Banking regulator: Home equity losses 'unprecedented'

WASHINGTON -- Home equity loans could be the next victim of the ongoing housing turmoil, as falling home prices and lax underwriting accelerate losses, a top U.S. banking regulator said Thursday.

"As we all know, house prices did indeed decline, and in some markets quite substantially," Comptroller of the Currency John Dugan said in prepared remarks. "That significant trend, combined with the relaxed underwriting practices ... has begun to produce unprecedented rates of loss."

Dugan, whose agency oversees large national banks, said the size of the HELOC market is significantly less than that for mortgage loans, reducing banks' overall exposure. The problem, however, is that banks usually keep the home equity loan on their own balance sheet, retaining all of the credit risk.

The loss rate for home equity loans has traditionally been about 20 basis points (0.20 percentage point), Dugan said, but that figure has climbed rapidly in recent quarters. The loss rate climbed to nearly 1 percent in the final three months of 2007, and hit 1.73 percent in the first quarter of this year.

In real dollar terms, losses on all home equity loans were $2.4 billion in the first three months of 2008, compared with $273 million in the first quarter of 2007.

Dugan noted that the largest home equity lenders expect those figures to deterioriate further, through 2008 and into next year. Still, he said the relatively small size of the HELOC market suggests that the losses will mitigate the effect on banks.

"While these elevated losses, depending on their magnitude, could have a significant effect on earnings over time, with few exceptions they are not in and of themselves likely to be large enough to impair capital," Dugan said.

To deal with the situation, he continued, banks need to be more aggressive in reserving for potential losses. Calling loan loss reserves "crucial," Dugan said OCC examiners are urging the banks they oversee to be more diligent in analyzing their loan portfolios and putting aside more funds to deal with home equity losses.

"I can't stress enough how crucial reserves will be in helping the industry manage it's way through this situation," Dugan said.

Going forward, Dugan said that federal banking regulators should more closely scrutinize the way banks make home equity loans. He suggested that this new oversight may require limits on home equity loans, including those based on a borrower's stated, but not verified, income.