I am back from a small summer hiatus and have more Big Bank news: They are making more money than previously forecasted due to the slow housing recovery. In July 2011, JPMorgan Chase earned $5.4 billion during the second quarter. Citigroup earned $3.3 billion. You would think this is good news to help stimulate the economy- meaning more lending. But that may not be the case as bank profits continue to soar.
Despite such good news for banks, many of them face a continuing challenge, and one federal regulators want to know more about: the potential costs associated with mortgage lending during the great credit boon. Still to be dealt with are potentially large legal bills and final settlements related to accusations that many banks acted improperly, in bundling loans into mortgage securities, and later in their foreclosure practices. But while the SEC has been pressing banks to make comprehensive disclosures about potential pitfalls, regulators have been quiet on another concern for investors: how banks are valuing their vast holdings of home equity lines of credit, or secondary liens.
A Second Lien is a type of loan with a security interest in the asset(s) that is second in ranking behind a traditional first lien. A lien is a form of security interest granted over a property (security) to secure the payment of a debt (for example a mortgage). The second lien lender will typically be required to agree contractually to subordinate its claims on the asset to the first lien secured lender. If a borrower defaults, second lien debts stand behind the first lien debt in terms of rights to collect proceeds from the debt's underlying collateral.
The SEC has been pushing banks hard on this issue. As regulators review banks’ annual reports, they are asking tough questions about how institutions are valuing their second liens. The numbers are significant. Banks held $624 billion of such loans in the first quarter, FDIC data shows. Millions of these loans are deeply troubled. According to recent statistics, almost 11 million of the nation’s mortgaged properties (which is about 23 percent of the total) were underwater at the end of March 2011. Some 4.5 million of those properties carried home equity loans- second liens.
When a first mortgage runs into trouble, second liens are at even greater peril, even if homeowners manage to keep up with their payments. That is because in a foreclosure, first mortgages are to be paid off first before second mortgages.
The Big Four Banks, JPMorgan, Citigroup, Bank of America and Wells Fargo, not only hold home equity lines (second mortgages) but also service first mortgages held by other lenders on the same properties. Some regulators worry that these servicers are able to protect their own holdings of second-lien loans while foreclosing on the first liens, since they are the same entity.
The big four are pretending that the second liens are still good because many are still performing, meaning that borrowers are making payments on the second mortgage, even 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. Most of those assets were related to housing, but write-downs on second liens have been pretty meager so far. 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 only $4.7 billion last year.
A write-down is reducing the book value of an asset because it is overvalued compared to its market value. This is then reflected in the banks’ income statement as an expense, thereby reducing its net income.
JPMorgan Chase’s exposure to second liens stood at $60 billion at the end of the second quarter. The bank wrote off $1.3 billion in the first half of 2011 and $3.44 billion in 2010. Citibank’s home equity lines of credit totaled $46 billion last March; $6.2 billion belonged to borrowers with credit scores below 660, which is risky, and consisted of loan amounts that were greater than the values of the underlying properties.
The trouble in the housing market does not appear to be reflected fully on bank balance sheets yet.
If average home prices do not stabilize and hopefully recover, then banks are likely to feel pressure to begin wholesale write-downs of first and second liens. There is probably as much loss prospectively facing the banking industry as a whole on residential real estate exposures as have already been written off.
This story will be continuing in the next several quarters.
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