As the FDIC pointed out in a Financial Institution Letter (FIL-58-2008), and as many banks know all too well, declines in home values and borrower financial difficulties have resulted in higher risk of default for home equity lines of credit (HELOCs) in the portfolios of many institutions.

The FDIC warned that while banks can respond to this growing risk of loss by reducing or suspending HELOC credit limits for “some borrowers,” they can do so only after making sure they comply with several legal requirements. Global reductions and freezes just won’t cut it.

Reg. Z

Although the Truth in Lending Act and Regulation Z generally prohibit lenders from changing the terms of HELOCs, Reg. Z expressly permits lenders to block additional extensions of credit or reduce the applicable credit limit “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.”

The Fed’s Official Staff Interpretations do not define “significant decline,” but they include an example indicating that, while a “significant decline” will vary according to the circumstances, such a decline certainly has occurred if the unencumbered equity is reduced by 50 percent or more.

Reg. Z provides other exceptions, including one for a creditor that “reasonably believes” the consumer will be unable to fulfill the HELOC repayment obligations because of a “material change” in financial circumstances. Banks that use this exception should have a factual basis that they apply consistently to avoid the risk of committing prohibited discrimination or an unfair practice.

Reg. Z also requires that a lender that reduces or suspends a HELOC limit as a result of a significant property value decline or material change in the consumer’s financial circumstances must provide written notice to the consumer not later than three business days after the action is taken.

This notice must contain specific reasons for the action and explain if the creditor requires the borrower to request reinstatement of credit privileges. If the creditor does not require a reinstatement request, it must monitor the line to determine when the condition that permitted the reduction or suspension ceases to exist and then reinstate the privileges as soon as reasonably possible.

FTC Act

Besides meeting Reg. Z requirements, banks must also ensure that reductions or suspensions of HELOC limits do not violate the FTC Act’s prohibition against unfairness and deception and the prohibition of discrimination in the Equal Credit Opportunity Act and the Fair Housing Act.

“Discrimination may occur in the context of HELOC reductions or suspensions if a lender inconsistently applies its policies or makes the changes in a manner that could constitute redlining,” the FDIC said. “Lenders should calculate revised property values and determine borrower financial circumstances using methods that have a sound factual basis and are applied consistently.”