Bloomberg News

Bank Values for Home-Equity Loans Said to Face U.S. Scrutiny

September 15, 2011

(Updates with new foreclosures in penultimate paragraph.)

Sept. 15 (Bloomberg) -- U.S. regulators are examining whether the nation’s home lenders have accurately valued $845 billion of home-equity and other second-lien mortgages, according to seven people with direct knowledge of the matter.

The Federal Reserve and the Office of the Comptroller of the Currency have teams checking on default risks at the biggest banks and whether they’ve set aside enough reserves to cover the loans, according to the people. They spoke on condition of anonymity because the review is continuing and examinations aren’t public.

A slowing economy has cast doubt on the value of second mortgages, whose collateral can be wiped out when home prices decline. The S&P/Case-Shiller index covering 20 U.S. cities has dropped 32 percent from its July 2006 peak, and the jobless rate, stuck above 9 percent, makes it harder for borrowers to keep up with payments. Bank of America Corp. and JPMorgan Chase & Co. are among the largest holders of second liens.

“If home prices continue to decline and the homes get more and more underwater and you have layoffs, it becomes an ever- bigger issue,” said Laurie Goodman, a senior managing director at Amherst Securities Group LP in New York.

Second mortgages allow borrowers to get extra cash by using the equity in their home as collateral for a loan. When the borrower stops paying or goes bankrupt, the holder of the primary mortgage has first claim on the assets. If the home’s value has fallen since the loan was made, the holder of the second mortgage may be left with little or no collateral to cover losses.

Object of Interest

Regulators are focusing on individual loans where borrowers are already overdue on their first mortgages, or where the value of the home has dropped below the size of the loans, according to the people. Examiners are requiring banks to conduct a special impairment analysis to determine the risks of steep losses on the loans, even if borrowers are current on payments, said two people with knowledge of the process. Such an analysis may result in a demand for more reserves, they said.

The Fed may use the results of the examination to help evaluate capital planning and future dividends at the largest lenders, one person said. With banks cutting reserves as overall defaults decrease, regulators want to ensure the firms still have enough to cover second liens that go sour, the person said.

“For a regulator, any time there’s an asset class that experiences a significant change, there’s a concern that there could be a decline in value that hasn’t been recognized by every single financial institution,” said Moshe Orenbuch, an analyst with Credit Suisse AG.

Popular Loans

Second mortgages soared in popularity during the housing bubble as homeowners sought to tap growing equity values. The balance of home-equity loans and other second mortgages held by lenders rose from $327.6 billion in 2000 to a peak of $1.14 trillion in 2007, according to Inside Mortgage Finance, a trade publication. The total fell to $845.3 billion in the first quarter of 2011.

Home-equity lines of credit made up the largest second-lien category with unpaid balances of $666.5 billion in the first quarter, the data show.

Investors are skeptical about the true worth of assets held by U.S. lenders, with the KBW Bank Index selling at about 75 percent of stated book value for the 24 companies represented. Bank of America, based in Charlotte, North Carolina, has been pummeled by speculation that it needed a bigger capital cushion to protect against unexpected losses. The stock has lost almost 50 percent this year and sells for about a third of book value.

Bank Rankings

Bank of America, the biggest U.S. lender by assets, holds the largest second-lien portfolio, with $129.3 billion in unpaid balances, according to first-quarter data from Inside Mortgage Finance. San Francisco-based Wells Fargo is second with $114.4 billion, and New York-based JPMorgan Chase & Co. is third, with $101.6 billion. New York’s Citigroup Inc. had $46 billion and PNC Financial Services Group Inc., based in Pittsburgh, had $30.1 billion. Spokesmen for the lenders declined to comment on the examination.

John Walsh, the acting comptroller, said in testimony before the Senate Banking Committee last December that examiners were looking into situations where banks had resisted offering loan modifications to distressed homeowners on first mortgages where the bank also held a second mortgage. Modifying the first loan could include an acknowledgement that that the home’s value had dropped, forcing the lender to take a loss or complete write-off of the second mortgage.

First and Second

“A conflict of interest could arise if the second-lien holder were trying to overstate the second lien’s carrying value (and under-allocate loan-loss reserves) for a troubled borrower,” Walsh said. The comptroller had required that banks take all such risks into consideration in their valuations, even if the second mortgages are performing, Walsh said.

The American Bankers Association reported delinquent closed-end home-equity loans rose to 4.12 percent in the first quarter from 4.05 percent in 2010’s final quarter. For open-end home-equity lines of credit, delinquencies rose to 1.8 percent from 1.73 percent. Closed-end loans are for a fixed amount with a fixed repayment period. Open-end loans come with a fixed amount of available credit, with the actual balance fluctuating based on usage.

Why They Pay

Regulators and lawmakers have been sounding alarms since at least 2009 about the value of second mortgages. The Federal Deposit Insurance Corp. sent a letter to banks in August 2009 asking them to consider boosting reserves for second liens, citing the impact of overdue first mortgages. Barney Frank, then the chairman of the House Financial Services Committee, sent a letter to banks in March 2010 urging them to recognize more losses because “large numbers of these second liens have no real economic value.”

Bankers have responded that American borrowers tend to meet their obligations and pay their bills as long as they are able, regardless of whether the value of their homes has declined. Customers keep paying because they want to keep access to the account and draw on the unused portion of their credit lines, according to a paper last December by staff members of the Federal Reserve Bank of Philadelphia.

The study found that 31 percent of borrowers who were 90 days or more in default on first mortgages remained current on their second liens, and 20 percent of borrowers in foreclosure on first mortgages still made payments on their seconds.

Higher Risk

Even if second-lien payments are current, the delinquency on the first loan means the default risk has grown and banks may need to set aside more reserves, two of the people said.

The conflict between first and second mortgages may become more acute as banks resume foreclosures, said Guy Cecala, publisher of Inside Mortgage Finance. Lenders halted or slowed the process after accusations that homes had been seized using legal shortcuts and forged documents. Those delays are ending, Cecala said.

Default notices sent to overdue U.S. homeowners surged 33 percent in August from the previous month, and total foreclosure filings increased 7 percent from a four-year low, according to a report today from RealtyTrac Inc., the Irvine, California-based data seller.

“When you see those foreclosures pick up, which you will, then the losses on the seconds will really start to come in,” he said.

--With assistance from Dawn Kopecki in New York and Craig Torres in Washington D.C. Editors: Rick Green, David Scheer

To contact the reporter on this story: James Sterngold in New York at Donal Griffin in New York at Cheyenne Hopkins at

To contact the editor responsible for this story: Rick Green in New York at

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