– 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.