Comptroller Dugan Tells Lenders that Unprecedented Home Equity Loan Losses Show Need for Higher Reserves.

Comptroller of the Currency John C. Dugan said today that accelerating losses in the home equity business show the need to build reserves and to return to the stronger underwriting standards of past years.

Home equity loans and lines of credit grew dramatically in recent years, more than doubling, to $1.1 trillion, since 2002. In part, that’s because of the rapid appreciation in house prices, the tax deductibility feature of home equity loans, and low interest rates.

“But another contributing factor was perhaps not so obvious: liberalized underwriting standards,” Mr. Dugan said, in a speech to the Financial Services Roundtable’s Housing Policy Council. “These relaxed standards helped more people to qualify for loans, and more people to qualify for significantly larger loans.”

These relaxed standards included limited verification of a borrower’s assets, employment, or income; higher debt to equity ratios; and the use of home equity loans as “piggyback” loans that helped borrowers qualify for first mortgages with low down payments and without mortgage insurance, resulting in ever-higher cumulative loan-to-value ratios.

“I can’t stress enough how crucial reserves will be in helping the industry manage its way through this situation,” he said. “At some banks, the portion of reserves attributable to home equity loans just barely covers 2007 chargeoffs. With losses accelerating, those reserves are simply not going to be adequate, and that’s why our examiners are encouraging more robust portfolio analysis and loss reserve levels.”

In assessing loan loss reserves for home equity loans, he said, banks need to recognize that they are in uncharted territory. “New product structures, relaxed underwriting, declining home prices, potential changes in consumer behavior – all of these factors make it difficult to predict future performance of home equity loans,” he said.

Circumstances have changed fundamentally, and historical trends have little relevance in estimating credit losses. As a result, qualitative factors such as environmental analysis and changing consumer behavior clearly should be factored into the reserve calculation. Likewise, lenders should take into account the very real possibilities that unemployment or interest rates will increase from their quite low current levels.

Too Late To Stop Bank Failures

MarketWatch is reporting Bank failures to surge in coming years.

“At this point in the crisis, you can’t stop bank failures,” said Joseph Mason, associate professor of finance at Drexel University’s LeBow College of Business, who has studied past financial crises.

At least 150 banks will fail in the U.S. during the next two to three years, according to a projection by Gerard Cassidy and his colleagues at RBC Capital Markets.

If the current economic slowdown deteriorates into a recession on the scale of those from the 1980s and early 1990’s, the number of failures will be much higher this time around — probably as high as 300 of them, by RBC’s reckoning.

Cassidy and his colleagues have developed an early-warning system for spotting future trouble at banks called the Texas Ratio.

The ratio is calculated by dividing a bank’s non-performing loans, including those 90 days delinquent, by the company’s tangible equity capital plus money set aside for future loan losses. The number basically measures credit problems as a percentage of the capital a lender has available to deal with them.

Cassidy came up with the idea after covering Texas banks in the 1980s. Until the recession hit that decade, many banks in the state were considered some of the best in the country. But as problem assets climbed, that view was cruelly challenged, Cassidy recalls.

The analyst noticed that when problem assets grew to more than 100% of capital, most of the Texas banks in that precarious position ended up going under. A similar pattern occurred in the New England banking sector during the recession of the early 1990s, Cassidy said.

The FDIC had highlighted 76 banks that it considered troubled at the end of 2007. That’s up from 50 at the end of 2006, which was the lowest level for at least 25 years.

Texas Ratios from the article

  • UCBH Holdings (UCBH) Texas Ratio jump to 31% at the end of the first quarter from 4.7% in 2006, according to RBC.
  • Colonial BancGroup (CNB) Texas Ratio jumped from 1.5% in 2006 to 25% at the end of March.
  • Sterling Financial Corp. (STSA) had a Texas ratio of 1.9% in 2006. It was nearly 24% at the end of the first quarter.
  • National City Corp. (NCC) had a Texas Ratio of 40% at the end of March though the bank did raise $7 billion in new capital in April.
  • IndyMac Bancorp (IMB) has a whopping Texas Ratio of 140%

Liquidity challenged banks offer some of the highest rates on CDs. IndyMac actually tops the list on one one year CDs according to the article. The irony is that money flows to the weakest banks taking the biggest risks instead of the strongest ones taking minimal risks, all because of government guarantees. This is one of the perverse “moral hazard” effects of FDIC.

If this was up to me, I would phase FDIC out over a period of time on CDs and savings accounts, keeping it only for checking accounts for which banks would be required to have 100% reserves. If people want guarantees they can buy US treasuries. Instead of having huge numbers of failures periodically, bank failures would be very widely scattered and people would care where they put their money instead of chasing the latest deal at banks that are destined to fail.

Mike “Mish” Shedlock
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