Bank of America Corp's $80 Billion Problem

While the nation's largest banks are moving further away from the financial crisis, they're getting ever closer to a final day of reckoning, which in Bank of America's (NYSE: BAC  )  case could trigger billions of dollars in losses.

The issue stems from home equity lines of credit, or HELOCs. In the lead-up to the crisis, lenders extended revolving lines of credit to homeowners to use as they deemed fit. For those of you who care to recall, this was the financial instrument that enabled Americans to turn their homes into ATMs during the housing bubble.

The typical HELOC worked like this: A bank would approve a line of credit secured by the borrower's house, albeit in a subordinate position to the original mortgage. The borrower could then draw from the line over the next 10 years, during which they would only be responsible for paying interest on the utilized amount. After 10 years had tolled, the loan began to amortize, meaning that principal was due in monthly installments over a 15-year period.

This worked great for everyone when home prices went up. Banks boosted their balance sheets by making more loans. Homeowners were able to tap increasing reserves of cash to buy whatever fit their fancy. And the American economy headed higher thanks to the seemingly endless conversion of home equity to cash.

The problem now is that the most problematic HELOCs -- those issued in 2005 through 2007 -- are on the verge of resetting. And when they do, many of the borrowers are expected to experience payment shock. According to an estimate by Citigroup (NYSE: C  ) , for instance, the average monthly payment on its HELOC accounts will increase by 170% once the amortization period begins.

With this in mind, it's easy to see how this could serve as a major speed bump in Bank of America's recovery. At the end of last year, it had $80.3 billion in outstanding HELOC principal, 48% of which was issued at the apex of the bubble in 2006 and 2007.

To be clear, this isn't to say that Bank of America is guaranteed to lose $38.5 billion (48% of $80.3 billion) over the next few years, as roughly 70% of these loans are collateralized by homes with a combined loan-to-value ratio of 90% or better. But that still leaves $11.7 billion in 2006 and 2007 vintage HELOCs that could experience elevated losses.

Here's how Bank of America explained the threat in its latest annual report:

There are certain characteristics of the home equity portfolio that have contributed to higher losses, including those loans with a high refreshed combined loan-to-value (CLTV), loans that were originated at the peak of home prices in 2006 and 2007, and loans in geographic areas that have experienced the most significant declines in home prices. Although we have seen recent home price appreciation, home price declines since 2006 coupled with the fact that most home equity [loans] are secured by second-lien positions have significantly reduced and, in some cases, eliminated all collateral value after consideration of the first-lien position.

What's the most likely extent of the damage? While this is impossible to predict with precision, it's probably safest to assume Bank of America will be on the hook for a minimum of a few billion dollars once the amortization periods kick in. Suffice it to say, the consolation is that, by then, the bank should be in a comfortable position to absorb the losses.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 03, 2014, at 12:26 PM, AMADUMBE wrote:

    and Lawyers will find legal reasons - loopholes and sue BAC for unethical lending etc., and more legal fees followed by another huge settlement...

  • Report this Comment On April 03, 2014, at 12:47 PM, Questioner5001 wrote:

    ... and people would claim that it was the bank's fault for letting them borrow against the value of their home, so that they could pay for that new car, vacation, big screen TV, or college tuition. The media and the Administration would tell the consumers that they are clear of any responsibility for the situation and thus absolved from any blame, because the big bad banks are the cause of all of their problems, (including their kids' acne). They'll be told that they, (the consumers) were too uneducated to know what they were doing, the banks "tricked them" by enabling them to commit to documentation that had a lot of words on them, and thus the banks OWED the consumers a reduction or elimination of the debts in question.

    And so stealing from the bank shareholders' piggy bank will continue until every hedge fund, investor pool, and private investor that scrambled for every last basis point of income during the housing boom, can cynically claim that they certainly would have gone through the collapse in housing prices without experiencing any negative impact, if it wasn't for the venality of those mean banks who sold them the securities they pursued or lent them money that they wanted, which they now feel too "stressed" to pay back years later.

    Boo hoo!

  • Report this Comment On April 03, 2014, at 12:58 PM, pr93 wrote:

    Ditto,Ditto,Ditto, I couldn't have said it better myself.THANK YOU, Questioner 5001 for the best summation yet written.

  • Report this Comment On April 03, 2014, at 4:07 PM, jkahlon wrote:

    Given that interest rates are so low the vast majority should be able to refinance their primary loan to accommodate this.

    Knowing that home values have appreciated considerably would this not be a non-issue?

    There will be some who defaulted or declared bankruptcy a few years back, however that should already be reflected in the numbers. Or some who still are underwater and cannot refinance even with the appreciated values but this should not be a considerable number.

    Not sure if there really is a real issue here.

  • Report this Comment On April 03, 2014, at 9:59 PM, pmrself wrote:

    I believe BAC is not recognizing losses on First Trust Deeds timely. Many of the ARMs purchased from Countrywide are resetting. Homeowners are struggling with the new payments. BAC is not recognizing the delinquencies timely not or they foreclosing in a timely manner. Profits are under reported.

  • Report this Comment On April 04, 2014, at 5:02 AM, DebtNEUTRALITY wrote:

    Some of the comments above are silly and hysterical and don't contribute much to the story.

    How about focusing on solutions, such as...

    Homeowners who only took out 10 to 40% Home Equity value and have no mortgage, how about letting those home owners use another portion of their home equity to pay off the first home equity line?

    Example, home worth 500,000 has 125,000 dollar HELOC that is about to reset. Let the Homeowner use a separate portion of home equity from their home (since they were responsible enough to not also have a huge mortgage) to pay off the first 125,000 HELOC. This allows the HELOC to extend as an interest only payment for the next 10 years. There is virtually no risk to BOA since there is no mortgage, just a HELOC. Or, does BOA want to foreclose on these homeowners to make up for their losses elsewhere?

  • Report this Comment On April 04, 2014, at 5:05 AM, DebtNEUTRALITY wrote:

    jkahlon, the problem is such a huge deal is being made out of income verification that people who were getting by on less than the minimum requirement and paying their HELOC every month won't be able to get a new loan even if they haven't missed payments and still have a ton of equity left in their home.

  • Report this Comment On April 04, 2014, at 10:21 AM, JeffMiller47 wrote:

    During that same time frame, from 2006-2007, a very high percentage of the jumbo loans issued were 10/1 interest-only ARMs that have the same problem: they recast at the end of ten years, and the payments jump, in many cases by more than $1,000 per month. Many of the HENRYs (High-Earnings-Not-Rich-Yet) won't be able to afford it, and can't refinance out of it due to new QM and ATP rules. Expect a new round of short-sales and foreclosures to depress housing values, coming soon to a theater near you.

  • Report this Comment On April 04, 2014, at 10:04 PM, JeffMiller47 wrote:

    jkalon, it depends on the neighborhood, but here in Colorado, the recent rise in property values still hasn't caught up to where values were at the peak in many areas. Furthermore, in the jumbo market, the rules of the game have changed. In 2006-2007, one could get 100% financing, with a lower required FICO score, and with a higher debt ratio, up to 50-55%. Now, it's minimum 720 FICO, 80% LTV, and max 43% DTI. The same income, credit, equity/down pmt, and debt ratio that allowed them to get into the loan aren't sufficient to allow them to get out of the loan. When those recasts hit on 10/1 Interest Only ARMs and HELOCS, there's going to be another wave of foreclosures and short sales.

  • Report this Comment On April 05, 2014, at 6:22 PM, panamajack1 wrote:

    Why write articles like. They don't help anyone!

    If you have something concrete to report say so if it is maybe this or maybe that maybe you should keep it to yourself. When the bank goes belly up let me know. I won't be hearing from you.

  • Report this Comment On April 06, 2014, at 6:16 PM, scitracker wrote:

    I doubt those, who have paid the interest owed, every month, will be the problem. Otherwise, they would have defaulted on this debt much earlier. The issue is what will the reset rate be? I suspect the reset rate will be higher than the going rate of mortgage loans and, as such, the bank should be criticized for not pursuing a refinance that would enable the borrower to get a lower rate, a longer term, or both. As a former banker, I am always amused at how many banks would rather take a loss than work with the customer to set up a beneficial repayment plan.

  • Report this Comment On April 08, 2014, at 11:34 PM, JaneHyada wrote:

    I would love to see John Maxfield or someone else from The Motley Fool write an article on the relationship between Nationstar Mortgage and Bank of America. BofA appears to have sold off a lot of second mortgages to Nationstar. Apparently, Nationstar's CEO Jay Bray is a former Bank of America executive, along with some of their Board of Directors. Many stories on the consumer complaint websites, that Nationstar is refusing to work with homeowners through HARP. Instead they are foreclosing on the homeowners, and then turning to Freddie or Fannie to collect mortgage insurance. I wouldn't be so quick to judge BofA as blameless, when it appears they have found a creative way to take more bad debt off their books. The $80B figure may be on the low side of what the true story was and is. Chalk it up to greed. I do hope there is some serious kharma coming their way. Anyone for shorting BofA??

  • Report this Comment On April 14, 2014, at 9:30 PM, PaulsMax wrote:

    Thanks for the article John. I agree with the worries expressed by pmrself, DebtNeutrality, and JeffMiller47: I think the Countrywide portfolio will continue to haunt BAC, especially when rates on ARMs begin to rise. I was at Goldman when the Countrywide deal closed - if trees grew to the sky, then the deal would have worked out, but trees don't grow to the sky, and BAC almost went bankrupt in 2008 as a result. Despite having a very high FICO score and more-than-adequate income stream, my last refi was more painful than I thought it would be (in terms of paper-work and LTV). After 2008, it seems as if the Feds have rightfully been forcing the banks to show greater due diligence before approving loans. The ultimate result is greater-than-anticipated slowdown in mortgage originations and refinancing as rates rise (see details of JPM results). Great point by JeffMiller47 about the ARMs - this will compound BAC's difficulties.

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