Some economists are warning that banks and mortgage lenders need to increase their loan-loss reserves to prepare for a potential downturn in the residential real estate market.

Banks have set aside very little to guard against unpaid loans during the housing boom. Loan losses are low now because anyone falling behind on payments can simply sell, pay off the loan and pocket the home equity. As a result, the reserve pools banks set aside are lower too.

But many banks have portfolios with a mix of riskier loan products that haven't been tested during a housing market downturn.

"There's no question that the extension of credit to borrowers has increased substantially, so you could expect that delinquencies and foreclosure rates will be higher," said Doug Duncan, senior vice president and chief economist at the Mortgage Banker's Association. "The question is whether the loans are appropriately priced and we won't know that until those loans go through an interest-rate cycle and the normal life cycle."

Southern California's largest home lenders, including Bank of America Corp., Wells Fargo & Co., Countrywide Financial Corp., Washington Mutual Inc. and Union Bank of California, have loan-loss rates near historic lows. Virtually all of them have beefed up their underwriting practices since the last real estate downturn in 1992 to 1994.

"We continue to see very low losses in our wholesale portfolios, and consumer losses remained below long-term average rates," said Wells Fargo Chief Credit Officer Dave Munio, who attributed low loan-loss reserves to "sound underwriting and collections practices" supported by a good economy.

Wells' outstanding loan portfolio rose 12 percent in the second quarter, to $300 billion, with home equity loans accounting for $56 billion of the total. The bank's provision for loan losses fell 4 percent in the second quarter, to $3.7 billion.

John Rice, senior vice president and manager of investor relations at Union Bank of California, said 97 percent of the bank's $11 billion residential mortgage portfolio is in California, but the bank (the operating unit of San Francisco's Unionbancal Corp.) has stringent underwriting standards.

"Credit quality is a cyclical thing and the collective perception in the banking industry is that it can't get a whole lot better than it is now," he said.

Bank of America, based in Charlotte, N.C., reduced the amount set aside for loan-loss and lease-loss reserves to 1.57 percent of loans outstanding as of June 30, down from 1.76 percent a year earlier.

But Keith Leggett, senior economist at the American Bankers Association, said most bankers realize that they're probably nearing the end of the current credit cycle. "Things have been good over the last couple of years, so you automatically have to start anticipating that losses will rise," he said. "So they have to evaluate more closely the value of loans in their portfolios."

Mortgage lenders have increased their earnings by loading up on nonconforming loans. Beefing up loan-loss reserves now would crimp those earnings and send a signal to investors that bigger losses may be in store.

In the first quarter of 2005, the use of so-called Alt-A products rose to 40 percent of the entire mortgage-lending landscape, with nearly three-fourths of all prime lenders offering products similar to those of subprime lenders.

Subprime lenders focus on borrowers with bad credit or no credit histories. Alt-A mortgages are primarily first-lien mortgages made to small-business owners, retirees or self-employed homebuyers who do not document their income sources but have solid credit histories.

Many baby boomers who want to purchase second homes also fall in this category if they do not qualify for a prime loan.

Loans with the highest likelihood of default usually are made to borrowers with poor credit histories. Such loans often have negative amortization or are option ARMs, which entice borrowers with low initial monthly payments. The problem is that those payments ratchet up sharply as interest rates rise.

A recent study by international consulting firm Mercer Oliver Wyman found that nonconforming and home-equity loans now generate 85 percent of industry profits. The non-conforming loan market has been hugely profitable for banks, which pocketed upwards of $32 billion in profits in 2003, the study found. (The study excluded profits made by government-backed Fannie Mae, Freddie Mac and secondary mortgaged-based securities markets.)

"When you look at the new loans that are made in California in the past year, 60 percent are adjustable-rate mortgages and low-documentation loans," said David Lareah, chief economist of the National Association of Realtors. "Hopefully, banks are increasing their loan-loss reserves and if they haven't, they're going to take some hits."

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