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.