BREAKINGVIEWS – Where’s America’s home equity loan Armageddon?

April 7, 2010

— The author is a Reuters Breakingviews columnist. The opinions expressed are his own —

By Rolfe Winkler

NEW YORK, April 7 (Reuters Breakingviews) – The biggest U.S. banks hold tens of billions of dollars of underwater second-lien loans. By all rights, these look like risky credits. Lenders have managed to avoid writing them down because borrowers are making payments. But muddling through is a risky strategy. Regulators would be wise to force them to hold more capital against these loans.

In total, U.S. commercial banks hold more than $700 billion of second-lien mortgages, also called home equity loans. Many were used to turn houses into ATMs, others to finance down payments. Typically subordinate to first mortgages, many of these look vulnerable to write-downs, as the homes are worth less than debt owed on them.

Wells Fargo  faces the biggest risk. Half its $124 billion home equity book eclipses the value of underlying properties. While many borrowers will pay off their loans despite their fallen values, CreditSights estimates Wells Fargo could lose $12.8 billion on the portfolio. For JPMorgan, Bank of America and Citigroup, losses could amount to $9.6 billion, $7.4 billion and $3.4 billion, respectively.

Thus far banks have escaped major home equity trauma thanks to forgiving accounting and capital treatment as well as occasionally irrational borrower behavior. For instance, stretched borrowers often make monthly payments on subordinate home equity loans despite defaulting on their first mortgages simply because the payment is lower.

Home equity charge-off rates have already increased to as much as 5 percent for big banks, yet even this understates the potential problem since they can treat loans as “performing” as long as borrowers make monthly payments.

Trouble is, home equity loans are often structured with big principal payments on the back end. Unless they sell or refinance the house at a price north of debt owed, borrowers may be unable to repay their balance. So the portion of debt that is above a home’s value may ultimately evaporate.

Regulators are aware of the issue. A proposed capital rule shelved during the financial crisis would have forced banks to hold more capital against home equity loans. The proposal, which is still hovering in the background, would force the four biggest banks to set aside an extra $7 billion or so. That seems a sensible way forward.

Of course, banks seem to think they’ve got little to worry about. For one, just because a homeowner has more debt than equity in his home doesn’t mean he will stop making payments — these are, after all, their residences. And it’s also true that if house prices rebound, the loan-to-value ratio moves in the other, positive, direction.

But with U.S. incomes flat, the economy rebounding only sluggishly and housing prices still stagnant, it would be foolish for regulators to assume the banks’ better-case scenarios. They need to prepare for a reckoning with the home equity loan glut.


— The U.S. Congress recently called on banks to write down their junior lien mortgages more aggressively in order to restore positive equity to so-called underwater borrowers.

— The Obama administration’s enhanced mortgage modification program encourages them to do so by offering to pay six to 21 cents for every dollar of mortgage principal forgiven.

— Before the banking crisis of late 2008, bank regulators released a notice of proposed rulemaking that, among other changes, would have raised risk weightings for home equity loans. If adopted, the rule would raise the capital banks are required to hold against these portfolios in order to be considered “well capitalized.”

— Treasury release:

— Notice of proposed rulemaking:

(Editing by Rob Cox and Martin Langfield)


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