Arnold: Increase Seen in Non-Performing Home Equity Loans

I have written in the recent past about the non-performing residential loans at the money centers. In this column I'll address the status of home equity loans that are held by these same institutions.

At about 24%, first trust residential loans account for the largest portion of banks' balance sheets; at about 8%, home equity loans are the fifth largest. As was the case with first trust loans, the home equity loans as a percentage of total assets is higher at the money centers at an average of about 12% at Bank of America ( BAC), Wells Fargo ( WFC) and JPMorgan ( JPM). Citibank ( C) is the only one with a lower figure of about 5%.

In the past three years, the value of home equity loans held by all banks has declined 12%, from about $670 billion to about $590 billion. More than half of these, about $300 billion worth, are concentrated in BAC, WFC, JPM and C with balances of $98 billion, $93 billion, $84 billion and $27 billion, respectively.

The value of the non-performing home equity loans in these four increased dramatically during the first quarter of this year and well above the preceding trend rate of the past three years. The value of loans being accounted for as non-performing roughly doubled at BAC, WFC, and C from the fourth quarter 2011 to the first quarter of 2012.

Non-performing loans are loans that are at least 90 days past due, are no longer accruing interest, but have not yet been charged off against loan loss reserves. At BAC, the jump was from about $2 billion to $4 billion, at WFC from about $2.2 billion to $3.5 billion and at C from $500 million to $1 billion. JPM stayed about the same at $2.2 billion.

For just one quarter, these are massive increases. Most notable, however, is the fact that during this same time there was almost no increase in the value of charged-off home equity loans. During this time frame, the total value of loans of all kinds on the balance sheets of these four money centers declined along with their loan loss reserves. Plus, the decline in loss reserves was greater than the decline in loan value.

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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