Sub-Prime Mortgage Crisis Has Spilled Over into Home Equity Loans and Lines

If 2007 is the year of the sub-prime mortgage crisis, 2008 could be the year of the home equity crisis. With the declining housing market in the US the second (and third) mortgage industry is coming under a lot of pressure. The real problem with trouble in the second and third mortgage sector is that unlike the primary mortgage business there is no well developed secondary market for home equity loans and lines. In other words, seconds and thirds are usually not securitized, but are usually held by the originating bank. That means as losses in this sector begin to mount they will not be taken by some obscure hedge fund, insurance company, or investment bank that the common man never does business with. Instead the losses will be taken by names that everyone is familiar with. Text in bold is my emphasis. From Market Watch:

Just as banks are struggling to get out from under the subprime mortgage mess, they're facing a new burden: growing delinquencies for home equity loans.

Three of the U.S.'s largest banks that reported earnings this week, Citigroup, Wells Fargo, and J.P. Morgan, said that mounting pressure on home equity loans were a major -- and growing -- problem in the fourth quarter.

J.P Morgan took a 34% cut in profit over the fourth quarter, a change it attributed at least in part to its lagging home equity products. The bank said it expects home equity chargeoffs to rise to 1.5% of total loans this quarter.

"Our consumer home equity and subprime loan portfolios performed worse than we expected," said Jamie Dimon, chief executive of J.P. Morgan, in a press release. The bank's continuing pain from subprime mortgage bets that went bad could now be coupled with the newer worry of nonperforming home equity lines of credit.

"J.P. Morgan is exiting one set of problems and write-downs in one part of the company but now must face more significant issues in the other half," Deutsche Bank analyst Mike Mayo wrote in a note to investors following Wednesday morning's conference call with J.P. Morgan management.

Likewise, Wells Fargo announced it would reserve $1.4 billion for losses in its home equity lending unit, more than half of the $2.6 billion it set aside for all loan losses. The company more than tripled the amount it would earmark for losses in the fourth quarter.

Well Fargo will also divest itself of more than $12 billion of its riskiest home equity loans, instantly cutting its $72 billion portfolio by 16%.

Wells said it was especially hard hit by rising default rates in states experiencing rapid home price depreciation such as California and Ohio.

Citigroup, too, pointed to faltering consumer loans as a major factor in the bank's decision to reserve $5.1 billion to increasing loan losses and delinquencies.

"We had losses in our U.S. consumer business, up over $4 billion, and these numbers completely overwhelmed record performance in many, many of our other large businesses," Chief Executive Vikram Pandit told analysts Tuesday.

Banks are right to be worried. Ratings agency Moody's and consumer credit reporting agency Equifax estimated last week that nearly 4.65% of fixed-rate home-equity loans were delinquent in the fourth quarter. The same data found that across the board, delinquencies on home-equity lines of credit have jumped to 2.01% from 1.07% a year earlier.

That troubling leap is coupled with the more than $58 billion in home equity loans outstanding at the end of July 2007.

Home equity loans were a popular option for many borrowers looking to capitalize on a booming housing market as a way to use home values to finance other aspects of their lifestyle.

But as housing prices have rapidly depreciated and the housing market has tanked, home equity loans are becoming increasingly delinquent. Borrowers who are already stressed by a slowing economy, rising gas prices and creeping unemployment are finding payments on home equity loans to be a lower priority.

Other banks are also hedging their risk to home equity loans, as they try to stay ahead of the curve in a tricky part of the lending industry. Washington Mutual Inc. announced last month that it would put a cap on the maximum amount 3,200 of its customers with home-equity lines of credit could ultimately borrow. If the program works, other banks may follow WaMu's lead in limiting their exposure to a faltering part of the business.

As for potential upcoming charge-offs, prime loans, too, could become a major problem in the next quarter. Government-chartered lender Freddie Mac released the results of its 24th Annual Adjustable-Rate Mortgage Survey of prime loans on Wednesday and said it found that delinquency rates for prime loans are also shooting up.

"Delinquency rates on prime ARMs have moved sharply higher over the past year, and are well above rates on prime fixed-rate loans, according to the Mortgage Bankers Association," said Frank E. Nothaft, chief economist for Freddie Mac, in a company press release. "They have reported that the serious delinquency rate on prime ARMs was 3.1 percent, compared with 0.8 percent for prime fixed-rate loans as of September 30, and with 1.1 percent on prime ARMs one year earlier."

J.P. Morgan's Dimon warned during the conference call that J.P. Morgan that although banks will continue to attempt to hedge lending risks, the housing market's direction is famously unpredictable -- making home equity loans an even bigger gamble.

"We are being a little conservative in assuming that they (home prices) are still continuing to go down in terms of reserve, and I was using a number like 5-10%," Dimon said. "But your guess is as good as our guess about future home prices."