Home equity lending is the other shoe that just won’t drop.
Bank portfolios, rather than securitized pools and nonbank lenders, have long held the vast majority of home equity loans, including lines of credit and the “piggyback” junior liens that became a substitute for down payments during the mortgage bubble. In particular, consolidation left the Big Four U.S. banks holding the bag as home values plunged below the amounts borrowed against many properties. But the recovery in home prices has helped reduce underwater loans, even though they still loom uneasily when measured against bank capital. (The first tab in the following graphic shows home equity loans as a percentage of Tier 1 common capital. The other tabs show data on credit performance. Text continues below.)
Among the big banks, Wells Fargo (WFC) has the largest exposure to home equity loans relative to its capital base. Its underwater principal balances fell 13 percentage points from the middle of 2011 to 34% of Tier 1 common capital at the end of the third quarter last year. (The actual sum of unsecured debt is smaller since collateral can partially cover amounts owed on underwater loans.)
The improvement reflects a better housing market, a 20% jump in Wells Fargo’s Tier 1 common equity, and the attrition from chargeoffs that have averaged $1 billion a quarter since 2008. (Industrywide, banks have charged off about $90 billion of home equity loans since 2008 and outstanding balances have declined by $220 billion, to $670 billion.)
Similarly, underwater home equity loans fell 16 percentage points to 28% of Tier 1 common at Bank of America (BAC) and 10 percentage points to 24% at JPMorgan Chase (JPM). At Citigroup (NYSE:C), which has the smallest relative exposure among the Big Four, underwater home equity loans fell 6 percentage points to 11% of Tier 1 common.
Credit metrics have suffered after regulatory guidance imposed stricter standards for the treatment of loans standing behind overdue first liens and of loans to borrowers who have gone through Chapter 7 bankruptcy.
Noncurrent loans jumped in the first and third quarters last year under the revised practices, as did chargeoffs in the third quarter. But lenders downplayed the broader financial impact, saying their loss reserves already largely contemplated the poor performance of the loans written down or reclassified.
At B of A, JPMorgan Chase and Wells Fargo, chargeoff rates on home equity lines retraced the third quarter spikes in the final three months of the year to fall back to levels well below peaks experienced in 2009 and 2010. Noncurrent loan rates remained elevated.
Skeptics of the health of home equity portfolios still suspect that banks are keeping them from falling apart by foisting losses on owners of first liens while refusing to take hits on their junior positions. (JPMorgan Chase, which has $70 billion of home equity loans excluding those it acquired when it bought the banking operations of Washington Mutual, said about $3 billion of its current junior liens stood behind delinquent or modified first mortgages, and that it owns about 5% and services about 25% of the first mortgages.)
The ultimate test, the skeptics say, will arrive in the coming years when borrowers can no longer make only monthly interest payments as their revolving loans enter amortization periods, typically ten years after origination.