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Arnold: Increase Seen in Non-Performing Home Equity Loans

The bottom line is that there was a dramatic increase in non-performing home equity loans in the first quarter that rightfully should have been reflected in an increase in charge-offs during the first quarter. This would have reduced loss reserves and mandated that income be set aside to replenish them.

I'm not quite sure why this didn't happen or why the equity markets did not respond to it. The catalyst may have been when the stock price for BAC fell below $5 this past December; with a response by all of the money centers being simply to stop recognizing losses even as non-performing loans increased.

The stock prices of all four companies did indeed increase during the first quarter before pulling back during the second quarter. The pattern of shrinking balance sheets and loss reserves commensurate with increasing non-performing loans is troubling. The opposite on both counts is necessary for the banking sector to absorb losses, and that requires an expanding economy.

The principal concern for investors in the money centers is how long this process will continue before both regulators and other investors become worried and decide to act on those concerns.

At the time of publication, Arnold held a position in JPM bonds.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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