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Bank Profits Dimmed by Prospect of Home-Equity Losses

The Bank of America Tower
The Bank of America Tower, headquarters of the banks investment banking unit, center, stands in New York, on Feb. 3, 2010. Photographer: Daniel Acker/Bloomberg

Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co. may have to set aside an additional $30 billion to cover possible losses on home-equity loans, an amount almost equal to analysts’ estimates of profit at the three banks this year.

The cost of these reserves was calculated by CreditSights Inc., a New York-based research firm whose prediction almost four years ago proved prescient after banks reported unprecedented mortgage-related writedowns. Recognizing the home-equity loan losses is unfinished business from the housing bubble, CreditSights said in a March 29 report.

Potential writedowns on the loans are casting a shadow over earnings, as analysts try to determine how much, and how quickly, loan-loss expenses will decline from the industrywide peak reached in June 2009. Banks led by New York-based JPMorgan begin reporting first-quarter results this week.

“While a lot of people are looking for dramatic improvement in the short term, one area that still has to be worked through in a material way is home equity,” said Baylor Lancaster, senior bank analyst at CreditSights in Miami.

The process will take months, and write-offs won’t hit financial statements until later this year, Lancaster said.

Second-Lien Mortgages

Action in Washington could spur banks to act. U.S. Representative Barney Frank, chairman of the House Financial Services Committee, is scheduled to hold a hearing tomorrow on how second-lien loans are getting in the way of reworking homeowners’ debts and easing the foreclosure crisis. Frank sent a letter March 4 asking banks to recognize more losses in order to clear the way for mortgage modifications.

Second-lien mortgages and most home-equity lines of credit rank behind first-lien debt, meaning they get wiped out in a foreclosure if the sale of a home doesn’t raise enough to pay off the first mortgage. Second liens are often closed-end loans in contrast to home-equity lines of credit, which can remain open for borrowers to withdraw money when needed, much like a credit card.

In many cases, first mortgages can’t be modified or written down because lien priority dictates that junior loans be erased first. Few lenders have agreed to reduce or extinguish home-equity loans when modifying mortgages, even if a property is worth less than what’s owed, according to a report by Troubled Asset Relief Program Special Inspector General Neil Barofsky.

Principal forgiveness makes sense only in certain cases and should be pursued after considering other options, according to testimony prepared for tomorrow’s hearing and submitted on behalf of bank executives.

Bank of America is “supportive of targeted principal reduction performed in a way that addresses the significant moral and financial hazards but also recognizes the reality regarding the diminished future prospects for home appreciation,” Barbara Desoer, head of the bank’s home lending unit said in her prepared testimony.

Bank of America

The four biggest U.S. banks by assets -- Bank of America, JPMorgan, Citigroup Inc. and Wells Fargo -- hold about 42 percent, or $442 billion of the $1.1 trillion in second-lien mortgage loans, according to Amherst Securities Group LP, an Austin, Texas-based firm that analyzes home-loan assets.

Late payments on home-equity loans rose to a record in the fourth quarter, the American Bankers Association said April 7.

“Banks have been saying we’re close to the end,” said Nancy Bush, an independent bank analyst at NAB Research LLC in Annandale, New Jersey. “People have built that into their expectations. I don’t think we’re there yet.”

Bank of America, the biggest home-equity lender in the U.S., may report April 16 a first-quarter profit of 10 cents a share compared with a fourth-quarter per-share loss of 52 cents, according to the average estimate of 20 analysts surveyed by Bloomberg. Wells Fargo, the biggest U.S. mortgage lender, may increase its earnings per share in the first quarter to 42 cents when the San Francisco-based company reports results April 21, estimates show. That would be more than five times the amount for the previous quarter.

Record Allowances

One reason for the optimism is that banks have already booked large loan-loss expenses, which can be used to absorb additional writedowns without subtracting from earnings. Any reduction in loan-loss expenses will boost earnings, analysts and investors say.

These accounting entries, called allowances or reserves, reached a record 3.7 percent of total loans in December, more than twice the average level since 1948, according to Moody’s Investors Service.

Christopher L. Henson, chief operating officer of Winston- Salem, North Carolina-based BB&T Corp., the 10th-largest bank by assets, said March 1 that the bank’s reserve coverage has likely peaked.

“The majority of banks last year saw the pace of reserve build slow,” said Jason M. Goldberg, a Barclays Capital senior analyst in New York. “That trend continues amid signs of stabilization in delinquency trends and an improving economy.”

Bank Stocks Rally

Investors have pushed up the price of financial stocks on the belief that the biggest loan losses are in the past and that banks will begin to restore dividend payments and buy back shares. The 24-company KBW Bank Index jumped 22 percent in the first three months of this year. The Standard & Poor’s 500 Financials Index rose 11 percent in the first quarter, while the broader S&P 500 was up by 4.9 percent.

The stocks of the four largest banks are among the best performers in the S&P 500 since the market reached its nadir March 9, 2009. Each ranks in the top 25 percent.

JPMorgan rose 16 cents to $46.14 at 4:15 p.m. in New York Stock Exchange composite trading. Bank of America advanced 7 cents to $18.66, Wells Fargo gained 12 cents to $32.42 and Citigroup climbed 9 cents to $4.64.

Whether banks will feel confident enough about the creditworthiness of their borrowers to draw down allowances this year is the focus of a disagreement about bank earnings. Analysts at Credit Suisse Group AG say that some lenders will start releasing reserves in the second half of this year. That could make profits surge and fortify balance sheets.

‘Little Recovery’

Joseph Pucella, an analyst at Moody’s in New York, said he expects banks to keep reserves topped off “at least through the end of the year” because they still face losses.

Second-mortgage loans are shaping up to be a big bump in the road, said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, and a former bank examiner.

“There’s very little recovery for home-equity loans,” Miller said.

The interest in second-lien loans comes after U.S. banks and brokers have taken $294.6 billion in losses related to credit costs, loan write-offs and increased provisions, according to Bloomberg data. Investors may still lack confidence that banks have shown them the worst of second-lien loans, said Jack Ablin, chief investment officer at Chicago-based Harris Private Bank, who oversees $55 billion.

JPMorgan Reserves

JPMorgan Chief Executive Officer Jamie Dimon told investors in the bank’s annual report published in February that quarterly writedowns for home-equity lending “could reach $1.4 billion” in 2010. That would produce record write-offs of $5.6 billion this year, 19 percent more than in 2009 and more than double the amount in 2008.

The bank’s home-equity losses will be three times higher than in normal times, analysts at Deutsche Bank Securities said in an April 1 report.

JPMorgan has earmarked $13.8 billion of loss reserves for the division holding all of its mortgages, the annual report said. The bank holds $101 billion of home-equity loans, the third-largest amount of any U.S. bank, and about 1.6 percent of its second-lien loans are nonperforming, according to data compiled by Bloomberg.

JPMorgan shares would be trading higher if not for its home-equity loans, Christopher Whalen, a bank analyst at Torrance, California-based Institutional Risk Analytics wrote in a March 22 note.

‘Not Going Away’

After factoring in reserves already set aside to cover second-lien losses, the CreditSights team, led by senior analyst David A. Hendler, calculated that if JPMorgan were to write down 40 percent of its loans in which borrowers owe more than their property is worth, it would reduce earnings by $9.6 billion after taxes, or $2.41 a share. CreditSights didn’t specify over what period of time those losses might be taken.

The bank is expected to earn $14.1 billion in 2010, according to the average estimate of 13 analysts surveyed by Bloomberg. In 2009, it earned $11.7 billion.

“This is a problem that’s not going away for several years,” Charles W. Scharf, JPMorgan’s head of retail financial services said at a Feb. 25 investor conference.

Jennifer Zuccarelli, a spokeswoman for JPMorgan, declined to comment.

Bank of America, based in Charlotte, North Carolina, holds $138 billion of home-equity loans. About $112 billion, or 81 percent, are second liens. The bank almost doubled its allowance for losses on the loans in 2009 to $10.2 billion from $5.39 billion the previous year. It wrote off $7.1 billion last year, up from $3.5 billion in 2008.

Wells Fargo

If Bank of America were to write off 40 percent of the loans to its underwater borrowers, net income would drop $7.4 billion, or 74 cents a share, CreditSights said. Bank of America is expected to earn $10.7 billion in 2010, according to the average estimate of 13 analysts surveyed by Bloomberg.

Wells Fargo holds about $123.8 billion of home-equity loans, with about $103.7 billion in a junior-lien position, according to company filings. The lender has $5.3 billion in reserves set aside to cover the second-lien mortgage loans and wrote off $4.6 billion last year. Almost 2.2 percent of the second liens are more than 120 days past due, the company said in its annual report.

CreditSights said potential home-equity losses could knock $12.8 billion, or $2.47 a share, off earnings at Wells Fargo. That’s more than the $10.9 billion the bank is expected to earn this year, according to the average estimate of 15 analysts surveyed by Bloomberg.

$100 Billion Shortfall

Citigroup has the smallest home-equity portfolio of the four biggest banks with $49.4 billion, according to CreditSights. About 3 percent of its second-lien mortgages were 90 days past due at the end of last year, according to a presentation on the bank’s Web site. The New York-based lender could face home-equity losses of $3.4 billion, or 12 cents a share, CreditSights said in its report.

Bank of America spokesman Scott Silvestri and Citigroup spokeswoman Natalie Riper declined to comment. Mary Berg, a Wells Fargo spokeswoman, said the bank is awaiting government data about second liens that are eligible to be modified.

Second-lien reserves set aside by the four big banks are $100 billion to $125 billion short of what’s needed in the next few years, said Joshua Rosner, an analyst at Graham Fisher & Co., an independent research firm based in New York, and co-author of a May 2007 report that said ratings companies were underestimating the risk of subprime-mortgage bonds.

“If banks were properly accounting for their second liens, there would be no problem with them choosing to do principal writedowns,” Rosner said in a phone interview. “They would already be reserved for it.”

Frank Letter

About 24 percent of homeowners own more on mortgage loans than their houses are worth, according to First American CoreLogic Inc., a San Francisco-based provider of mortgage data and analytics. Those people are increasingly likely to give up their homes to foreclosures, slashing the value of associated second-lien loans, Frank said in his March 4 letter.

“Large numbers of these second liens have no real economic value -- the first liens are well underwater and the prospect for any real return on the seconds is negligible,” Frank wrote.

The banks have been slow to take writedowns on second liens since many borrowers keep paying, even if their primary mortgage is underwater. Eighty percent of home-equity borrowers who owe more than 100 percent of the value of their homes continue to pay on time and in full, Bank of America CEO Brian T. Moynihan said at a March 10 investor conference.

‘Inappropriate Application’

The chance that banks will write off 100 percent of such loans is “minimal,” CreditSights said. That’s why the firm assumed write-offs of 40 percent of the worst loans when estimating the potential hits to bank earnings.

The Federal Deposit Insurance Corp., which oversees U.S. commercial lenders, asked banks in August to consider boosting reserves for potential losses on home-equity loans.

“Failing to properly consider the current effect of more senior liens on the collectability of an institution’s existing junior-lien loans is an inappropriate application” of accounting principles, the FDIC said in an Aug. 3 letter to banks and examiners.

Just over half of first mortgages have second-lien loans behind them, according to a Jan. 29 report by Laurie Goodman of Amherst Securities. Those loans add more than 20 percent of the value of the property to the amount owed.

Potential losses might be mitigated if regulators allow the banks to account for second-lien losses over time, avoiding a sudden hit to their balance sheets, Goodman wrote.

Mortgage Modifications

Frank’s letter and congressional hearing are part of a renewed effort by the government to get the banking industry to modify mortgages so borrowers can afford to keep their homes. Initial modifications focused on reducing required monthly interest payments without reducing the total amount owed.

The Treasury Department announced on March 26 a plan to encourage banks to modify or write down principal on second mortgages in exchange for cash incentives. The plan is tied to the Home Affordable Modification Program, which was designed to ease the burden of first mortgages. All four banks signed on to the second-lien program, which isn’t mandatory. Bank of America said April 9 it started implementing the plan, and Citigroup said the same day it would do so in late summer. JPMorgan said today it would start the program in the second quarter.

“The banks are saying that they can work through it,” Lancaster said. “Our view is that it may be bigger than they are letting on.”

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