Banks Could Face U.S. Home-Equity ‘Payment Shock,’ Moody’s Says

Home-equity lenders could see delinquencies rise in the next two years as borrowers face a “payment shock,” Moody’s Investors Service said.

The majority of home-equity loans were issued during the housing bubble before the 2008 financial crisis when underwriting standards were “dismal,” Moody’s said today in a report.

Those loans will reach the 10-year mark between 2015 and 2017, when borrowers who are paying only interest must start repaying principal, and some won’t be able to keep up, Moody’s said.

Home-equity loans were among the largest sources of bad debt in the Federal Reserve’s stress tests of U.S. banks conducted earlier this year, with $37.2 billion of projected losses on junior-lien and home-equity loans.

Those tests were designed to show how the biggest U.S. financial firms would fare in a severe economic shock.

“This will slow down the improvement in the banks’ non-performing levels,’’ Sean Jones, associate managing director of banking at Moody’s, said in a telephone interview.

“It’s another indicator that they will remain stubbornly high even though the economy elsewhere is slowly recovering.”

Of the 15 rated U.S. regional banks with the largest holdings of home-equity loans, 12 had portfolios greater than their tangible common equity as of March 31, according to the report.

The four biggest lenders have comparatively smaller concentrations, according to Moody’s, which said it doesn’t yet know what the costs will be to banks.

Moody’s sketched a scenario in which a homeowner with a $210,000 first-lien mortgage and $40,000 drawn from a home-equity line could face a 26% increase in monthly payments when the home-equity loan reaches the 10-year mark.

Banks should start preparing for the payment shock now by surveying clients likely to default and making modifications to reduce losses, according to the report.

A stronger housing market and higher capital levels at banks should help mitigate the risk, Moody’s said.