Latest Bank Headache: Home Equity Loans

Includes: BAC, JPM
by: Barry Ritholtz

"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."

-Charles Scharf, head of J.P. Morgan's (NYSE:JPM) retail business.

That is, in a short phrase, the reason that the U.S. consumer is all spent out. They used debt and home equity -- as opposed to Income gains -- to finance an improving lifestyle. After the vacations are passed, the big screen TV and new cars become old, what are you left with?

Appreciation in the value of your home has long been considered a form of forced savings (as in don't eat your seed corn). The economic boost is over, the savings impact is significant, and you are left with a financial hangover. Talk about a negative wealth effect.

For the banks, it raises all different manners of headaches. Unlike Mortgages, Home Equity loans are secondary against the collateral -- the house itself:

"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... 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. (NYSE:BAC), 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.

Pretty amazing stuff.

The bankers are finally asking themselves "How the hell did we get into this mess?" The answer surprises no one:

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


Latest Trouble Spot for Banks: Souring Home-Equity Loans
Losses May Hit Lenders That Skirted Subprime; Surprise Delinquents
WSJ, March 12, 2008