Wednesday, April 2, 2008

Latest Trouble Spot for Banks: Souring Home-Equity Loans

Losses May Hit Lenders That Skirted Subprime; Surprise Delinquents

Here comes another headache for banks suffering from the mortgage downturn: Losses on home-equity loans are soaring, even at some lenders that avoided big blunders on subprime loans.

When times were good, banks raked in billions of dollars in profit from home-equity loans, which allow borrowers to tap the accumulated value in their property with either a loan for a specific amount or a line of credit. As long as home prices were rising, lenders had little to worry about.

But falling home values are leaving banks with little or nothing to collect on many home-equity loans in case of default. Some stretched borrowers are keeping up with their mortgage and credit cards -- but not their home-equity loan.

The problems are already causing trouble for J.P. Morgan Chase & Co. and Wells Fargo & Co., and are expected to hit other large banks when first-quarter earnings results are released next month. The pain is likely to deepen through the rest of 2008, sapping capital levels and resulting in tighter lending standards as banks try to reduce their risk.

"These losses are well beyond what we would have modeled...and continue to get worse," said Charles Scharf, head of J.P. Morgan's retail business.

At a meeting with analysts and investors last month, Mr. Scharf spent more than 30 minutes dissecting the second-largest U.S. bank's $95 billion home-equity portfolio. It wasn't pretty. J.P. Morgan expects home-equity-related losses of about $450 million in the first quarter, up from $248 million in last year's fourth quarter. By the end of 2008, home-equity losses could double from current levels, he said.

Because J.P. Morgan largely escaped the brunt of the subprime crisis, its ominous tone on home-equity loans has fueled anxious number-crunching.
David Hilder, a banking analyst at Bear Stearns, last week cut his 2008 and 2009 earnings estimates for National City Corp., SunTrust Banks Inc., Washington Mutual Inc. and Wells Fargo, citing rising home-equity losses. Each of those lenders has 12% to 19% of its total assets tied up in home-equity loans.

Fitch Ratings, a unit of Fimalac SA of Paris, predicts that "banks will significantly ratchet up loan-loss provisions against home-equity loans in 2008."

Projected losses from home-equity loans aren't anywhere close in size to the carnage caused by the declining value of mortgage-related securities. (Those losses now total more than $150 billion.) But the cascading delinquencies and charge-offs represent one more piece of the U.S. banking industry that is in big trouble after years of bumper-crop profits.

Originally used to finance home-improvement projects, borrowers increasingly turned to home-equity loans to pay off other debts, such as credit cards. Home-equity loans also became a popular way to fund vacations and expensive electronics -- or to buy a house with little or no money down without paying for private mortgage insurance.

Now, the steep decline in housing prices and weak economy are turning the home-equity business upside down. About 4.65% of fixed-rate home-equity loans were delinquent in the fourth quarter of 2007, up from 3.11% a year earlier, according to Equifax Inc. and Moody's

"We will continue to see banks increasing reserves for their home-equity portfolios and tightening their home-equity policies, changing their credit standards in response to price declines," said Doug Duncan, chief economist of the Mortgage Bankers Association.

While banks can foreclose on a first-lien mortgage, lenders often have little recourse when trying to collect a delinquent home-equity loan, especially if another bank holds the primary mortgage. Banks holding home-equity loans generally can only seize the collateral -- a house -- after the mortgage is paid off.

When another bank holds the mortgage and the mortgage payments are current, the home-equity lender is effectively powerless to collect the debt.

Unfortunately for home-equity lenders, many borrowers understand that pecking order, concluding there are few repercussions if they stop making payments on their home-equity loan. "Lenders are seeing people go delinquent on home equity who by all rights wouldn't be expected to go delinquent," said Dan Balkin of Wholesale Access, a Maryland research and consulting firm that specializes in the mortgage industry.

Other types of consumer loans also are souring, including credit cards and auto loans. But delinquent home-equity loans are rising faster, representing 12.5% of all delinquent loans in the fourth quarter at Bank of America Corp., the largest U.S. bank in stock-market value. That was up from 9.4% in last year's first quarter, according to research firm SNL Financial.

Leaning on outside mortgage brokers for home-equity business was "one of the biggest mistakes we've made," said Mr. Scharf. Those loans have performed worse than home-equity loans generated by J.P. Morgan.

J.P. Morgan, Wells Fargo and other banks are now backing away from brokers to focus on home-equity loans offered through their own retail branches, where customers already have a relationship with the bank. Citigroup Inc. has slashed the number of home-equity loans originated through brokers by 90%.

Meanwhile, financial institutions are refusing to provide home-equity loans to homeowners whose residences are already weighed down by big mortgages in states like California and Florida where home values are falling fast.

"This product was meant to help people do construction on their house, [and] do debt consolidation -- not to take out every last dollar of equity in their home to finance a different kind of lifestyle," Mr. Scharf said. J.P. Morgan is "rolling our changes back to represent that kind of product."

By: Robin Sidel; Ruth Simon contributed to this article.
Wall Street Journal; March 12, 2008

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