Home equity horror

April 8, 2010

By now everyone knows that big banks have A LOT of second lien loans on their balance sheet. But how much is at risk of being written off? CreditSights put out a report that helps answer that question (no link). In the meantime, regulators may dust off a shelved capital rule so that they’ve more capital to deal with the problem.

(Click here to expand)

Home equity exposures

Total home equity exposure at banks is pretty big. Amherst Securities has said commercial banks hold approximately $767 billion of the total $1.05 trillion of second mortgages outstanding, with the Big 4 holding over $400 billion alone.

But the key issue is what portion of these are at risk of writedowns. Most vulnerable are loans (or portions thereof) that are no longer backed by property. That is, the price of the underlying home has fallen below the balance on the loan. In banker shorthand: “loan-to-value” (LTV) is greater than 100%.

These are in peril because home equity loans are frequently structured with big principal payments on the back end, so even though many borrowers are currently making payments they’d need to stump up an awful lot of cash to pay off the balance. Unless housing miraculously recovers and they can sell or refinance at a price that will pay back all their debt, well, expect a spike in walk-aways…

CreditSights takes a stab at the potential writedown for the Big 4 banks and finds that Wells Fargo is particularly vulnerable.

The tricky part of the analysis is how much reserves banks have built against these loan books to absorb losses. There, disclosure varies by bank, so CS had to take a stab.

The truly dire scenario would be to mark down the entire portion of home equity debt that exceeds home values. Net of estimated reserves that would be:

—$37.2 billion for Wells
—$29.9 billion for JP Morgan
—$28.6 billion for BofA
—$11.5 billion for Citi

Banks would say this is overstating likely losses. And they’d be right. Plenty of other unsecured loans get paid down (credit cards, student loans) so unsecured home equity loan balances aren’t a total writeoff. But again, unless house prices come back, folks may have big trouble paying off balances.

By the way, it’s a testament to banks’ short-sightedness during the bubble that they held on to most home equity paper. They thought they were reducing interest rate risk by holding these loans, which carry higher, often variable rates. But they ignored credit risk, blithely assuming house prices would perpetually ascend allowing borrowers to perpetually refinance.

Luckily regulators are paying attention. In fact, they plan to dust off a new capital rule that was shelved during the crisis. Among other things it would force banks to hold more capital against home equity loans where LTV is above 90%.

Specifically, such loans would see their “risk-weighting” boosted from 100% to 150%. To be considered “well-capitalized” banks must hold capital equivalent to 10% of risk-weighted assets. So, for instance, Wells might have to hold an additional $3.1 billion (=$62.6bln*50%*10%). For the other three, see the graphic.

Even if banks hold more capital against these books, it may not be enough to avoid a substantial hit to their earnings…


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What is the percentage ratio of the banking industry compared to the non-banking size of the total economy?

If I remember well, it is around 40%. In the 80’s it was a healthy 20%.

You simply can not have a good running economy where both the banking industry and the government are sucking all the credit away.

Posted by MTLCAN | Report as abusive

The banking sector is sucking all the credit away, eh?

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I have a question: if I have a $100,000 HELOC (home-equity line of credit) from, say, Citigroup but have actually only borrowed $5,000 against it, which number would be reflected in the graph?

Are both types of numbers for HELOCs tracked in the statistics? It would be interesting to see how most Americans approach such accounts, and also how many reacted when it hit the news that banks were pulling back unused credit (reducing credit lines, cancelling credit cards, etc.).

Posted by karen2 | Report as abusive

Great article and graphics !

The 10% requirement always makes me nervous…Who decided on that ? It looks like 20 – 40% is more appropriate.

One question, how will they finance this additional capital, through plowing back ‘earnings’ or rights issues or new issuance ?

Posted by Ghandiolfini | Report as abusive

1/3 of all foreclosures are strategic right now

Posted by Story_Burn | Report as abusive

I’ve heard that “commercial” banks, credit card companies and foreign banks hold more than 60% of our national debt. It is important to remember that this specific market represents about 7.3% of our nations GNP. It has been suggested that this is a cycle that the American banks are perpetuating to gain more concessions (cheap dollars) from the U.S. Gov. Sadly, it is the weak and naive who are going to be crushed. This may cause a well deserved revolt against greed.

If the American people ever allow private banks to control their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their prosperity until their children will wake up homeless on the continent their fathers conquered. — Thomas Jefferson

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