Fair Game: 2nd Loans, 2nd Wave of Losses

HAVE you heard the good news? Big banks are making more money than we thought.

On Thursday, JPMorgan Chase said it earned $5.4 billion during the second quarter. On Friday, Citigroup said it earned $3.3 billion.

Despite such happy tidings, many banks face a daunting challenge, and one federal regulators want to know more about: the potential costs associated with home loans that banks made during the great credit mania.

Still to be dealt with are potentially large legal bills — and settlements — related to accusations that many banks acted improperly, first in bundling all those loans into mortgage securities, and later in foreclosing on homeowners.

Under pressure from the Securities and Exchange Commission, banks have been estimating the potential damage in their financial filings. Last October, the S.E.C. warned them to be scrupulous in detailing risks associated with demands that they buy back soured loans or securities, as well as about possible defects in securitizations and foreclosures.

But while the S.E.C. has been pressing banks to make comprehensive disclosures about these potential pitfalls, regulators have been quiet on another worry for investors: how banks are valuing their vast holdings of home equity lines of credit, also known as second liens.

Privately, however, the S.E.C. has been pushing banks hard on this issue, according to Meredith Cross, the director of the commission’s corporation finance unit. As regulators review banks’ annual reports, they are asking tough questions about how institutions are valuing their second liens. Ms. Cross expects banks to provide more details about these loans in quarterly reports due next month.

The numbers are significant. Banks held $624 billion of such loans in the first quarter, Federal Deposit Insurance Corporation data show. Millions of these loans are deeply troubled. According to CoreLogic, a real estate data concern, almost 11 million of the nation’s mortgaged properties — nearly 23 percent of the total — were underwater at the end of March. Some 4.5 million of those properties carried home equity loans, according to CoreLogic. The average amount of negative equity shouldered by borrowers across the nation was $65,000.

WHEN first mortgages run into trouble, second liens are at greater peril, even if homeowners manage to keep up with their payments. That is because in a foreclosure, first mortgages are supposed to be paid off before second mortgages.

It is not clear that is happening, however. Banks like the big four — JPMorgan, Citigroup, Bank of America and Wells Fargo — not only hold home equity lines but also service first mortgages held by others on the same properties. Some analysts worry that servicers are able to protect their own holdings of second-lien loans while foreclosing on the first liens.

“The big four are pretending that the second liens are still money good because many are still performing,” said Christopher Whalen, editor of the Institutional Risk Analyst, a research publication. By performing, he means that borrowers are still making payments, if only the minimum. Many home equity lines require only the payment of interest for the first 10 years.

Banks have written off about $500 billion in assets since 2008, Mr. Whalen said. Most of those assets were related to housing, but write-downs on second liens have been pretty sparse so far at the big banks. As of the first quarter of this year, Bank of America carried $136 billion of second liens on its books. During 2010, it wrote down $6.8 billion. Wells Fargo held $108 billion in such loans in the first quarter; it wrote down $4.7 billion last year.

JPMorgan Chase’s exposure to second liens stood at $60 billion at the end of the second quarter. The bank charged off $1.3 billion in the first half of 2011 and $3.44 billion in 2010, said Joseph M. Evangelisti, a spokesman for the bank. As for how Morgan values these assets, he said that since 2010 the bank has routinely reserved for the higher probability of defaults on them, assuming an average loss rate of 60 percent on high-risk second liens.

Citibank’s home equity lines of credit totaled $46 billion last March; $6.2 billion belonged to borrowers with credit scores below 660 — that is, risky — and consisted of loan amounts that were greater than the values of the underlying properties.

Spokeswomen for Wells Fargo and Citigroup declined to comment.

Jerry Dubrowski, a spokesman for Bank of America, says the bank considers whether first mortgages are distressed when valuing home equity loans. If the second liens are performing, the bank doesn’t book a full loss on them. But if foreclosure seems inevitable on a first mortgage, the bank books a 100 percent loss on the second lien, he said.

But Mr. Whalen suspects some values are too high. The trouble in the housing market does not appear to be reflected fully on bank balance sheets yet.

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“If home prices do not stabilize, much less recover, then banks are likely to feel pressure to begin wholesale write-downs of first and second liens,” Mr. Whalen said. “There is probably as much loss prospectively facing the banking industry as a whole on residential real estate exposures as have already been charged off.”

DENIAL in the banking industry — known in the trade as “extend and pretend” — is a powerful thing. But it works for only so long.

Article source: http://feeds.nytimes.com/click.phdo?i=e66c94e971d94c1a4b3af8811599bde6