Earnings Reports Likely to Feature More Home-Equity Losses

Many large and mid-sized regional banks with elevated exposure to home-equity loans and second liens could be facing big chargeoffs in the third-quarter following those already taken by Citigroup (NYSE: C), JPMorgan Chase (JPM) and Wells Fargo (WFC).

The Office of the Comptroller of the Currency ordered banks in June to adhere to new guidance regarding the treatment of mortgage loans where the borrower has gone through a Chapter 7 bankruptcy. Even if the loans are still performing — and bankers say most are — the OCC is requiring banks to move the loans to nonaccrual status because they pose a higher risk of default.

JPMorgan Chase and Wells announced chargeoffs of $825 million and $567 million, respectively, in their third-quarter earnings reports Friday and Citi on Monday said that it charged off $635 million.

In a research note to investors Monday, Keefe, Bruyette & Woods said that other banks at risk of elevated chargeoffs could include Bank of America (BAC), Capital One (COF), Fifth Third (FITB), First Horizon National (FHN), Huntington Bancshares (HBAN), PNC Financial (PNC), Regions Financial (RF) and TCF Financial (TCB).

Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods, says that while he expects the third-quarter chargeoffs to be manageable — and are likely a one-time event — they are catching analysts by surprise because banks gave little warning that they were coming.

"It's not a big headache, it's just another headache, and it was a subject matter that most people didn't understand so it took some explaining by the banks," he says.

Investors, too, seemed caught off guard — at least at first. JPMorgan Chase and Wells' share prices tumbled Friday even though both reported record quarterly profits, though Citi's shares climbed 5.5% Monday following its earnings announcement.

Citi said in its earnings release that "the vast majority" of the chargeoffs were related to loans that are current but had to be reclassified as a result of the new OCC rules. In a conference call with analysts, Chief Financial Officer John Gerspach said that action did not have a significant impact on net earnings because the company released reserves it was already holding against the assets.

The impact will be felt differently by each bank depending on whether they already have specific reserves set aside or high enough reserves to cover the charges, Kleinhanzl says. Still, the accounting change will add pressure to banks' net interest income because interest on such loans will stop accruing, he says. The loans will simply remain on nonaccrual status until they are repaid or potentially sold off.

On the upside, the elevated chargeoffs are likely a one-time event with most banks taking charges in the third quarter for all borrowers that have cleared Chapter 7 over a number of years, Kleinhanzl says. Going forward, quarterly chargeoffs are expected to be much smaller, tracking the number of Chapter 7 filers.

The OCC's guidance requires that banks write down even performing consumer loans to their collateral value, regardless of their delinquency status. Banks are calling the chargeoffs merely an accounting issue. On conference calls, executives have said they expect to recoup at least some of the money from borrowers because many are still making principal payments.

Doug Braunstein, JPMorgan Chase's chief financial officer, said on a conference call Friday that 97% of the borrowers were current and 85% were making principal payments.

But repayment of the debt now depends on the value of the underlying collateral, which can be dicey given the collapse — and only slight rebound so far — of property values.

Often a borrower will go through Chapter 7 to discharge medical bills in bankruptcy, but keep paying their mortgages because they want to stay in their homes, Kleinhanzl says. "If they stopped paying, the bank would have foreclosed."