What Lurks on the Books of Banks

At first glance, banks seem to be recovering nicely from the financial crisis. But investors cheered by optimistic earnings reports could soon face a painful surprise.

Many banks appear to be postponing inevitable losses on home-equity loans and commercial mortgages. Others face new trouble in consumer banking, especially credit cards. "Banks know they've got big holes on their balance sheets," says Paul Miller, an analyst for FBR Capital Markets.

The hopeful news is that overall bank industry earnings tripled, to $2.8 billion in the third quarter, compared with the disastrous three-month period a year earlier. But plenty of pitfalls remain, and more grief is certain if the economy takes a turn for the worse.

Consider home-equity lines of credit. During the real estate boom, many homeowners borrowed against the value of their dwellings to pay down credit-card balances, buy new cars, or even cover down payments on the very houses that anchored the loans. With property values down sharply in most markets, a lot of those loans now look shaky. Already, payments on $21 billion in credit lines are past due.

The full extent of the problem hasn't shown up yet on the books of some banks. Lenders generally don't write down questionable home-equity loans until after a borrower has stopped making payments. So far, just 2.94% of home-equity loans have defaulted, vs. 5.96% of traditional mortgages, according to real estate data company First American CoreLogic. Industry analysts predict the percentage of home-equity defaults will rise significantly.

When home-equity loans sour, the damage to banks tends to be greater than losses on traditional first mortgages. That's because home-equity lenders stand in line behind first-mortgage lenders when a foreclosure occurs. The bank holding the first mortgage has claim to the underlying property and often sells it to recoup some money. Home-equity lenders must fight for any remaining scraps. Recovery rates on home-equity lines that have gone bad averaged about 40% during the boom; mortgage-servicer Clayton Holdings says the figure now hovers near zero.

Many banks are reluctant to write down the value of their home-equity loans because that could force them to raise more capital, further denting profits. Problems with home-equity lines and other residential loans in Florida alone could shrink financial reserves at Atlanta-based SunTrust Bank by $745 million to nearly $1 billion over the next several quarters, ultimately hurting profits, according to Gradient Analytics, a research firm that serves hedge funds and other investors. SunTrust declined to comment.

Home-equity loans aren't the only weak spot in consumer lending. A number of big banks are increasingly dependent on fees, a source of profits that may soon diminish. Wells Fargo has collected $27.2 billion in credit-card and other fees so far this year, roughly 38% of its total income. Bank of America (BAC) has had a 28% increase in card fees since 2007. Meanwhile, interest income at both lenders has fallen.

Fees probably will become more difficult to collect next year. Under federal rules taking effect in February, lenders won't be allowed to charge card customers for exceeding credit limits or missing a single payment. And in November the Fed banned programs that charge automatically for "overdraft protection" tied to deposit accounts. Instead, lenders now must get customers' permission to cover bounced checks. Changes to overdraft policies could cost Bank of America $200 million a quarter, according to BofA. The figure could hit $300 million at Wells Fargo.

Spokesmen for the banks play down the potential peril related to dependence on fees. Much of the increased reliance on fees at Wells Fargo occurred as a result of its acquisition of Wachovia, which was completed in January 2009, says a spokeswoman. A large portion of the bank's fee income comes from its brokerage and mortgage banking units. At BofA, fee income swelled largely because of the acquisition of four smaller lenders since 2007, says spokesman Scott Silvestri. Demand for loans lagged during the past year, causing fees to grow as a proportion of the bank's revenue and income, he adds.

In response to these challenges, many credit-card companies have hiked interest rates—to as high as 30% in some cases. But the new federal rules will also make it harder to raise rates further without borrowers' agreement.

Commercial real estate presents another potential hazard. Prices have dropped 39% since the market peak in October 2007, according to the Moody's/REAL Commercial Property Price Index. Banks own some $1.8 trillion of commercial real estate loans. In many instances, the outstanding debt exceeds the property's value. Some borrowers are simply walking away, leaving lenders to take a nasty hit.

Trying to forestall disaster, some lenders are granting temporary extensions on commercial loan payments. The strategy has become so common that industry players now refer to it as "extend and pretend." In May, MGM Mirage got extensions on $5 billion in credit until 2011, which allowed the Las Vegas casino to finish its new CityCenter project. MGM Mirage didn't respond to requests for comment.

"HOPE IS NOT A STRATEGY"

Some analysts fear that a number of banks are cutting desperate deals with property owners unlikely to repay. "If you're reissuing loans when it's clear the borrower can't pay, that's just disingenuous," says Rachel Barnard, managing partner of Midway Capital Research & Management, a Chicago investment firm. Recent moves by the government may have encouraged the banks' dubious conduct. In late October, federal regulators said that banks don't necessarily have to write down commercial loans when the underlying properties lose a big chunk of their value. That leeway may give some banks an excuse to adjust loan values in inappropriate ways, according to industry analysts.

Dean DeBuck, a spokesman for the U.S. Office of the Comptroller of the Currency, which regulates national banks, says the guidance was intended to ensure consistent reporting and doesn't allow extend-and-pretend maneuvers. Still, says David Iannarone, president of CWCapital Asset Management: "Hope is not a strategy."

With Christopher Palmeri and Mara Der Hovanesian

Silver-Greenberg is a reporter for BusinessWeek.com. Francis is a correspondent in BusinessWeek's Washington bureau.