Illustration by Dan Page
Bank shareholders have reason to be pleased. On Apr. 14, JPMorgan Chase (JPM), the first major bank to report first-quarter earnings, beat analysts' estimates with a 55% gain. The 24-company KBW Bank Index jumped 22% in the first three months of this year, more than four times the 4.9% gain of the Standard & Poor's 500-stock index. Investors have pushed up the price of financial stocks in the belief that the biggest loan losses are in the past and banks will begin to restore dividend payments and buy back shares.
Their party may be premature. Banks are sitting on a problem that won't show up in the current round of earnings reports but has the power to stall the bank rally and economic recovery as well: bad home-equity loans.
An analysis by CreditSights, a New York research firm, shows that the four biggest banks by assets—Bank of America (BAC), JPMorgan Chase, Citigroup (C), and Wells Fargo (WFC)—may need to set aside an extra $33.2 billion to cover additional losses on home-equity loans that could begin hitting their balance sheets later this year. That amount is almost equal to what analysts expect the four banks to earn in 2010.
The four companies hold $442 billion of the nation's $1.1 trillion in second-lien mortgage loans, according to Amherst Securities Group, an Austin (Tex.) firm that analyzes home loans.
JPMorgan CEO Jamie Dimon told investors earlier in the year that his bank's quarterly writedowns for home-equity lending this year "could reach $1.4 billion." While the bank wrote down $1.1 billion of home-equity loans in the first quarter, in a conference call Dimon cited "uncertainty" about the rest of 2010.
The losses mean bank earnings "are going to be very disappointing for a while," says R. Christopher Whalen, managing director of Torrance (Calif.)-based Institutional Risk Analytics. "That's bad news for people who are long financials because they bought into this momentum play, and yet the fundamentals at the banks are still deteriorating."
Bad home-equity loans are getting in the way of reworking homeowners' debts and easing the foreclosure crisis. That's because in many cases first mortgages can't be modified or written down unless junior loans are erased first. Yet 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 M. Barofsky.
Last month House Financial Services Committee Chairman Barney Frank (D-Mass.) sent a letter asking banks to recognize more losses to clear the way for mortgage modifications. "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.
That may be so, but banks have been slow to take writedowns on second liens because many borrowers keep paying even if their primary mortgage is underwater. According to Bank of America CEO Brian T. Moynihan, 80% of home-equity borrowers who owe more than 100% of the value of their homes continue to pay on time and in full. At a hearing Frank held on Apr. 13 in Washington dealing with the issue of second-lien mortgages, the four big banks said their foreclosure prevention efforts are working and discouraged plans that would force them to reduce mortgage debt for distressed homeowners.
So home-equity loans seem likely to bedevil banks, homeowners, and the economy for some time to come. "The banks are saying that they can work through it," says Baylor A. Lancaster, senior bank analyst at CreditSights. "Our view is that [the problem] may be bigger than they are letting on."
Campbell is a reporter for Bloomberg News in New York. Henry is a senior writer at Bloomberg BusinessWeek.
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