Home-Equity Debt Lurks

A recent improvement in beleaguered home-equity loans has been a rare sign of encouragement for banks. But bullish investors need to remove their rose-colored glasses.

Banks have about $700 billion of home-equity loans -- in which a bank lends money to a homeowner against the equity in his house. That includes both fixed-rate loans and floating-rate debt drawn from credit lines. Lenders usually can't collect on a defaulted home-equity loan by seizing a house unless the borrower has no mortgage, since mortgage lenders have first claim.

The so-called piggyback loans are the riskiest of this home-equity debt. Most were taken out during the raging real-estate market. These loans came on top of a first mortgage, aren't backed by insurance and enabled some borrowers to buy homes without making a down payment. These loans represent more than 8% of the value of outstanding home-equity loans, according to SMR Research.

Banks have been reducing unused credit lines, especially in areas with housing problems. James Dimon, chief of J.P. Morgan Chase, which has been hurt by losses in its home-equity portfolio, recently said delinquencies could be stabilizing. "It's a little ray of sunshine that is OK to grab onto for now," he said.

Many who were caught flat-footed when these loans turned sour now assume that home-equity loan risk already is factored into bank stock prices, which have tumbled. But investors may be too upbeat once again. For one thing, the recent news isn't exactly uplifting: 2.22% of all home-equity loans were charged off by banks in the second quarter, an all-time high. That is up from 1.69% in the first quarter and 0.9% in the fourth quarter of last year. Tax refunds and government-issued stimulus checks likely are at least partly responsible for why things aren't worse.

The losses likely will remain elevated for the foreseeable future. It isn't easy to see why home-equity losses would improve until there is a true bottom for housing. Analysts at Goldman Sachs predict home-equity losses won't peak until the first quarter of next year.

For investors, it would be best to avoid lenders with heavy exposure to home-equity loans written by outside mortgage brokers and other third parties that often employ lax underwriting standards. Instead, stick with banks that made their own loans during the real-estate surge.

Using this stance, investors should use caution when it comes to First Horizon National. According to a Goldman analysis, 15% of First Horizon's home-equity loans, or 5% of all its loans, were made by outside parties. Outsider-written loans represented 22% of Fifth Third Bancorp's portfolio, or 3% of its total loans. And 14% of Wells Fargo's home loans, or 3% of total loans, were written by third parties.

These three banks also have a relatively high number of home-equity loans that are at least 90% of the value of the underlying houses, which is worrisome. Some investors also are concerned about E*Trade, which also was a big buyer of home-equity loans.

On the flip side, Comerica, Regions Financial and BB&T Corp. hold almost no loans made by outsiders, which is a good sign.

By: Gregory Zuckerman
Wall Street Journal; August 1, 2008