings about escalating home prices, industry fraud, the potential for higher interest rates and other concerns factoring into the potential for a housing bubble that goes bust, the Federal Reserve, along with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration, this week issued "Credit Risk Management Guidance For Home Equity Lending".

The report says the quality of lenders' home equity portfolios is of concern, especially if "interest rates rise and home values decline. Sound underwriting practices and effective risk management systems are essential to mitigate this risk."

Along with vulnerability to interest rate increases, federal agencies identified the following practices as risk factors warranting scrutiny:

• Interest-only loans with no principal amortization for a protracted period.

• Higher loan-to-value (LTV) and debt-to-income ratios.

• Permitting lower credit scores for loan approval.

• Greater use of automated property valuation for appraisals.

• An increased number of transactions generated through a loan broker or other third party.

• Limited or no documentation of a borrower's assets, employment and income.

"Most lenders that give these loans without income and asset documentation require good credit or a large amount of equity in the property. The lenders' studies have shown that one's credit history and equity position are better indicators of one's likelihood of paying their bills than one's income or assets," says Brandon Knapp, a mortgage planner with Lawson & Associates Mortgage Planners in Campbell, CA.

Most of these approaches to making home equity loans and first mortgages have gained widespread appeal in recent years because they greatly improve the chances of those who may not qualify under stricter guidelines, but who can actually afford to buy a home.

"One thought is that people will be more responsible with a home equity line of credit than an unsecured credit card because it is secured by their home, something that is extremely important to them," said Knapp.

However, the Feds fear too many of the loans may be going to those who can't always afford to make a mortgage payment and the terms could put them in danger of default later down the road.

"To date, delinquency and loss rates for home equity portfolios have been low, due at least in part to the modest repayment requirements and relaxed structures of this lending," the report says.

While the guidelines tell lenders and their underwriters to toe the line, consumers may also have to make sure they maintain their income, credit, debt and other qualifying financials on par with the levels that qualified them for the loan.

Otherwise, lenders who adhere strictly to the guidelines could call loans due, cut off unused credit or otherwise take steps to reduce risk caused by marginal loans. Loans typically come with provisions that allow lenders to take action under certain circumstances and consumers should read the small print to determine what those circumstances are.

When it comes to recommendations related to how consumers maintain their financial status, the federal guidelines call for:

• Periodically refreshing credit risk scores on all customers.

• Using behavioral scoring and analysis of individual borrower characteristics to identify potential problem accounts.

• Periodically assessing payment patterns, including borrowers who make only minimum payments over a period of time or those who use the line of credit to make payments on the line of credit.

• Obtaining updated information on the home's value when significant market factors indicate a potential decline in home values, or when the borrower's payment performance deteriorates and there's a greater reliance upon the home as collateral.

"I've never seen a lender withdraw credit because someone's credit changed, but if somebody can call a loan or take away a line of credit, they need to disclose that to consumers. When you take out a line of credit you are usually depending on it and if it's suddenly taken away that could cause you to lose your home," said Cindy Marcus, an agent with RE/MAX Santa Barbara-Montecito-Goleta, CA.

The guidelines are, however, largely aimed at lenders and a financially sound approach to making loans.

For lenders they advise:

• Requiring sufficient documentation to support the property's appraisal.

• Establishing criteria for determining the appropriate appraisal method for a particular transaction based on the risk in the transaction and loan portfolio's balance. For example, higher risk transactions or non-homogeneous property types should be supported by more thorough valuations. Lenders should also set criteria for determining when an site inspection of the property is necessary.

• Make sure an expected or estimated value of the property is not communicated to the appraiser. That's a technique appraisers have complained about as pressure on them to appraise a property at some desired level to get the loan approved.

• Preclude shopping around for the best property value. Lenders are advised to use the most reliable valuation method rather than the one that returns the highest value.

• Lenders with a high concentration of home equity loans should generate reports and analyses on the types of loans by product, loan structure, source, credit score, loan-to-value, documentation type, market, property type and other variables to better gauge risk.

• Likewise, lenders should analyze delinquency and losses by originator and underwriting characteristics and they should analyze the performance of brokers' loans and trends by geographic area and property type to keep tabs on areas of rapidly appreciating or depreciating home values.

The feds also reminded lenders to scrutinize monitoring of high loan-to-value mortgages based on existing, but not always followed guidelines, "The Interagency Guidance on High LTV Residential Real Estate Lending".

"In recent examinations, supervisory staff has noted several instances of noncompliance with the supervisory loan-to-value limits," the feds' guidelines said.

Lenders should also have in place assistance for consumers in trouble.

"Financial institutions should have established policies and procedures for problem loan workouts and loss mitigation strategies... in accordance with the 'Uniform Retail Credit Classification and Account Management Policy', " the report said.

Among other details, the policies for consumer assistance should contain qualifying requirements for consumers who need help based on an analysis of a consumer's ability to repay the debt under new terms; workout program tracking to determine programs' effectiveness and stated requirements for circumstances leading up to foreclosure.

"Just pulling the rug out will cause havoc in the economy. If you can't make payments and have to sell quickly, if that's many owners, that could affect the whole market," Marcus said.

Published: May 19, 2005

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Broderick Perkins parlayed a career in old-school journalism into a contemporary digital news service that really hits home. The award-winning consumer journalist, originally from Wilmington, DE, is founder, publisher and executive editor of the bootstrap DeadlineNews Group, a Silicon Valley-based editorial content and consulting service specializing in residential real estate, consumer news and related editorial consulting services. The DeadlineNews Group includes the website, DeadlineNews.com, offering real estate editorial content and consulting services, and its back shop, the Deadline Newsroom, an open house on news that really hits home. Perkins obtained his formal journalism education from University of Delaware and a journalism boot camp, the Institute of Journalism Education at the University of California-Berkeley. He went on to 20 years of service as a daily newspaper journalist at the Wilmington, DE News Journal and San Jose, CA Mercury News. Perkins covered housing on the San Jose Mercury News reporting team which earned a General News Reporting Pulitzer Prize in 1989 for coverage of the Loma Prieta earthquake. He has also produced real estate, consumer and small business content for the Wall Street Journal, Los Angeles Times, RealtyTimes.com, Nolo.com, Better Homes and Gardens, the National Association of Realtors, Homestore/Move and Intuit/Quicken among more than three dozen publications. In addition to managing the DeadlineNews Group, Perkins most recently served as chief editorial consultant for Nolo's Essential Guide To Buying Your First Home, Nolo, and writes real estate television scripts for RealtyTimes.com.